oversight

Financial Audit: IRS' Fiscal Year 1998 Financial Statements

Published by the Government Accountability Office on 1999-03-01.

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

                 United States General Accounting Office

GAO              Report to the Secretary of the Treasury




March 1999
                 FINANCIAL AUDIT
                 IRS’ Fiscal Year 1998
                 Financial Statements




GAO/AIMD-99-75
      United States
GAO   General Accounting Office
      Washington, D.C. 20548

      Comptroller General
      of the United States

      B-281967

      March 1, 1999

      The Honorable Robert E. Rubin
      The Secretary of the Treasury

      Dear Mr. Secretary:

      This report presents the results of our audit of the principal financial
      statements of the Internal Revenue Service (IRS) for the fiscal year ending
      September 30, 1998, which we performed in accordance with the Chief
      Financial Officer’s Act of 1990, as expanded by the Government
      Management Reform Act of 1994. It contains our (1) opinions on IRS’
      balance sheet and statement of custodial activity, (2) disclaimers of
      opinion on IRS’ statement of net cost, statement of changes in net position,
      statement of budgetary resources, and statement of financing, (3) opinion
      on IRS management’s assertion about the effectiveness of its internal
      controls, and (4) conclusions on IRS’ compliance with significant
      provisions of laws and regulations we tested and on whether its financial
      management systems comply with the requirements of the Federal
      Financial Management Improvement Act of 1996.

      This report also discusses significant matters that we considered in
      performing our audit and in forming our conclusions, including identified
      weaknesses in IRS’ internal controls, noncompliance with laws and
      regulations and the requirements of the Federal Financial Management
      Improvement Act of 1996, and other matters that should be brought to the
      attention of IRS management and users of IRS’ principal financial
      statements and other reported IRS financial information. We will be
      separately reporting in more detail and recommending corrective actions
      to address the weaknesses in IRS’ internal controls and compliance with
      laws and regulations issues discussed in this report.

      We are sending copies of this report to the Chairmen and Ranking
      Minority Members of the Senate Committee on Appropriations; Senate
      Committee on Finance; Senate Committee on Governmental Affairs;
      Senate Committee on the Budget; Subcommittee on Treasury, General
      Government, and Civil Service, Senate Committee on Appropriations;
      Subcommittee on Taxation and IRS Oversight, Senate Committee on
      Finance; Subcommittee on Oversight of Government Management,
      Restructuring, and the District of Columbia, Senate Committee on
      Governmental Affairs; House Committee on Appropriations; House
      Committee on Ways and Means; House Committee on Government




      Page 1                     GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
B-281967




Reform; House Committee on the Budget; Subcommittee on Government
Management, Information, and Technology, House Committee on
Government Reform; Subcommittee on Oversight, House Committee on
Ways and Means; and Subcommittee on Treasury, Postal Service, and
General Government, House Committee on Appropriations. We are also
sending copies of this report to the Chairmen and Vice Chairmen of the
Special Committee on the Year 2000 Technology Problem and Joint
Committee on Taxation, the Commissioner of the Internal Revenue
Service, the Director of the Office of Management and Budget, and other
interested parties. Copies will be made available to others upon request.

If I can be of further assistance, please call me at (202) 512-5500. This
report was prepared under the direction of Gregory D. Kutz, Associate
Director, Governmentwide Accounting and Financial Management Issues,
Accounting and Information Management Division, who can be reached at
(202) 512-3406.

Sincerely yours,




David M. Walker
Comptroller General
of the United States




Page 2                    GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Page 3   GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Contents



Letter                                                                                                  1


Opinion Letter                                                                                          6


Principal Financial                                                                                    38
                         Balance Sheet                                                                 38
Statements               Statement of Net Cost                                                         39
                         Statement of Changes in Net Position                                          40
                         Statement of Budgetary Resources                                              41
                         Statement of Financing                                                        42
                         Statement of Custodial Activity                                               43
                         Notes to Financial Statements                                                 44


Supplemental and                                                                                       51
                         Supplemental Financial Information - Unaudited                                51
Other Accompanying       Other Accompanying Information - Unaudited                                    53
Information
Management                                                                                             55
Discussion and
Analysis
Appendix I                                                                                             83
Provisions of Internal
Revenue Code Tested
for the Fiscal Year
1998 Audit
Appendix II                                                                                            84
Comments From the
Internal Revenue
Service




                         Page 4                   GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Contents




Abbreviations

BPD        Bureau of the Public Debt
CFO        Chief Financial Officer
EITC       Earned Income Tax Credit
FASAB      Federal Accounting Standards Advisory Board
FFMIA      Federal Financial Management Improvement Act of 1996
FFMSR      Federal Financial Management Systems Requirements
FIA        Financial Integrity Act
FMS        Financial Management Service
GPRA       Government Performance and Results Act
HI         Hospital Insurance Trust Fund
IRS        Internal Revenue Service
JFMIP      Joint Financial Management Improvement Program
MD&A       management discussion and analysis
OMB        Office of Management and Budget
OTA        Office of Tax Analysis
P&E        property and equipment
SFFAS      Statement of Federal Financial Accounting Standards
SGL        U.S. Government Standard General Ledger
SMI        Supplemental Medical Insurance Trust Fund
SSA        Social Security Administration


Page 5                  GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
      United States
GAO   General Accounting Office
      Washington, D.C. 20548

      Comptroller General
      of the United States

      B-281967

      To the Commissioner of Internal Revenue

      In accordance with the Chief Financial Officers’ Act of 1990, as expanded
      by the Government Management Reform Act of 1994, this report presents
      the results of our audit of the principal financial statements of the Internal
      Revenue Service (IRS) for fiscal year 1998. The principal financial
      statements report the assets, liabilities, net position, net costs, changes in
      net position, budgetary resources, reconciliation of net costs to budgetary
      obligations, and custodial activity related to IRS’ administration of its
      responsibilities for implementing federal tax legislation, which include
      collecting federal tax revenues, refunding overpayments of taxes, and
      pursuing collection of amounts owed.

      During fiscal year 1998, IRS combined the financial reporting of its
      administrative1 and custodial activities, which had previously been
      reported and audited separately, into a single set of principal financial
      statements.2 This required IRS to include both administrative and custodial
      activities on its balance sheet. Also, IRS has presented four principal
      financial statements which were required for the first time for fiscal year
      1998: the (1) statement of net cost, (2) statement of changes in net
      position, (3) statement of budgetary resources, and (4) statement of
      financing. As a result of these changes, comparison of IRS’ fiscal year 1998
      principal financial statements with the fiscal year 1997 financial
      statements would not be meaningful. Accordingly, these financial
      statements reflect financial information as of and for the fiscal year ended
      September 30, 1998, only.

      IRS continues to face significant financial and other management
      challenges and risks. Although focusing primarily on financial
      management and federal taxes receivable and other unpaid assessments,
      this report alerts readers to other significant issues facing IRS including tax
      systems modernization, filing fraud, information systems security, and the
      Year 2000 computer problem.3 We reported on these issues in

      1
       IRS’ administrative activities include managing costs funded by appropriations and reimbursements
      from other federal agencies, state and local governments, and the public.
      2
       The fiscal year 1997 results of IRS’ administrative activities were audited by the Department of the
      Treasury Office of Inspector General. See Internal Revenue Service Accountability Report, Fiscal Year
      1997, Department of the Treasury (March 1998).
      3
       The Year 2000 problem is rooted in the way dates are recorded and computed in automated
      information systems. For the past several decades, systems have used two digits to represent the year,
      such as “99” representing 1999, to conserve on electronic data storage and reduce costs. With this two
      digit format, however, the Year 2000 is indistinguishable from 1900, or 2001, from 1901, etc. As a result,
      system or application programs that use dates to perform calculations, comparisons, or sorting may
      generate incorrect results or, worse, not function at all.



      Page 6                               GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
    B-281967




    January 1999 in our high-risk series update and a report on major
    management challenges and program risks facing the Department of the
    Treasury.4 We realize that IRS’ ability to successfully meet the financial
    management challenges it faces must be balanced with the competing
    demands placed on its resources by its customer service and tax law
    compliance responsibilities. However, it is critical that IRS rise to the
    challenges posed by these financial management issues, because IRS’
    success in achieving all aspects of its strategic objectives depends in part
    upon reliable financial management information and effective internal
    controls. It is also important to recognize that several of the financial
    management issues raised in this report directly or indirectly affect IRS’
    ability to meet its customer service and tax law responsibilities.

    In summary, pervasive weaknesses in the design and operation of IRS’
    financial management systems, accounting procedures, documentation,
    recordkeeping, and internal controls, including computer security
    controls, prevented IRS from reliably reporting on the results of its
    administrative activities. IRS was able to reliably report on the results of its
    custodial activities for fiscal year 1998, including tax revenue received, tax
    refunds disbursed, and taxes receivable due from the public. However, this
    achievement required extensive, costly, and time-consuming ad hoc
    procedures to overcome pervasive and long-standing internal control and
    systems weaknesses. IRS’ major accounting, reporting, and internal control
    deficiencies include:

•   an inadequate financial reporting process that resulted in IRS’ inability to
    reliably prepare several of the required principal financial statements,
•   the lack of a subsidiary ledger to properly manage unpaid assessments,
    which has resulted in both taxpayer burden and lost revenue to the
    government,
•   deficiencies in preventive controls over tax refunds that have permitted
    the disbursement of millions of dollars of fraudulent refunds,
•   a failure to reconcile its fund balance to Treasury records during fiscal
    year 1998,
•   the inability to properly safeguard or reliably report its property and
    equipment,
•   vulnerabilities in computer security that may allow unauthorized
    individuals to access, alter, or abuse proprietary IRS programs and data,
    and taxpayer information,



    4
     See High-Risk Series: An Update (GAO/HR-99-1, January 1999) and Major Management Challenges and
    Program Risks: Department of the Treasury (GAO/OCG-99-14, January 1999).



    Page 7                           GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                            B-281967




                        •   vulnerabilities in controls over tax receipts and taxpayer data that
                            increase the government’s and the taxpayers’ risk of loss or inappropriate
                            disclosure of sensitive taxpayer data, and
                        •   an inability to provide assurance that its budgetary resources are being
                            properly accounted for, reported, and controlled.

                            These weaknesses, as they relate to IRS’ administrative activities,
                            prevented us from rendering an unqualified opinion on five of IRS’ six
                            principal financial statements. With respect to IRS’ custodial activities, we
                            were able, through extensive audit procedures, to verify that the reported
                            balances were reliable. However, the substantial deficiencies we identified
                            in our audit represent serious agencywide financial and other management
                            challenges that will require a substantial commitment of resources, time,
                            effort, and expertise to correct. IRS has acknowledged these weaknesses
                            and has plans in place or under development to address these challenges.
                            We will follow up in future audits to assess the effectiveness of these plans
                            in resolving these issues.


                            Our opinion on the statement of custodial activity is unqualified. The
Opinions on Principal       statement of custodial activity and accompanying notes present fairly, in
Financial Statements        all material respects, in conformity with federal accounting standards as
                            described in note 1, IRS’ fiscal year 1998 custodial activities. The basis of
                            accounting described in note 1 is a comprehensive basis of accounting
                            other than generally accepted accounting principles.

                            Our opinion on the balance sheet is qualified. Except for (1) the limitations
                            on the scope of our work resulting from insufficient evidence about the
                            reliability of the fund balance with Treasury and accounts payable, and the
                            resulting effect on net position, and (2) evidence that leads us to conclude
                            that property and equipment is likely to be materially understated, the
                            balance sheet and accompanying notes present fairly, in all material
                            respects, in conformity with federal accounting standards as described in
                            note 1, IRS’ assets and liabilities as of September 30, 1998.

                            We are unable to render an opinion on the statement of net cost, statement
                            of changes in net position, statement of budgetary resources, or statement
                            of financing because of limitations on the scope of our work resulting
                            from the balance sheet issues described in the previous paragraph, and
                            insufficient evidence about nonpayroll expenses and budgetary balances.




                            Page 8                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                          B-281967




                          We evaluated IRS management’s assertion about the effectiveness of its
Opinion on                internal controls designed to provide reasonable assurance that the
Management’s              following objectives are met:
Assertion About the
                      •   Reliability of financial reporting - transactions are properly recorded,
Effectiveness of          processed, and summarized to permit the preparation of principal
Internal Controls         financial statements in accordance with federal accounting standards and
                          safeguarding of assets against loss from unauthorized acquisition, use, and
                          disposition.
                      •   Compliance with applicable laws and regulations - transactions are
                          executed in accordance with laws governing the use of budget authority
                          and with other laws and regulations that could have a direct and material
                          effect on the principal financial statements and any other applicable laws,
                          regulations, and governmentwide policies identified by the Office of
                          Management and Budget (OMB) in Bulletin 98-08,5 Appendix C, as
                          applicable.

                          IRS management asserted that, due to the material weaknesses in internal
                          controls presented in the agency’s fiscal year 1998 Federal Managers’
                          Financial Integrity Act (FIA) annual assurance statements to Treasury on
                          compliance with relevant internal control and accounting standards,
                          internal controls provided qualified assurance that misstatements, losses,
                          or noncompliance material in relation to the principal financial statements
                          would be prevented or detected on a timely basis.

                          Management made this assertion based on criteria under FIA and the OMB
                          Circular A-123, Management Accountability and Control. Our internal
                          control work would not necessarily disclose material weaknesses not
                          reported by IRS. However, due to material weaknesses in its financial
                          accounting, reporting, and safeguarding controls, which were also cited by
                          IRS in its fiscal year 1998 FIA assurance statements to Treasury, IRS cannot
                          provide reasonable assurance that (1) government assets, taxpayer funds,
                          and confidential taxpayer information are appropriately safeguarded,
                          (2) laws and regulations material to the principal financial statements are
                          complied with, and (3) financial or budgetary information reported by IRS
                          is accurate, timely, and meaningful to users. Consequently, we found that
                          IRS’ internal controls were not effective in satisfying the above objectives.




                          5
                           Audit Requirements for Federal Financial Statements, August 24, 1998.



                          Page 9                             GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                           B-281967




                           Our tests of compliance with selected provisions of laws and regulations
Compliance With            disclosed one instance of noncompliance with laws and regulations which
Laws and Regulations       we consider to be reportable under generally accepted government
and the Requirements       auditing standards and OMB Bulletin 98-08. This concerns IRS’
                           noncompliance with a provision of the Internal Revenue Code concerning
of FFMIA                   the use of installment agreements to collect delinquent taxes. Also, due to
                           the limitations on the scope of our work discussed above, we were unable
                           to test compliance with the Anti-Deficiency Act, as amended.6 We also
                           concluded that IRS’ financial management systems do not substantially
                           comply with the following requirements of the Federal Financial
                           Management Improvement Act of 1996 (FFMIA), which is reportable under
                           OMB Bulletin 98-08:


                       •   Federal Financial Management Systems Requirements;
                       •   applicable federal accounting standards; and
                       •   the U.S. Government Standard General Ledger at the transaction level.

                           In its fiscal year 1998 FIA assurance statement to the Treasury, IRS also
                           concluded that its financial management systems do not comply with
                           FFMIA. The objective of our audit was not to provide an opinion on overall
                           compliance with laws, regulations, and requirements tested. Accordingly,
                           we do not express such an opinion.


                           During our audit of IRS’ fiscal year 1998 principal financial statements, we
Material Weaknesses        identified six material weaknesses7 in internal controls that may adversely
                           affect any decision by IRS’ management which is based, in whole or in part,
                           on information that is inaccurate because of these deficiencies. We were
                           unable to obtain, through substantive audit procedures, reasonable
                           assurance that IRS’ fund balance with Treasury, accounts payable, net
                           position, nonpayroll expenses and budgetary balances were reliable. In
                           addition, we found evidence that leads us to conclude that property and

                           6
                            The Anti-Deficiency Act, as amended (31 U.S.C. § 1341), prohibits officers and employees of the
                           Federal government from (1) making or authorizing an expenditure or obligation exceeding an amount
                           in an appropriation or fund for the expenditure or obligation, or (2) involving the Federal government
                           in a contract or obligation for the payment of money before an appropriation is made unless
                           authorized by law.
                           7
                            A material weakness is a reportable condition in which the design or operation of the internal control
                           elements does not reduce to a relatively low level the risk that errors, fraud, or noncompliance in
                           amounts that would be material in relation to the principal financial statements being audited may
                           occur and not be detected within a timely period by employees in the normal course of performing
                           their assigned functions. Reportable conditions are matters coming to our attention that, in our
                           judgment, should be communicated because they represent significant deficiencies in the design or
                           operation of internal control that could adversely affect IRS’ ability to meet the objectives described in
                           this report.



                           Page 10                              GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
    B-281967




    equipment is likely materially understated. Unaudited financial
    information reported by IRS, including budget and performance
    information, may also contain misstatements resulting from these
    deficiencies. In addition, some of these material weaknesses have allowed
    inappropriate refund payments and errors in taxpayer accounts, resulting
    in increased taxpayer burden. These material weaknesses relate to IRS’

•   financial reporting process,
•   supporting subsidiary ledger and documentation for unpaid assessments,
•   controls over refunds,
•   controls over fund balance with Treasury,
•   controls over property and equipment, and
•   computer security.

    In our report on IRS’ fiscal year 1997 custodial financial statements,8 we
    reported a material weakness in IRS’ revenue accounting and reporting
    because of its inability to (1) separately report Social Security, Hospital
    Insurance,9 and individual income taxes collected on its statement of
    custodial activity for fiscal year 1997 as required by OMB’s form and
    content of governmentwide financial statements,10 and (2) determine the
    amount of excise tax revenue it collected for the relevant trust funds. We
    also noted that effective for fiscal year 1998, federal accounting standards
    would require IRS to separately report Social Security, Hospital Insurance,
    and individual income taxes. However, during fiscal year 1998, the Federal
    Accounting Standards Advisory Board (FASAB)11 provided clarification on
    the federal accounting standards requirement and OMB provided
    clarification noting that agencies are allowed flexibility in the
    classification of tax revenues on the statement of custodial activity. IRS’
    presentation of federal tax revenues on its fiscal year 1998 statement of
    custodial activity is consistent with federal accounting standards and OMB
    reporting requirements. Accordingly, we no longer consider this issue to
    be a material weakness since it does not materially affect IRS’ principal

    8
     See Financial Audit: Examination of IRS’ Fiscal Year 1997 Custodial Financial Statements
    (GAO/AIMD-98-77, February 26, 1998).
    9
     The Hospital Insurance Trust Fund (HI) is one of two trust funds comprising the accumulated funds
    of the Medicare program. The other Medicare trust fund is the Supplemental Medical Insurance Trust
    Fund (SMI). Of these trust funds, only HI receives distributions from the Treasury’s general revenue
    fund.
    10
     OMB’s Formats and Instructions for the Form and Content of the Financial Statements of the U.S.
    Government (September 2, 1997).
    11
     FASAB considers and recommends accounting standards and principles for the Federal government
    considering the financial and budgetary information needs of congressional oversight groups,
    executive agencies, and the needs of other users of federal financial information.



    Page 11                             GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                               B-281967




                               financial statements. However, we still consider this limitation to be a
                               reportable condition as discussed later in this report.


IRS’ Financial Reporting       IRS does not have internal controls over its financial reporting process
Controls Are Inadequate        adequate to provide reasonable assurance that its principal financial
                               statements are fairly presented. As a result, IRS (1) was unable to prepare
                               reliable statements of net cost, changes in net position, budgetary
                               resources, and financing, and (2) could not support material amounts
                               reported on its balance sheet, including fund balance with Treasury,
                               accounts payable, and net position. In addition, we found evidence that
                               leads us to conclude that property and equipment is likely materially
                               understated. These weaknesses also left IRS reliant on extensive and labor
                               intensive compensating ad hoc procedures to enable it to report reliable
                               revenue and refund balances on its statement of custodial activities, and
                               reliable tax refunds payable, taxes receivable and the corresponding
                               liability to Treasury amounts on its balance sheet. We found that

                           •   the custodial and administrative general ledger systems which support the
                               principal financial statements are not in conformance with the U.S.
                               Government Standard General Ledger (SGL)12 at the transaction level and
                               do not provide a complete audit trail for recorded transactions,
                           •   material balances reported on IRS’ principal financial statements are not
                               supported by detailed subsidiary records, and
                           •   IRS’ principal financial statements are not subject to management oversight
                               adequate to provide reasonable assurance that significant errors and
                               omissions are identified and corrected before they are issued.

                               During our audit of IRS’ fiscal year 1997 custodial financial statements,13 we
                               reported that IRS’ general ledger system for its custodial activities was not
                               able to routinely generate the information on custodial assets and
                               liabilities needed to prepare principal financial statements, and did not use
                               the standard federal accounting classification structure or provide a
                               complete audit trail. During fiscal year 1998, these problems continued. IRS
                               was again unable to rely on its custodial general ledger to support related
                               amounts on the principal financial statements.

                               We also found problems that affected IRS’ administrative general ledger.
                               IRS’ general ledger for its administrative activities does utilize the SGL


                               12
                                The SGL establishes the general ledger account structure for federal agencies as well as the rules for
                               agencies to follow in recording financial events.
                               13
                                 See GAO/AIMD-98-77, February 26, 1998.



                               Page 12                             GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
B-281967




account structure. However, it does not conform to the SGL at the
transaction level since it does not provide an adequate audit trail for
significant administrative activities including property and equipment,
accounts payable, nonpayroll expenses, and undelivered orders. For
example, IRS’ property and equipment system does not interface with its
general ledger system. Also, IRS initially records property and equipment
purchases in its operating expense account, and at year-end posts entries
to record the purchases in the property and equipment general ledger
account. Our testing of nonpayroll operating expenses revealed that
property and equipment purchases were inappropriately included as
operating expenses.

Implementation of the SGL is required by the Core Financial System
Requirements of the Joint Financial Management Improvement Program,14
and OMB Circular A-127. FFMIA also requires financial systems that
implement the SGL at the transaction level. Because of the problems
discussed above, IRS’ general ledgers do not comply with these
requirements. In addition, IRS does not consistently capture costs to permit
it to routinely prepare reliable cost-based performance measures for
inclusion in its management discussion and analysis which accompanies
its principal financial statements, or to prepare the information to be
included in its annual performance plan as required by the Government
Performance and Results Act (GPRA) of 1993.

Also, IRS does not have a detailed subsidiary ledger for undelivered orders,
taxes receivable or accounts payable. For example, IRS relies upon a
detailed transaction history to support its balance for accounts payable.
However, this transaction history includes all transactions which have
been recorded in accounts payable, including amounts that have since
been paid and are therefore no longer payables. As a result, IRS cannot
readily determine the basis for the reported total nor determine the basis
for the total amount owed to each of its creditors. In addition, the detailed
history for nonpayroll expenses included transactions which were not
valid current year expenses, such as property and equipment and prior
year expenses. As a result, we were unable to verify that total nonpayroll
expenses were reliable.

In an effort to overcome these pervasive deficiencies, IRS employs a costly,
labor intensive and time-consuming process involving extensive and

14
 The Joint Financial Management Improvement Program (JFMIP) is a cooperative undertaking of the
Office of Management and Budget, the Department of the Treasury, the Office of Personnel
Management, and GAO, working in cooperation with each other and with operating agencies to
improve financial management practices.



Page 13                           GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
B-281967




complex analysis and ad hoc procedures to assist in preparing its principal
financial statements. IRS continues to utilize specialized computer
programs to extract information from data bases underlying the
administrative and custodial general ledgers to derive and/or support
amounts to be reported in the principal financial statements. For example,
IRS must use this process to identify the portion of its unpaid assessments
that represent taxes receivable for financial reporting purposes. However,
similar to fiscal year 1997, the amounts produced by this approach needed
material audit adjustments to produce reliable financial statement
balances. With respect to IRS’ administrative activities, this approach was
unsuccessful in producing reliable balances.

In addition, IRS’ basic approach was designed specifically for the narrowly
defined purpose of preparing auditable balances at year end only. This
mechanism is not capable of producing reliable agencywide principal
financial statements or financial performance information to measure
results throughout the year as a management tool, which is standard
practice in private industry and some federal entities. Also, for custodial
activities, even the successful application of this approach at year-end
requires extensive technical knowledge of IRS’ master files—its data base
of taxpayer information—which is possessed by only a limited number of
key individuals. Should these individuals become unavailable for any
reason, this approach could cease to be a viable option, and IRS will be
forced to rely on a financial reporting process which, in the absence of
such specialized expertise, cannot generate reliable custodial balances.
Also, IRS’ previously separate financial reporting processes for its custodial
and administrative activities, respectively, have not been integrated under
unified supervision at the operational level. This unnecessarily
complicates IRS’ year-end financial reporting process and hampers efforts
to provide interim IRS-wide financial information as a management tool.

IRS’ complex and often manual financial reporting process requires
extensive technical computer and accounting expertise, and is highly
vulnerable to human error. It is therefore critical that this process be
adequately staffed and supervised, and be subject to adequate
management oversight at each stage as balances and disclosures are
developed. Similarly, the final financial statements should be carefully
reviewed by senior IRS management prior to public issuance to ensure they
are in accordance with all applicable standards and meet the objectives of
management.




Page 14                    GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                           B-281967




                           However, we found that IRS’ financial reporting process often lacked these
                           basic controls. For example, during fiscal year 1998, key personnel with
                           responsibilities for financial systems and reporting on IRS’ administrative
                           activities left IRS and had not been replaced by year-end. Consequently, IRS
                           was compelled to attempt to prepare its financial statements without the
                           necessary staff. These problems were compounded by the implementation
                           of new federal accounting and reporting requirements which required IRS
                           to prepare four new financial statements. In addition, throughout the
                           process, we found numerous errors and omissions in financial reporting
                           documentation as well as draft financial statements themselves, which
                           likely would have been caught and corrected had these records been
                           appropriately reviewed by management.


IRS Continues to Lack a    As we have previously reported,15 IRS does not have a detailed listing, or
Subsidiary Ledger and      subsidiary ledger, which tracks and accumulates unpaid assessments and
Adequate Supporting        their status16 on an ongoing basis. This condition adversely affects IRS’
                           ability to effectively manage and accurately report unpaid assessments. As
Documentation for Unpaid   a result, IRS is unable to readily identify and focus collection efforts on
Assessments                those accounts most likely to prove collectible,17 and cannot readily
                           prevent or detect and correct errors in taxpayer accounts. This condition
                           has resulted in instances of unnecessary taxpayer burden. In addition, IRS
                           continues to experience difficulty locating and providing adequate
                           supporting documentation for individual unpaid assessment balances.

                           To compensate for the lack of a subsidiary ledger, IRS runs computer
                           programs against its master files to identify, extract, and classify the
                           universe of unpaid assessments for financial reporting purposes. However,
                           this approach is only designed for the limited purpose of allowing IRS to
                           report auditable financial statement totals at year-end, and is not an
                           adequate substitute for a reliable subsidiary ledger which provides an

                           15
                             See GAO/AIMD-98-77, February 26, 1998.
                           16
                             Unpaid assessments consist of (1) taxes due from taxpayers for which IRS can support the existence
                           of a receivable through taxpayer agreement or a favorable court ruling (federal taxes receivable),
                           (2) compliance assessments where neither the taxpayer nor the court has affirmed that the amounts
                           are owed, and (3) write-offs, which represent unpaid assessments for which IRS does not expect
                           further collections due to factors such as the taxpayer’s death, bankruptcy, or insolvency. Of these
                           three classifications of unpaid assessments, only federal taxes receivable are reported on the principal
                           financial statements. As of September 30, 1998, IRS reported $26 billion (net of an allowance for
                           doubtful accounts of $55 billion), $22 billion, and $119 billion in these three categories, respectively.
                           17
                             It should be noted that, despite the fact that certain taxpayer accounts have little likelihood of
                           collection, IRS would generally continue some efforts to collect, to reinforce continued compliance by
                           those taxpayers who appropriately report and pay their tax obligations and to increase compliance by
                           taxpayers who are not compliant with respect to reporting and paying their tax obligations.



                           Page 15                              GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
B-281967




accurate outstanding balance for each taxpayer on an ongoing basis.
Without this information, IRS cannot ensure that payments and
assessments are promptly posted to the appropriate taxpayer accounts.
We found in our sample of fiscal year 1998 unpaid assessments that this
problem resulted in inaccurate taxpayer account balances, and led to IRS
pursuing collection efforts against taxpayers that had already paid their
taxes in full. In addition, in our sample we found that IRS inappropriately
issued refunds to taxpayers with outstanding tax assessment balances.

For example, when a company does not pay IRS the taxes that have been
withheld from employee’s wages, such as Social Security or individual
income tax withholdings, IRS has the authority to assess the responsible
officers individually for the amount withheld from employees. Thus, IRS
may record assessments against several individuals (officers) each for the
employee withholding component of the payroll tax liability in an effort to
collect the total tax liability of the business. While these
assessments—known as trust fund recovery penalties—are a necessary
enforcement tool, IRS’ current systems cannot automatically link each of
the multiple assessments made to one tax liability. This is due to the fact
that the corporation’s tax liability is maintained in IRS’ business master
files, while the trust fund recovery penalties assessed against the
corporation’s officers are maintained in the individual master files. These
are two separate databases, each of which is independent of the other. In
fact, in numerous unpaid payroll tax cases we reviewed involving multiple
assessments, we found that payments were not accurately recorded to
reflect each responsible party’s reduction in tax liability. Also, we found
that IRS’ failure to quickly identify and assess responsible officers resulted
in refunds being sent to those officers that could have been offset by IRS
against amounts due.

We previously reported that IRS had significant problems locating
supporting documentation for unpaid assessment transactions. To address
this issue, we worked closely with IRS and identified various forms of
documentation to support these items, and we requested these documents
in performing our fiscal year 1998 testing. We did note some improvement
in the documentation. For example, estate case files we reviewed
generally contained an independent appraisal of the estate’s assets.
However, we continued to find that IRS experienced difficulties in
providing other supporting documentation. For example, bankruptcy case
files frequently did not include the information necessary to verify the IRS’
creditor status. In addition, nonestate installment agreement cases rarely




Page 16                    GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                          B-281967




                          contained documentation sufficient to validate all of the installment
                          agreements.

                          The lack of adequate supporting documentation may make it difficult for
                          IRS to readily identify and focus collection efforts. The lack of
                          documentation also made it difficult to assess the classification and
                          collectibility of unpaid assessments reported in the principal financial
                          statements as federal tax receivables. Through our audit procedures, we
                          were able to verify the existence and proper classification of unpaid
                          assessments and obtain reasonable assurance that reported balances were
                          reliable. However, this required tens of billions of dollars of audit
                          adjustments to IRS’ principal financial statements to correct misstated and
                          duplicate unpaid assessment balances identified by our testing.


Continued Weaknesses in   We previously reported18 that IRS did not have sufficient preventive
Controls Over Refunds     controls over refunds to reduce to an acceptable level the risk that
                          inappropriate payments for tax refunds will be disbursed. We found that in
                          fiscal year 1998, inappropriate refund payments continued to be issued
                          due to (1) IRS comparing the information on tax returns and third party
                          data such as W-2s (Wage and Tax Statement) too late to identify and
                          correct discrepancies between these documents, (2) significant levels of
                          invalid Earned Income Tax Credit (EITC) claims, and (3) deficiencies in
                          controls that allowed duplicate refunds to be issued. We also found
                          instances of erroneous refunds being issued as a result of errors or delays
                          in posting assessments to taxpayer accounts. Although IRS has detective
                          (post-refund) controls in place, the lack of sufficient preventative controls
                          exposes the government to potentially significant losses due to
                          inappropriate disbursements for refunds. According to IRS’ records, IRS’
                          investigators identified over $17 million in alleged fraudulent refunds that
                          had been disbursed during the first 9 months of calendar year 1998 and
                          prevented the disbursement of an additional $65 million in alleged
                          fraudulent refund claims. During calendar year 1997, IRS’ records indicate
                          that intervention by IRS investigators prevented the disbursement of
                          additional alleged fraudulent refund claims totaling over $1.5 billion.
                          However, the full magnitude of invalid refunds disbursed by IRS is
                          unknown.

                          As we have previously reported, IRS does not compare tax returns to
                          accompanying W-2s until months after the tax return has been processed.
                          As a result, we found differences between these documents that were not

                          18
                            See GAO/AIMD-98-77, February 26, 1998.



                          Page 17                           GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
B-281967




detected by IRS. These differences could indicate an invalid refund claim
filing that is not being detected in time to prevent the disbursement of
incorrect refund amounts. We also found instances where inappropriate
refunds were issued as a result of errors or delays in posting tax
assessments to taxpayers accounts. For example, we identified a case
where a taxpayer who owed taxes was erroneously issued a refund
because the tax assessment had not yet been posted to the taxpayer’s
account. Errors and posting delays such as these also impair IRS’ ability to
effectively offset refunds due taxpayers against amounts owed by the
same taxpayers on another account. For example, IRS does not always
properly offset refunds against other amounts owed by individuals. Most
frequently, we noted this was a problem where multiple payees were
responsible for the same unpaid assessment. In some cases we reviewed
involving unpaid payroll taxes, individuals received a refund even though
amounts were owed by their businesses.

As we previously reported, EITC have historically been vulnerable to high
rates of invalid claims.19 During fiscal year 1998, IRS reported that it
processed EITC claims totaling over $29 billion, including over $23 billion
(79 percent) in refunds.20 In an effort to minimize losses due to invalid EITC
claims, IRS electronically screens tax returns claiming EITC to identify those
exhibiting characteristics considered indicative of potentially questionable
claims based on past experience, and then selects those claims considered
most likely to be invalid for detailed examination. During fiscal year 1998,
IRS examiners reviewed over 290,000 tax returns claiming $662 million in
EITC, of which $448 million (68 percent) was found to be invalid. These
examinations are an important control mechanism for detecting
questionable claims and providing a deterrent to future invalid claims.
However, because examinations are often performed after any related
refunds are disbursed, they cannot substitute for effective preventative
controls designed to identify invalid claims before refund disbursement. In
fiscal year 1998, IRS began implementing a 5-year EITC compliance initiative
intended to expand customer service to increase taxpayer awareness of
their rights and responsibilities related to EITC, strengthen enforcement of
EITC requirements, and enhance research into the sources of EITC
noncompliance. However, most of IRS’ efforts under that initiative had not
progressed far enough at the time we completed our audit work for us to
make any judgment about their effectiveness.


19
 High Risk Series: An Update (GAO/HR-99-1, January 1999), and Major Management Challenges and
Program Risks: Department of the Treasury (GAO/OCG-99-14, January 1999).
20
  EITC claims do not always result in refunds. They may also reduce tax assessments.



Page 18                             GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                            B-281967




                            As we have previously reported, IRS is also vulnerable to issuance of
                            duplicate refunds allowed by gaps in its internal controls. IRS’ manual and
                            automated systems are not properly coordinated to prevent identical
                            refunds from being processed through both systems. For example, we
                            identified three refunds which were paid twice. In each case, IRS processed
                            one manually, and the other through automated procedures. Since IRS
                            systems were not coordinated to compare the two, both were paid. IRS
                            reported this condition as a material weakness in its fiscal year 1998 FIA
                            assurance statement to Treasury. While we were able to substantiate the
                            amounts of refunds disbursed as reported on IRS’ fiscal year 1998 principal
                            financial statements, IRS nevertheless lacks effective preventive controls to
                            minimize its vulnerability to payment of inappropriate refunds. Once an
                            inappropriate refund has been disbursed, IRS is compelled to expend both
                            the time and expense to attempt to recover it, with dubious prospect of
                            success.


IRS Did Not Reconcile Its   During fiscal year 1998, IRS did not reconcile its administrative fund
Fund Balance With           balance with Treasury accounts, in accordance with federal accounting
Treasury                    standards.21 Treasury policy and prudent financial management practices
                            require an agency to routinely reconcile its fund balance with Treasury
                            accounts to Treasury’s records. Reconciling these accounts involves
                            identifying differences between IRS and Treasury records, determining the
                            reason for the differences, and correcting them. Differences arise when
                            either IRS or Treasury erroneously records or delays recording of deposits
                            and disbursements to IRS cash accounts. Correcting such differences
                            should result in adjustments to either Treasury’s or IRS’ records, or both.
                            This process is similar to a company or individuals reconciling their
                            checkbook to the monthly bank statement.

                            In January 1999, IRS’ contractor provided what it considered to be
                            reconciliations of IRS’ Treasury fund balance for the 12 months of fiscal
                            year 1998. However, we found that these efforts were inadequate in
                            several respects. For example, material amounts on the reconciliations for
                            Treasury and IRS balances did not agree with Treasury and IRS records, and
                            reconciling items listed on the reconciliations were not investigated and
                            resolved. Similarly, IRS has not been investigating and resolving amounts in
                            its administrative suspense accounts. As of September 30, 1998, IRS had
                            items totaling a net credit balance of over $100 million in its fund balance



                            21
                             Statement of Federal Financial Accounting Standards No. 1 Accounting for Selected Assets and
                            Liabilities.



                            Page 19                            GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                         B-281967




                         with Treasury suspense account, including some items dating back to 1989
                         appropriations.

                         Lack of timely, thorough reconciliations makes it difficult if not impossible
                         for IRS to determine if operating funds have been properly spent, or if
                         reported amounts for operating expenses, assets, and liabilities are
                         reliable. Without performing such reconciliations, IRS has no assurance
                         that its fund balance with Treasury is accurate. Lack of reconciliations
                         also impact IRS’ ability to ensure that it complies with the law governing
                         the use of its budget authority. Because this fundamental internal control
                         was not followed, we were unable to conclude whether IRS’ fund balance
                         with Treasury account was reliable at September 30, 1998. This
                         contributed to our qualification on IRS’ fiscal year 1998 balance sheet. For
                         the future, it will be important for IRS to prepare these reconciliations
                         monthly, and timely resolve any differences. Absent timely, appropriate
                         reconciliations of fund balance with Treasury, this historically problematic
                         area for IRS will continue to affect its ability to produce reliable financial
                         information.


Weaknesses in Controls   As previously reported,22 IRS’ controls over its property and equipment
Over Property and        (P&E) records are not adequate to ensure that these records provide a
Equipment Records        complete and reliable record of P&E assets. IRS cannot ensure the
                         completeness of its reported P&E balance because it does not have policies
                         and procedures in place to ensure that all P&E purchases are identified and
                         capitalized at the appropriate cost in accordance with federal accounting
                         standards.23 Consequently, P&E balances are likely materially understated.
                         IRS also does not record individual property transactions in its general
                         ledger P&E account throughout the year. Instead, IRS records adjustments
                         at year-end for all property activity during the year. Consequently, the
                         general ledger does not contain the transaction detail information
                         necessary to allow IRS to reconcile it to the P&E detailed records.

                         Weaknesses in IRS’ controls over P&E on hand increase its vulnerability to
                         loss. IRS reported P&E controls as a material weakness in its fiscal year 1998
                         FIA assurance statement to Treasury. This issue was also reported as a
                         material weakness by the Department of the Treasury’s Office of Inspector
                         General in its report on IRS’ fiscal year 1997 administrative financial

                         22
                          Financial Audit: Examination of IRS’ Fiscal Year 1996 Administrative Financial Statements
                         (GAO/AIMD-97-89, August 29, 1997).
                         23
                          Statement of Federal Financial Accounting Standards (SFFAS) No. 6 Accounting for Property, Plant,
                         and Equipment (effective beginning with fiscal year 1998).



                         Page 20                            GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
B-281967




statements. The effects of these weaknesses, taken together resulted in
our concluding that P&E is likely to be materially understated.

The Comptroller General’s Standards for Internal Controls in the Federal
Government require that documentation of transactions or other
significant events be complete and accurate. Property and equipment
subsidiary records need to be promptly updated to reflect changes due to
purchases and dispositions. In addition, all transactions should be
accurately recorded, and balances should be periodically reconciled to the
general ledger and to the results of physical inventories of P&E on hand.
Without current and accurate records, IRS cannot ensure that the P&E items
it owns are not lost or stolen, that new purchases of equipment are
appropriately capitalized in its accounting records, or that related
principal financial statements balances are reliable.

We found evidence in our audit work that IRS does not have policies and
procedures in place to ensure that material P&E are recorded in IRS’
financial statements. For example, IRS’ computer systems information
shows substantial funding available and used for computer systems, such
as mainframe consolidation and a new receipts processing system. IRS’
computer systems information also shows evidence of contractor services
related to design, plans, and specifications for computer hardware and
software projects—costs required to be capitalized under federal
accounting standards. Also, IRS’ financial records show equipment-related
expenses of $339 million in fiscal year 1998.

Although this significant P&E activity occurred, only about $30 million was
recognized as P&E additions in fiscal year 1998. We also saw evidence of
substantial unrecorded capital expenditures in fiscal year 1997. These
problems are compounded by IRS’ use of a $50,000 minimum financial
statement cost capitalization threshold as permitted by Treasury policy.
This amount far exceeds the cost of most of the P&E items IRS purchases
and results in a material distortion of IRS’ reported P&E in its financial
statements. We found, based on assets included in IRS’ property systems,
that $1.2 billion or 69 percent of IRS’ gross P&E was not included in property
and equipment in the financial statements because of the use of this
threshold to capitalize P&E assets. Although IRS uses the $50,000 minimum
for financial reporting purposes, it uses a much lower threshold for
recording and tracking P&E in its subsidiary systems.

In addition to the P&E completeness problem, IRS’ policies and procedures
for recording P&E transactions impede its ability to reconcile the general



Page 21                    GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
B-281967




ledger to related P&E subsidiary records. IRS’ field offices record individual
property acquisitions and dispositions on site throughout the year.
However, IRS’ accounting system expenses property purchases during the
year, then records adjustments at year end to reflect P&E dispositions, and
to move property purchases from expenses to P&E based on subsidiary
records maintained in the field offices. As a result, IRS has no assurance
that the amounts it records in its general ledger and underlying P&E
subsidiary systems, respectively, are complete and agree with each other.
IRS is compelled to manually adjust the general ledger at year end to force
it to agree with its P&E subsidiary records. In making this adjustment, IRS
attempts to eliminate from its nonpayroll operating expenses the P&E
additions for the fiscal year. However, IRS has no assurance that the
amount it removes from nonpayroll operating expenses for specific P&E
additions reflects the actual amount paid.

Because IRS ultimately relies on its subsidiary P&E records to support the
reported P&E balance, we tested the reliability of those records by
attempting to physically verify the existence of selected property items.
However, we found that IRS was unable to locate 10 (7 percent) of the 153
items we selected for review from IRS detailed records of P&E, including
items such as a Chevrolet Blazer motor vehicle, a laptop computer, and a
laser printer costing over $300,000. Additionally, we found that 10
(7 percent) of 141 items we selected from the floor of IRS’ field offices were
not included in IRS’ detailed property records, including items such as a
television, a facsimile machine, and a video cassette recorder. We also
found instances where different IRS field offices had recorded substantially
identical items at significantly different costs. For example, the cost IRS
assigned to substantially identical machines used to sort and open mail
ranged from $300,000 to $1,000,000 at different field offices.

We observed IRS staff conducting physical inventories of P&E at two field
offices. At one office, of 130 computer equipment assets each costing over
$50,000 identified from IRS P&E records, IRS staff were unable to locate 19
(15 percent). In addition, 20 (5 percent) of 443 items identified from the
floor were not included in IRS’ P&E records. At a different office, we found
that 11 of 12 (91 percent) items over $50,000 that had been disposed of had
not been removed from the P&E records. We also found problems with IRS’
internal controls over physical inventories of P&E. An April 1998 IRS
internal audit report on the Northeast Region noted that P&E inventory
procedures for computer equipment and software were not effective for
maintaining an accurate inventory or consistently followed by all districts
in the region. Also, IRS reported that district management did not ensure



Page 22                    GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                          B-281967




                          that the computer property records were always updated to reflect an
                          accurate inventory. These discrepancies and reported problems reflect
                          weaknesses in IRS property management controls that impair its ability to
                          ensure that P&E are used only in accordance with IRS policy and that
                          related records are accurate.


Controls Over Computer    As we have previously reported,24 IRS has significant and long-standing
Security Are Inadequate   weaknesses in controls over its computer information systems. IRS places
                          extensive reliance on these computer information systems to perform its
                          basic functions such as processing tax returns, maintaining sensitive
                          taxpayer data, calculating interest and penalties, and generating refunds.
                          Consequently, such weaknesses could render IRS unable to perform these
                          vital functions, or result in the unauthorized disclosure, modification, or
                          destruction of taxpayer data. In December 1998, we reported that as of
                          July 1998, IRS was significantly progressing in improving its computer
                          security.25 For example, IRS has centralized responsibility for IRS’ security
                          and privacy issues in its Office of Systems Standards and Evaluation. The
                          office is implementing a servicewide security program to manage risk and
                          has led IRS’ efforts in mitigating about 75 percent of the weaknesses
                          identified in our April 1997 report.26

                          We found, however, serious weaknesses continued to exist in the
                          following six functional areas: (1) security program management,
                          (2) access control, (3) application software development and change
                          controls, (4) system software, (5) segregation of duties, and (6) service
                          continuity. Continued weaknesses in these areas can allow unauthorized
                          individuals access to critical hardware and software where they may
                          intentionally or inadvertently add, alter, or delete sensitive data or
                          programs. Such individuals can also obtain personal taxpayer information
                          and use it to commit financial crimes in the taxpayers’ name (identity
                          fraud), such as fraudulently establishing credit, running up debts, and
                          taking over and depleting banks accounts. IRS has agreed with our
                          recommendations to address these problems and stated that our
                          conclusions and recommendations were consistent with its ongoing
                          actions to improve system security and mitigate the remaining


                          24
                           See IRS Systems Security: Tax Processing Operations and Data Still at Risk Due to Serious
                          Weaknesses (GAO/AIMD-97-49, April 8, 1997) and GAO/AIMD-98-77, February 26, 1998.
                          25
                           IRS Systems Security: Although Significant Improvements Made, Tax Processing Operations and
                          Data Still at Serious Risk (GAO/AIMD-99-38, December 14, 1998).
                          26
                            See GAO/AIMD-97-49, April 8, 1997.



                          Page 23                            GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                           B-281967




                           weaknesses. We will follow up during future audits to assess the
                           effectiveness of IRS’ efforts to resolve these problems.


                           In addition to the material weaknesses discussed above, we identified two
Reportable Conditions      reportable conditions which, although not material to the principal
                           financial statements, represent significant deficiencies in the design or
                           operation of internal controls which could adversely affect IRS’ ability to
                           meet the internal control objectives described in this report. These
                           conditions concern weaknesses in IRS’ internal controls over (1) manually
                           processed tax receipts and taxpayer information and (2) revenue reporting
                           and distribution to trust funds.


Inadequate Physical        As we have previously reported,27 IRS’ controls over cash, checks, and
Security Over Manual Tax   related hardcopy taxpayer data it manually receives from taxpayers are
Receipts and Taxpayer      not adequate to reduce to an acceptably low level the risk that these
                           payments will not be properly credited to taxpayer accounts and
Information                deposited in the Treasury, or that proprietary taxpayer information will
                           not be properly safeguarded. We found weaknesses in IRS’ physical
                           security over tax receipts and taxpayer data on hand at IRS field offices and
                           in transit to depository institutions. In addition, we found that delays in
                           background and fingerprint checks resulted in new employees being hired
                           and entrusted with taxpayer receipts and data before the results of these
                           checks were known. We found that similar weaknesses exist at
                           commercial lockbox banks under contract to IRS.28 Although we do not
                           consider this weakness to be material to IRS’ principal financial statements,
                           it involves issues central to IRS’ customer service goals. It is therefore
                           critical that IRS resolve these issues promptly and effectively.

                           The Comptroller General’s Standards for Internal Controls in the Federal
                           Government require that access to resources and records be limited to
                           authorized individuals. Such physical security is critical to ensure that
                           receipts are not lost or stolen nor sensitive taxpayer data compromised.
                           However, we found that (1) unattended checks and tax returns were often
                           stored in open and easily accessible areas, (2) hundreds of millions of
                           dollars of receipts in the form of checks, and in one case cash, were


                           27
                            See Internal Revenue Service: Physical Security Over Taxpayer Receipts and Data Needs
                           Improvement (GAO/AIMD-99-15, November 30, 1998); Internal Revenue Service: Immediate and
                           Long-Term Actions Needed to Improve Financial Management (GAO/AIMD-99-16, October 30, 1998);
                           and GAO/AIMD-98-77, February 26, 1998.
                           28
                             IRS contracts with 10 lockbox banks nationwide to process receipts—one for each service center.



                           Page 24                            GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                        B-281967




                        transported from IRS field offices to financial institutions by unarmed
                        couriers who often used unmarked civilian vehicles including, in one
                        instance, a bicycle, and (3) individuals were hired and entrusted with
                        access to cash, checks, and sensitive taxpayer data before completion of
                        background or fingerprint checks. This problem is particularly acute
                        during peak filing season when IRS typically hires thousands of temporary
                        employees. We found similar weaknesses exist at commercial lockbox
                        banks IRS contracts with to process tax receipts, including the use of
                        unarmed couriers and the hiring of temporary employees before
                        background checks are completed.

                        In fiscal years 1997 and 1998, IRS identified 56 actual or alleged employee
                        thefts of receipts at IRS field offices and lockbox banks totaling about
                        $1 million. However, based on IRS’ inspections’ database, an additional 100
                        cases were opened during the period in which the amount potentially
                        stolen was not quantified. Further, the magnitude of thefts not identified
                        by IRS is unknown. The weaknesses discussed above also expose
                        taxpayers to increased risk of losses due to financial crimes committed by
                        individuals who inappropriately gain access to confidential information
                        entrusted to IRS. For example, this information, which includes names,
                        addresses, social security and bank account numbers, and details of
                        financial holdings, may be used to commit identity fraud. Although
                        receipts and taxpayer information will always be vulnerable to theft, IRS
                        has a responsibility to protect the government and taxpayers from such
                        losses. IRS substantially agreed with the recommendations we provided to
                        address these issues and indicated that it plans to address the control
                        deficiencies we identified related to tax receipts and taxpayer data. We
                        will follow up in future audits to assess the effectiveness of IRS’ corrective
                        actions.


Weaknesses in IRS’      IRS is unable to currently determine the specific amount of revenue it
Revenue Reporting and   actually collects for Social Security, Hospital Insurance, Highway, or other
Distribution Process    relevant trust funds. As we previously reported,29 this is primarily because
                        the accounting information needed to validate the taxpayer’s liability and
                        record the payment to the proper trust fund is provided on the tax return,
                        which is received months after the payment is submitted. Further, the
                        information on the return only pertains to the amount of the tax liability,
                        not the distribution of the amount previously collected. As a result, IRS
                        cannot report the specific amount of revenue it actually collected for three

                        29
                         See Excise Taxes: Internal Control Weaknesses Affect Accuracy of Distributions to the Trust Funds
                        (GAO/AIMD-99-17, November 9, 1998); GAO/AIMD-98-77, February 26, 1998; and GAO/AIMD-99-16,
                        October 30, 1998.



                        Page 25                            GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
B-281967




of the federal government’s four largest revenue sources, including Social
Security, Hospital Insurance, and individual income taxes. In response to
our previous reports, IRS conducted a study to consider whether it should
require taxpayers to provide this additional information when they remit
their taxes. The results of this study were not available for our review at
the completion of our audit.

This condition presents other operational issues for IRS and Treasury in the
distribution of excise tax receipts to the trust funds. Because data is not
available to allocate excise taxes to the appropriate trust funds when
deposits are made, Treasury uses a process to estimate the initial
distribution of excise taxes. This process involves the use of economic
models prepared by the Office of Tax Analysis (OTA) to estimate the initial
distribution of tax receipts. Treasury’s Financial Management Service
(FMS) uses these estimates to prepare entries for the initial distribution to
the trust funds, which are then recorded by the Bureau of Public Debt
(BPD) in the books and records of the trust funds maintained by the
Treasury. Subsequent to the initial distribution, IRS certifies quarterly the
amounts that should have been distributed to the excise tax related trust
funds using its records of payments received and the subsequently
provided tax returns. FMS uses these certifications to prepare adjustments
to the initial trust fund distributions, which are then recorded by BPD.
Typically, there is a 6-month lag between the quarter end and the excise
tax certification by IRS.

As we have reported,30 this process is complex, cumbersome and prone to
error. During our fiscal year 1997 audit, we found that weaknesses in
fundamental internal controls, such as supervisory review, allowed errors
in the certification process to occur and not be detected. These included
taxpayer errors in preparing excise tax returns — errors that IRS did not
identify; errors by IRS when inputting excise tax information to its master
files; and IRS errors in using this information in preparing the certification.
We found similar problems during our fiscal year 1998 audit. As long as IRS
lacks the data to identify the specific amount of revenue received for each
tax type at the time of receipt, IRS, Treasury, and excise tax related trust
funds such as the Highway and Airport and Airways trust funds, will
continue to depend on a complex estimation process for determining
revenue distributions which continues to be vulnerable to errors.




30
  See GAO/AIMD-99-17, November 9, 1998.



Page 26                          GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                           B-281967




                           As discussed above, limitations on the scope of our work prevented us
Noncompliance With         from testing compliance with the Anti-Deficiency Act. Otherwise, our tests
Laws and Regulations       of compliance with selected provisions of laws and regulations disclosed
and FFMIA                  one instance of noncompliance which is reportable under generally
                           accepted government auditing standards and OMB Bulletin 98-08, Audit
Requirements               Requirements for Federal Financial Statements. This concerns IRS’
                           noncompliance with a provision of the Internal Revenue Code concerning
                           the use of installment agreements to collect delinquent taxes. We also
                           found that IRS’ financial management systems do not substantially comply
                           with the requirements of FFMIA.


IRS’ Use of Installment    Section 6159 of the Internal Revenue Code authorizes IRS to enter into
Agreements Did Not         installment agreements with taxpayers to satisfy the taxpayer’s liability.
Comply With the Internal   During our fiscal year 1998 audit, we identified numerous instances in
                           which IRS has entered into installment agreements under whose terms the
Revenue Code               payments will not be sufficient to satisfy the taxpayers’ outstanding tax
                           liability prior to the expiration of the statutory collection period for these
                           tax liabilities.31 Specifically, in 48 of the 93 unpaid assessment cases we
                           reviewed (52 percent) where active individual installment agreements
                           were in place between the taxpayer and IRS, we found that the payments to
                           be received under the installment agreement would not be sufficient to
                           fully satisfy the outstanding liability. For example, in one case, an
                           installment agreement required the taxpayer to make payments of $25
                           each month toward an outstanding tax liability due of over $16 million.
                           Based on the number of months remaining in the statutory collection
                           period, we determined that under the terms of the agreement, IRS would
                           only collect a maximum of $1,625, assuming the taxpayer does not default
                           on the installment agreement.

                           Because these agreements will not result in full satisfaction of the
                           outstanding tax liability, the 48 cases are not in compliance with Section
                           6159 of the Internal Revenue Code. IRS’ Collection Division recognized this
                           problem. In March, 1998, the Deputy Commissioner issued a memorandum
                           stating clearly that under any new installment agreement, the taxpayer
                           must fully satisfy his/her tax liability. This memorandum was followed in
                           August 1998 by a memorandum from the Chief Operations Officer issuing
                           guidelines on installment agreements pending updates to the Internal
                           Revenue Manual.


                           31
                             The statutory collection period is generally 10 years from the date of the assessment. However, this
                           period can be extended by agreement with the taxpayer when an installment agreement is entered
                           into.



                           Page 27                             GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                            B-281967




IRS’ Financial Management   In our previous audit,32 we reported that IRS’ custodial financial
Systems Are Not in          management systems did not substantially comply with the Federal
Compliance With FFMIA       Financial Management Systems Requirements (FFMSR),33 federal
                            accounting standards, and the SGL at the transaction level. During fiscal
                            year 1998, we found that this condition continued, and that IRS’
                            administrative financial management systems also had significant
                            problems. We found that IRS (1) cannot reliably prepare four of the six
                            principal financial statements required by OMB 97-01, as amended, (2) does
                            not have a general ledger(s) that conforms to the SGL, (3) lacks a
                            subsidiary ledger for its unpaid assessments, accounts payable, and
                            undelivered orders, and (4) lacks an effective audit trail from its general
                            ledgers back to subsidiary detailed records and transaction source
                            documents. In its FIA assurance statement to Treasury, IRS also reported
                            that its financial management systems did not substantially comply with
                            FFMIA in fiscal year 1998.


                            In addition, IRS does not consistently capture cost information in
                            accordance with federal accounting standards.34 For example, in our
                            sample of IRS payroll transactions we tested, we found that most
                            employees did not charge their time to individual job codes for specific
                            services and activities. As a result, actual cost information for specific
                            services and activities is not available. Consequently, IRS is unable to
                            reliably report cost-based performance measures in its management
                            discussion and analysis (MD&A) that accompanies the principal financial
                            statements, or otherwise report cost-based information for its
                            performance plan in accordance with the Government Performance and
                            Results Act of 1993. This deficiency also renders IRS unable to include
                            reliable cost-based performance information in its budget submission to
                            Congress.

                            These are all requirements under FFMSR. The other four material
                            weaknesses we discussed above—controls over refunds, property and
                            equipment, fund balance with Treasury, and computer security—also are
                            conditions indicating that IRS’ systems do not comply with FFMSR. These
                            material weaknesses indicate that IRS cannot routinely produce auditable
                            principal financial statements and related disclosures in conformance with
                            federal accounting standards. Since IRS’ systems do not comply with FFMSR,


                            32
                              See GAO/AIMD-98-77, February 26, 1998.
                            33
                              FFMSR are a series of requirements produced by the JFMIP to improve federal financial management
                            through uniform requirements for financial information, financial systems, and financial organization.
                            34
                              Statement of Federal Financial Accounting Standards No. 4, Managerial Cost Accounting Standards.



                            Page 28                             GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
B-281967




federal accounting standards, and the SGL, they also do not comply with
OMB Circular A-127, Financial Management Systems.


In May 1997, IRS provided Congress a systems modernization plan intended
to bring IRS’ custodial financial systems into conformance with FFMIA.
Planned improvements include (1) an SGL compliant code and
classification structure which is traceable to detail in the master files,
(2) automated preparation of financial statement balances from the
general ledger, (3) improved unpaid assessment documentation retention
requirements, and (4) extracts of summary unpaid assessment information
by taxpayer, tax module, account status, age, and installment information.
However, in re-evaluating the modernization plan in light of the material
weaknesses we reported in our previous audit, IRS concluded that the
current modernization strategy cannot achieve compliance within the
3-year time frame required by FFMIA. In IRS’ FFMIA noncompliance
remediation plan for its custodial financial management systems, IRS cited
plans to develop an alternative approach employing modifications to
existing systems and additional manual procedures in lieu of building
some modernized subsystems. Some of the planned financial reporting
improvements are embodied in IRS’ Financial Reporting Release which is
currently scheduled to be installed by April 2000. IRS plans to completely
address its computer security weaknesses by December 2000.
Implementation of the full plan as originally envisioned is not expected for
a decade or more.

In October 1998, IRS prepared a remediation plan designed to address the
material weaknesses cited by the Treasury OIG in its audit of IRS’ fiscal
year 1997 administrative financial statements, which reported material
weaknesses in IRS’ property and equipment and accounting for liabilities
and accrued expenses. However, the corrective actions detailed in this
plan focus primarily on measures such as enhancements to policies and
procedures relevant to these processes and training staff to follow them.
This plan does not address the accounting issues and systemic problems
affecting P&E and accounts payable detailed above, such as the lack of an
accounts payable subsidiary ledger and the inability to account for P&E in
accordance with SFFAS No. 6. In addition, the plan does not address the
additional weaknesses discussed above, such as an administrative general
ledger that does not comply with the SGL, financial reporting weaknesses
that rendered IRS unable to reliably prepare four required principal
financial statements (all of which report only administrative accounts), or
the lack of effective management oversight of the financial reporting
process.



Page 29                   GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                       B-281967




Status of Prior Year   In our audit of IRS’ fiscal year 1997 Custodial Financial Statements, we
Compliance Issue       reported that IRS certified distributions of excise taxes to the recipient
                       trust funds based on amounts assessed taxpayers, rather than certifying
                       them based on actual collections, as required by the Internal Revenue
                       Code. We first reported this problem in our audit of IRS’ fiscal year 1992
                       financial statements.35 We also reported this issue in our fiscal year 1993
                       audit and recommended that IRS develop a means of capturing information
                       on the specific taxes collected for trust funds so that the amounts
                       collected by trust funds are readily determinable and excise tax receipts
                       can be distributed as required by law.36

                       During fiscal year 1998, IRS certified distributions of excise tax revenue
                       collected in the last half of fiscal year 1997 based on amounts assessed
                       taxpayers. IRS developed a method to allocate total excise tax collections
                       to specific excise tax related trust funds based on the related taxpayer
                       returns and implemented this method beginning with the June 1998
                       certification of first quarter fiscal year 1998 excise tax revenue. This new
                       approach is consistent with our recommendation and brings IRS into
                       compliance with the requirements of the Code. However, as discussed
                       above, weaknesses in the internal controls over this process persist.

                       In addition to the weaknesses and FFMIA noncompliance discussed above,
                       we noted other, less significant matters involving IRS’ system of accounting
                       controls and its operations which we will be reporting separately in a
                       management letter to IRS.


                       In addition to the material weaknesses and other reportable conditions
Other Significant      and noncompliance with laws and regulations discussed above, we
Matters                identified two other significant matters which we believe should be
                       brought to the attention of users of IRS’ principal financial statements and
                       other financial reports. These concern (1) the importance of IRS
                       successfully preparing its automated systems for the year 2000 and
                       (2) supplementing of the Social Security and Hospital Insurance Trust
                       funds by general fund tax revenues.




                       35
                        Financial Audit: Examination of IRS’ Fiscal Year 1992 Financial Statements (GAO/AIMD-93-2,
                       June 30, 1993).
                       36
                         See Examination of IRS’ Fiscal Year 1993 Financial Statements (GAO/AIMD-94-120, June 15, 1994).



                       Page 30                            GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                         B-281967




Year 2000 Problem        IRS is highly dependent on information technology to carry out its mission.
Presents a Significant   However, most of IRS’ information systems were not designed to read dates
Challenge for IRS        beyond December 31, 1999. As a result, IRS is in the midst of a massive
                         effort to make its information systems Year 2000 compliant in order to
                         avoid significant disruptions in its operations. IRS’ program represents one
                         of the largest civilian Year 2000 efforts, with an estimated cost of about
                         $1.4 billion. These cost estimates include work needed for its
                         mission-critical information systems, telecommunications networks, and
                         buildings. At the outset, IRS faced significant challenges in making its
                         systems Year 2000 compliant. In addition to the size of its effort, IRS lacked
                         a comprehensive inventory of information system assets, particularly of its
                         information systems infrastructure (i.e., systems software, hardware, and
                         telecommunications networks), and IRS’ Chief Information Officer did not
                         control all mission-critical assets.

                         In a June 1998 report,37 we provided a status of IRS’ Year 2000 efforts. We
                         reported that IRS had made more progress in fixing its applications than its
                         infrastructure, and that two major Year 2000 system replacement efforts
                         were experiencing schedule slippages. In addition, we identified two risk
                         areas for IRS’ Year 2000 effort—that is, the absence of an integrated master
                         schedule showing the interdependencies among the many Year 2000
                         efforts and a limited approach to contingency planning. If IRS is unable to
                         make its mission-critical systems Year 2000 compliant, IRS could be
                         rendered unable to properly and promptly process tax returns, issue
                         refunds, correctly calculate interest and penalties, effectively collect taxes,
                         or prepare accurate principal financial statements and other financial
                         reports.

                         IRS has been acting to address our concerns about a master schedule. The
                         Commissioner is also taking steps to broaden the contingency planning
                         effort to help ensure that IRS had adequately assessed the vulnerabilities of
                         its core business processes to potential Year 2000 system failures.
                         Specifically, we recommended that the Commissioner (1) solicit input
                         from the business functional areas to identify core business processes and
                         identify those processes that must continue in the event of a Year 2000
                         failure, (2) map IRS’ mission-critical systems to those core business
                         processes, (3) determine the impact of information system failures on
                         each core business process, (4) assess existing contingency plans for their
                         applicability to potential Year 2000 failures, and (5) develop and test



                         37
                          IRS’ Year 2000 Efforts: Business Continuity Planning Needed for Potential Year 2000 System Failures
                         (GAO/GGD-98-138, June 15, 1998).



                         Page 31                            GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                          B-281967




                          contingency plans for core business processes if existing plans are not
                          appropriate.

                          Since we issued our report, IRS has been taking actions to address our
                          recommendations. IRS had originally planned to have its first set of
                          contingency plans by December 15, 1998; however, according to its
                          officials, IRS did not meet that milestone. We plan to continue monitoring
                          IRS’ progress in developing contingency plans.



Social Security and       Taxes collected on behalf of the federal government are deposited in the
Hospital Insurance Are    general revenue fund of the Department of the Treasury, from which they
Supplemented by General   are subsequently distributed to the appropriate trust funds. Amounts
                          representing Social Security and Hospital Insurance taxes are distributed
Fund Revenues             to their respective trust funds based on employee wage information
                          certified by the Commissioner of the Social Security Administration (SSA).
                          Consistent with the statutory verification process, the Commissioner
                          bases this certification on a consideration of both wage information
                          maintained by SSA and wage information provided by IRS.

                          Because the distribution of the Social Security taxes IRS collects from
                          employers is based on this certification rather than actual collections, the
                          federal government’s general fund revenues supplement the Social
                          Security and Hospital Insurance trust funds. This supplement occurs
                          primarily because a significant number of employers that file tax returns
                          for Social Security and Hospital Insurance taxes never actually pay the
                          assessed amounts. Many of these businesses ultimately go bankrupt or
                          otherwise go out of business. Also, a significant number of self-employed
                          individuals do not pay the assessed amounts. As of September 30, 1998,
                          the estimated amount of unpaid taxes and interest in IRS’ unpaid
                          assessments balance was approximately $38 billion for Social Security and
                          Hospital Insurance.38 While these totals do not include amounts no longer
                          in the unpaid assessments balance due to the expiration of the statutory
                          collection period,39 they nevertheless give an indication of the cumulative
                          amount of the supplement provided from the general fund.



                          38
                           We included interest accrued in these amounts because assessments distributed to the trust funds
                          earn interest at Treasury-based interest rates, similar to IRS’ interest accruals.
                          39
                           As noted earlier, the statutory collection period for collecting taxes is generally 10 years from the
                          date of the tax assessment. However, this period can be extended under a variety of circumstances,
                          such as agreements by the taxpayer to extend the collection period, bankruptcy litigation, and court
                          appeals. Consequently, some tax assessments can and do remain on IRS’ records for decades.



                          Page 32                              GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                           B-281967




                           IRS’ management discussion and analysis, supplemental information, and
Consistency of Other       other accompanying information contain various data, some of which are
Information                not directly related to the principal financial statements. We did not audit
                           and do not express an overall opinion on this information. However, we
                           compared this information for consistency with the principal financial
                           statements and discussed the methods of measurement and presentation
                           with IRS officials. Based on our limited work, we found no material
                           inconsistencies with the principal financial statements or OMB guidance.
                           However, given the severity of the issues raised earlier with respect to
                           accounting, reporting, and internal controls over IRS’ administrative
                           activities, such comparisons may not be meaningful.

                           In performing our review of IRS’ key performance indicators, we found that
                           the measure related to toll-free telephone level of access40 is potentially
                           misleading. IRS reports that for fiscal year 1998, the toll-free telephone
                           level of access is 89.96 percent. Based on this, readers of IRS’ MD&A will
                           likely conclude that over 89 percent of callers successfully contacted an
                           IRS representative. However, IRS defines “access” as including all callers
                           who reach IRS’ telephone system, including those who subsequently hang
                           up before an IRS representative comes on the line. We found that based
                           upon another measure IRS refers to as “toll-free telephone level of service,”
                           approximately 70 percent of callers to IRS actually succeed in having their
                           calls answered by IRS. We believe this measure, which is not included in its
                           MD&A, more accurately represents the percentage of callers that
                           successfully contact IRS.


                           Management is responsible for
Objectives, Scope,
and Methodology        •   preparing the annual principal financial statements in conformity with the
                           basis of accounting described in note 1 to the principal financial
                           statements;
                       •   establishing, maintaining, and assessing internal controls to provide
                           reasonable assurance that the broad control objectives of FIA are met; and
                       •   complying with applicable laws and regulations and FFMIA requirements.

                           We are responsible for obtaining reasonable assurance about whether



                           40
                             Toll-free telephone level of access is defined as the sum of the number of calls answered and the
                           number of calls that are abandoned by the caller before getting assistance divided by total call
                           attempts (which consist of calls answered, calls that are abandoned, and calls that receive a busy
                           signal).



                           Page 33                             GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
    B-281967




•   the principal financial statements are reliable (free of material
    misstatements and presented fairly, in all material respects, in conformity
    with the basis of accounting described in note 1), and
•   management’s assertion about the effectiveness of internal controls is
    fairly stated, in all material respects, based upon criteria established under
    the Federal Managers’ Financial Integrity Act of 1982 and OMB Circular
    A-123, Management Accountability and Control.

    We are also responsible for testing compliance with selected provisions of
    laws and regulations41 and FFMIA requirements, and for performing limited
    procedures with respect to certain other information appearing in these
    annual principal financial statements.

    Except as discussed above, in order to fulfill these responsibilities, we

•   examined, on a test basis, evidence supporting the amounts and
    disclosures in the principal financial statements;
•   assessed the accounting principles used and significant estimates made by
    management;
•   evaluated the overall presentation of the principal financial statements;
•   obtained an understanding of internal controls related to financial
    reporting, including safeguarding assets, and compliance with laws and
    regulations, including execution of transactions in accordance with budget
    authority;
•   tested relevant internal controls over financial reporting, including
    safeguarding assets and compliance, and evaluated management’s
    assertion about the effectiveness of internal controls;
•   considered compliance with the process required by the Federal
    Managers’ Financial Integrity Act for evaluating and reporting on internal
    control and financial management systems;
•   tested compliance with selected provisions of the following laws and
    regulations (referenced to the United States Code)
    • Internal Revenue Code (appendix I),
    • Government Management Reform Act of 1994 {31 U.S.C. §§ 3515, 3521
      (f)},
    • Civil Service Reform Act of 1978 {5 U.S.C. § 5332},
    • Fair Labor Standard Act of 1938, as amended {29 U.S.C. § 206},
    • Civil Service Retirement Act of 1930, as amended {5 U.S.C. § 8334},
    • Federal Employees’ Retirement System Act of 1986, as amended {5
      U.S.C. § 8423},

    41
      These are laws and regulations that, we believe, have a direct and material effect on the principal
    financial statements.



    Page 34                              GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
    B-281967




    • Social Security Act, as amended {26 U.S.C. §§ 3101, 3121, and 42 U.S.C.
      § 430},
    • Federal Employees Benefits Act of 1959, as amended {5 U.S.C. §§ 8905,
      8906, 8909}, and
    • Federal Employees’ Group Life Insurance Act of 1980 {5 U.S.C. § 8701},
      and
•   tested whether IRS’ financial management systems comply with FFMIA
    requirements: (1) Federal Financial Management Systems Requirements,
    (2) applicable federal accounting standards, and (3) the U.S. Standard
    General Ledger at the transaction level.

    We did not evaluate all internal controls relevant to operating objectives as
    broadly defined by FIA, such as those controls relevant to preparing
    statistical reports and ensuring efficient operations. We limited our
    internal control testing to those controls necessary to achieve the
    objectives outlined in our opinion on management’s assertion about the
    effectiveness of internal controls. Because of inherent limitations in any
    internal control system, losses, noncompliance, or misstatements may
    nevertheless occur and not be detected.

    As the auditor of IRS’ principal financial statements, we are reporting under
    FFMIA on whether IRS’ financial management systems substantially comply
    with the Federal Financial Management Systems Requirements, applicable
    federal accounting standards, and the U.S. Standard General Ledger at the
    transaction level. In making this report, we considered the implementation
    guidance for FFMIA issued by OMB in Bulletin 98-08 Audit Requirements for
    Federal Financial Statements.

    We did not test compliance with all laws and regulations applicable to IRS.
    We limited our tests of compliance to those required by OMB under Bulletin
    98-08 and which we deemed applicable to the principal financial
    statements of IRS. We caution that noncompliance other than that
    discussed in this report may occur and not be detected by these tests and
    that such testing may not be sufficient for other purposes.

    Except for the limitations on the scope of our work on the principal
    financial statements described above, we performed our work in
    accordance with generally accepted government auditing standards and
    OMB Bulletin 98-08.




    Page 35                    GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                     B-281967




                     In commenting on a draft of this report, IRS stated that it generally agreed
Agency Comments      with the findings and conclusions in the report. IRS acknowledged the
and Our Evaluation   issues, concerns, and internal control weaknesses we cited, and
                     emphasized its commitment to address these matters. IRS stated that it has
                     assembled a corrective action team under the direction of the Chief
                     Financial Officer (CFO) to formulate a detailed plan for addressing each of
                     the issues raised in the report. IRS stated that it anticipates completing the
                     plan by March 31, 1999. IRS also stated that it would be bringing in outside
                     experts to assist its staff in resolving known deficiencies and problems
                     with respect to the agency’s administrative operations. IRS stated that,
                     while its financial management systems were not designed to meet current
                     systems and financial reporting standards, the agency is in the process of
                     planning and implementing interim solutions until such time as enhanced
                     systems are available over the next several years. The Chief Information
                     Officer is working in conjunction with the CFO to identify priorities and
                     resources needed to complete the necessary systems solutions. We will
                     continue to work closely with IRS and evaluate the effectiveness of its
                     corrective actions as part of our audit of IRS’ fiscal year 1999 financial
                     statements.

                     Additionally, IRS stated that it had a number of initiatives underway to
                     address several of the issues raised in this report and in our prior audits.
                     First, with respect to its unpaid assessments, these initiatives include (1) a
                     review of multiple assessments—trust fund recovery penalties—and
                     alternatives to ensure that taxpayer accounts are appropriately credited
                     for payments and adjustments made to related accounts, and (2) a task
                     force established to address documentation standards and record
                     retention policies and practices. We will review the results of these
                     initiatives as they are completed. With respect to revenue reporting and
                     distribution, IRS also stated that it had recently completed its study on
                     whether to require taxpayers to provide information on how payments
                     should be applied to specific types of taxes at the time the taxpayer
                     submits the payments, and has concluded that at this time IRS would not
                     pursue such reporting requirements. We will review the results of this
                     study as part of our audit of IRS’ fiscal year 1999 financial statements. We
                     remain concerned, however, that the existing process results in IRS’
                     inability to separately report on the specific amount of revenue it actually
                     collects for three of the federal government’s four largest revenue sources,
                     and necessitates the need for a multi-stage, complex, and error-prone
                     process to distribute excise taxes to the recipient trust funds.




                     Page 36                    GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
B-281967




We agree with IRS’ comment that the issue of capitalization thresholds for
P&E is a governmentwide issue. We have initiated discussions with the OMB
on the development of governmentwide guidance on P&E capitalization
thresholds. However, as it relates to IRS, we do not believe that
capitalization thresholds used by other agencies are relevant. It is our
position that each federal agency, because of its size and diversity of asset
base, needs a capitalization threshold that is appropriate for its own
unique circumstances. As our report notes, IRS’ use of a $50,000 threshold,
established by the Treasury Department CFO Council, resulted in $1.2
billion (69 percent) of its gross P&E being excluded from the September 30,
1998, financial statements. In addition, IRS’ financial statements show
$339 million of expenses for P&E purchased during fiscal year 1998, while
only about $30 million (9 percent) was actually capitalized. We continue to
believe that the $50,000 capitalization threshold is inappropriate and
significantly contributed to the likely material understatement of IRS’
September 30, 1998, P&E balance.

IRS stated that it continues to report the toll-free telephone level of access
because it is one of seven high impact agency goals identified and tracked
by the National Partnership for Reinventing Government. IRS further stated
that in the future this measure will be replaced with the “toll-free
telephone level of service.” However, reporting of the toll-free telephone
level of access as it is presented in IRS’ MD&A for fiscal year 1998 is
potentially misleading. Readers of IRS’ MD&A will likely inappropriately
conclude that 89.96 percent of taxpayers calling IRS actually speak to an IRS
representative. The use of IRS’ toll-free telephone level of service measure,
which does not recognize an abandoned taxpayer call as a success, is a
more appropriate measure. We support IRS’ use of the toll-free telephone
level of service measure in future years.

The complete text of IRS’ response to our draft report is presented in
appendix II.




David M. Walker
Comptroller General
of the United States

February 12, 1999

Page 37                    GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Principal Financial Statements


Balance Sheet




                Page 38   GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                        Principal Financial Statements




Statement of Net Cost




                        Page 39                          GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                                       Principal Financial Statements




Statement of Changes in Net Position




                                       Page 40                          GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                                   Principal Financial Statements




Statement of Budgetary Resources




                                   Page 41                          GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                         Principal Financial Statements




Statement of Financing




                         Page 42                          GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                                  Principal Financial Statements




Statement of Custodial Activity




                                  Page 43                          GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                                Principal Financial Statements




Notes to Financial Statements




                                Page 44                          GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Principal Financial Statements




Page 45                          GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Principal Financial Statements




Page 46                          GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Principal Financial Statements




Page 47                          GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Principal Financial Statements




Page 48                          GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Principal Financial Statements




Page 49                          GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Principal Financial Statements




Page 50                          GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Supplemental and Other Accompanying
Information

Supplemental Financial Information - Unaudited




                                         Page 51   GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Supplemental and Other Accompanying
Information




Page 52                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
                                        Supplemental and Other Accompanying
                                        Information




Other Accompanying Information - Unaudited




                                        Page 53                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Supplemental and Other Accompanying
Information




Page 54                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




              Page 55   GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 56                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 57                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 58                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 59                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 60                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 61                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 62                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 63                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 64                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 65                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 66                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 67                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 68                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 69                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 70                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 71                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 72                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 73                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 74                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 75                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 76                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 77                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 78                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 79                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 80                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 81                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Management Discussion and Analysis




Page 82                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Appendix I

Provisions of Internal Revenue Code Tested
for the Fiscal Year 1998 Audit

               26 U.S.C. § 6159 Agreements for Payment of Tax Liability in Installments

               26 U.S.C. § 6402 Authority to Make Credits or Refunds

               26 U.S.C. § 6402 Authority to Make Refund Offsets

               26 U.S.C. § 6511 Limitations on Credits or Refunds

               26 U.S.C. § 6601 Interest on Underpayment, Nonpayment, or Extension of
                 Time for Payment of Tax

               26 U.S.C. § 6611 Interest on Overpayments

               26 U.S.C. § 6621 Determination of Rate of Interest

               26 U.S.C. § 6651 Failure to File Tax Return or to Pay Tax

               26 U.S.C. § 6654 Penalty for Failure by Individual to Pay Estimated
                 Income Tax

               26 U.S.C. § 6655 Penalty for Failure by Corporations to Pay Estimated
                 Income Tax

               26 U.S.C. §§ 9501-9511
                 Trust Funds




               Page 83                   GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Appendix II

Comments From the Internal Revenue
Service




              Page 84   GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Appendix II
Comments From the Internal Revenue
Service




Page 85                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Appendix II
Comments From the Internal Revenue
Service




Page 86                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
           Appendix II
           Comments From the Internal Revenue
           Service




(919205)   Page 87                      GAO/AIMD-99-75 IRS Fiscal Year 1998 Financial Statements
Ordering Information

The first copy of each GAO report and testimony is free.
Additional copies are $2 each. Orders should be sent to the
following address, accompanied by a check or money order
made out to the Superintendent of Documents, when
necessary. VISA and MasterCard credit cards are accepted, also.
Orders for 100 or more copies to be mailed to a single address
are discounted 25 percent.

Orders by mail:

U.S. General Accounting Office
P.O. Box 37050
Washington, DC 20013

or visit:

Room 1100
700 4th St. NW (corner of 4th and G Sts. NW)
U.S. General Accounting Office
Washington, DC

Orders may also be placed by calling (202) 512-6000
or by using fax number (202) 512-6061, or TDD (202) 512-2537.

Each day, GAO issues a list of newly available reports and
testimony. To receive facsimile copies of the daily list or any
list from the past 30 days, please call (202) 512-6000 using a
touchtone phone. A recorded menu will provide information on
how to obtain these lists.

For information on how to access GAO reports on the INTERNET,
send an e-mail message with "info" in the body to:

info@www.gao.gov

or visit GAO’s World Wide Web Home Page at:

http://www.gao.gov




PRINTED ON    RECYCLED PAPER
United States                       Bulk Rate
General Accounting Office      Postage & Fees Paid
Washington, D.C. 20548-0001           GAO
                                 Permit No. G100
Official Business
Penalty for Private Use $300

Address Correction Requested