oversight

Fiscal Year 2002 U.S. Government Financial Statements: Sustained Leadership and Oversight Needed for Effective Implementation of Financial Management Reform

Published by the Government Accountability Office on 2003-04-08.

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

                          United States General Accounting Office

GAO                       Testimony
                          Before the Subcommittee on Government Efficiency and
                          Financial Management, Committee on Government
                          Reform, House of Representatives


For Release on Delivery
Expected at 10:30 a.m.
Tuesday, April 8, 2003
                          FISCAL YEAR 2002
                          U.S. GOVERNMENT
                          FINANCIAL STATEMENTS
                          Sustained Leadership and
                          Oversight Needed for
                          Effective Implementation
                          of Financial Management
                          Reform
                          Statement of David M. Walker
                          Comptroller General of the United States




GAO-03-572T
                          A
                                               April 8, 2003


                                               FISCAL YEAR 2002 U.S. GOVERNMENT
                                               FINANCIAL STATEMENTS
Highlights of GAO-03-572T, testimony
before the Subcommittee on Government          Sustained Leadership and Oversight
Efficiency and Financial Management,
Committee on Government Reform,
House of Representatives
                                               Needed for Effective Implementation of
                                               Financial Management Reform

GAO is required by law to audit the            As in the 5 previous fiscal years, the federal government continues to have a
consolidated financial statements              significant number of material weaknesses related to financial systems,
of the U.S. government.                        fundamental recordkeeping and financial reporting, and incomplete
                                               documentation. Several of these material weaknesses resulted in conditions
Timely, accurate, and useful                   that continued to prevent us from expressing an opinion on the U.S.
financial information is essential
for making informed operating
                                               government’s consolidated financial statements for the fiscal years ended
decisions day to day, managing the             September 30, 2002 and 2001.
federal government’s operations
more efficiently and effectively,              Three major impediments to an opinion on the consolidated financial
meeting the goals of federal                   statements are (1) serious financial management problems at DOD, (2) the
financial management reform                    federal government’s inability to fully account for and reconcile billions of
legislation, supporting results-               dollars of transactions between federal entities, and (3) the federal
oriented management approaches,                government’s inability to properly prepare the consolidated financial
and ensuring accountability on an              statements.
ongoing basis.
                                               Federal agencies have continued to make progress in obtaining unqualified
The importance of such
information is heightened by the
                                               audit opinions—21 of 24 Chief Financial Officers (CFO) Act agencies for
unprecedented demographic                      fiscal year 2002 (see table), up from 6 for fiscal year 1996. Irrespective of the
challenge of an aging population.              unqualified opinions, many federal agencies do not have timely, accurate,
Federal spending on the elderly,               and useful financial information and sound controls with which to make
health care, and new homeland                  informed decisions and to ensure accountability on an ongoing basis.
security and defense commitments
increases the need to look at                  Building on the success achieved in obtaining unqualified audit opinions,
competing claims on the budget                 federal agency management must continue to work toward fully resolving
and at new priorities.                         the pervasive and generally long-standing material weaknesses that have
Over the past year, the Principals of          been reported for the past 6 fiscal years. The President’s Management
the Joint Financial Management                 Agenda stated that without sound internal control and accurate and timely
Improvement Program continued                  financial information, it is not possible to accomplish the President’s agenda
efforts to accelerate progress in              to secure the best performance and highest measure of accountability for the
financial management reform. Also,             American people.
President Bush has implemented
the President’s Management
Agenda to provide direction to, and            Fiscal Year 2002 CFO Act Agency Results Reported by Auditors
closely monitor, management                                                                    Agencies with unqualified opinions and no
reform across government, which                    Agencies with unqualified opinions          material weaknesses or noncompliances
encompasses improved financial                     21
                                                        a
                                                                                               4
                                                                                                   b


management performance. To
                                               Source: GAO.
effectively implement federal
financial management reform,                   a
                                                 Agriculture, Commerce, Education, Energy, Federal Emergency Management Agency, Health and
sustained leadership and oversight             Human Services, Housing and Urban Development, Interior, Justice, Labor, State, Transportation,
                                               Treasury, Veterans Affairs, Environmental Protection Agency, General Services Administration,
are essential.
                                               National Aeronautics and Space Administration, National Science Foundation, Nuclear Regulatory
                                               Commission, Office of Personnel Management, and Social Security Administration.
www.gao.gov/cgi-bin/getrpt?GAO-03-572T.        b
                                                 Energy, General Services Administration, National Science Foundation, and Social Security
                                               Administration.
To view the full report, including the scope
and methodology, click on the link above.
For more information, contact Jeffrey
Steinhoff or Gary Engel at (202) 512-2600.
Mr. Chairman and Members of the Subcommittee:

I am pleased to be here today to discuss our report on the U.S.
government’s consolidated financial statements for fiscal years 2002 and
2001. Both the consolidated financial statements and our report are
included in the fiscal year 2002 Financial Report of the United States
Government, which was issued by the Department of the Treasury
(Treasury) on March 31, 2003, and is available through GAO’s Internet site,
at www.gao.gov, and Treasury’s Internet site, at
www.fms.treas.gov/fr/index.html. At the outset, I would like to thank the
subcommittee for continuing an annual tradition of oversight hearings on
this important subject. The work of the former Subcommittee on
Government Efficiency, Financial Management, and Intergovernmental
Relations, along with its leader, former Congressman Stephen Horn, has
been a catalyst to facilitate government management reform over the past 6
years. The continued involvement of this subcommittee will be critical to
ultimately restoring public confidence in the federal government as a
financial steward that is accountable for its finances.

As in the 5 previous fiscal years, certain material weaknesses1 in internal
control and in accounting and reporting prevented us from being able to
provide the Congress and American citizens an opinion as to whether the
consolidated financial statements are fairly stated in conformity with U.S.
generally accepted accounting principles. Until the problems discussed in
our report are adequately addressed, they will continue to (1) hamper the
federal government’s ability to accurately report a significant portion of its
assets, liabilities, and costs, (2) affect the federal government’s ability to
accurately measure the full cost and financial performance of certain
programs and effectively manage related operations, and (3) significantly
impair the federal government’s ability to adequately safeguard certain
significant assets and properly record various transactions.

Across government, financial management improvement initiatives are
under way that, if effectively implemented, have the potential to
appreciably improve the quality of the federal government’s financial
management and reporting. A number of federal agencies have started to


1
 A material weakness is a condition that precludes the entity’s internal control from
providing reasonable assurance that misstatements, losses, or noncompliance material in
relation to the financial statements or to stewardship information would be prevented or
detected on a timely basis.




Page 1                                                                       GAO-03-572T
make progress in their efforts to modernize their financial management
systems and improve financial management performance as called for in
the President’s Management Agenda. For example, the Department of the
Treasury’s Internal Revenue Service (IRS) has made significant progress in
addressing its financial management weaknesses, including addressing
controls over budgetary activity and its accountability over property and
equipment. Resolving many of IRS’s most serious financial management
weaknesses—identified by GAO as a high-risk area since 1995—will require
a sustained, long-term commitment of resources, continued strong
involvement of senior IRS management, and sustained progress in systems
modernization.

This year marks the earliest that federal agencies’ audited financial
statements have ever been available. For the first time, Chief Financial
Officers Act (CFO) Act agencies were required to combine their audited
financial statements with performance reports and deliver both to the
Office of Management and Budget (OMB) by February 1, a month earlier
than last year. Furthermore, the Principals of the Joint Financial
Management Improvement Program (JFMIP)2—the Secretary of the
Treasury, the Directors of OMB and the Office of Personnel Management
(OPM), and I, as Comptroller General of the United States—have agreed to
accelerate the agency financial statement reporting date to November 15
for fiscal year 2004. The Social Security Administration (SSA), which has a
long-standing record of delivering its audited financial statements well
before the mandated deadline, issued its fiscal year 2002 audited financial
statements on November 19, 2002. Treasury also accelerated its time frame
and issued its fiscal year 2002 audited financial statements on November
15, 2002, which was more than 3 months earlier than for fiscal year 2001.

For fiscal year 2002, 21 of the 24 CFO Act agencies were able to attain
unqualified audit opinions on their financial statements (the appendix lists
the 24 CFO Act agencies, their audit results, and auditors), up from 6
agencies for fiscal year 1996. Also, 4 CFO Act agencies showed
improvement by receiving unqualified opinions from their auditors this
year—the Department of Education, the National Aeronautics and Space
Administration (NASA), the Federal Emergency Management Agency, and


2
 JFMIP is a joint and cooperative undertaking of Treasury, GAO, OMB, and OPM working in
cooperation with each other and other federal agencies to improve financial management
practices in the federal government. Leadership and program guidance are provided by the
four JFMIP Principals.




Page 2                                                                     GAO-03-572T
the Department of Agriculture (USDA), which received an unqualified audit
opinion for the first time. On the other hand, after receiving unqualified
opinions on its financial statements since fiscal year 1996, the Small
Business Administration’s (SBA) independent auditor withdrew its
unqualified audit opinions on the agency’s fiscal years 2001 and 2000
financial statements and issued disclaimers of opinion on the agency’s
fiscal years 2002 and 2001 financial statements.

Although obtaining unqualified audit opinions is important, according to
the President’s Management Agenda, “most federal agencies that obtain
clean audits only do so after making extraordinary, labor-intensive assaults
on financial records.” Further, the President’s Management Agenda stated
that without sound internal control and accurate and timely financial
information, it is not possible to accomplish the President’s agenda to
secure the best performance and highest measure of accountability for the
American people. It will be increasingly difficult for federal agencies to
continue to rely on significant costly and time-intensive manual efforts to
achieve or maintain unqualified opinions until automated, integrated
processes and systems are implemented that readily produce the necessary
information. As a result, many federal agencies must accelerate their
efforts to improve underlying financial management systems and controls,
which is consistent with reaching the financial management success
measures envisioned by the JFMIP Principals and called for by the
President’s Management Agenda.

Before discussing the results of the audit of the U.S. government’s
consolidated financial statements in more detail, I would like to discuss
why sound financial management is especially necessary for the future, as
well as for today, to meet tomorrow’s fiscal needs. I then will highlight the
major issues relating to the consolidated financial statements for fiscal
years 2002 and 2001. I will then discuss the urgency of providing sustained
leadership and oversight for effective implementation of financial
management reform, provide my perspectives on the importance of federal
agencies’ building on the success of their unqualified audit opinions by
significantly improving underlying financial management systems, and
underscore the need to address major impediments to an opinion on the
consolidated financial statements. Also, I will present my observations on
selected audit matters that are key to protecting the public interest.




Page 3                                                            GAO-03-572T
Meeting Tomorrow’s   The requirement for timely, accurate, and useful financial and performance
                     management information is greater than ever. The long-term fiscal
Fiscal Needs         pressures created by the retirement of the baby boom generation and new
                     homeland security and defense commitments, including the ongoing
                     Operation Iraqi Freedom, sharpen the need to look at competing claims on
                     federal budgetary resources and new priorities. In previous testimony, I
                     noted that it should be the norm to reconsider the relevance or “fit ” of any
                     federal program or activity in today’s world and for the future.3 Such a
                     fundamental review is necessary both to increase fiscal flexibility and to
                     make government fit the modern world. Stated differently, there is a need
                     to consider what the proper role of the federal government will be in the
                     21st century and how the government should do business in the future.
                     The budget and performance integration initiative undertaken as part of the
                     President’s Management Agenda should help provide information for use in
                     conducting such reviews. OMB’s Program Assessment Rating Tool (PART)
                     represents a step toward more structured involvement of program and
                     performance analysis in the budget. PART includes general questions on
                     (1) program purpose and design, (2) strategic planning, (3) program
                     management, and (4) program results. It also includes a set of more
                     specific questions that vary according to the type of delivery mechanism or
                     approach the program uses.

                     As we look ahead, the federal government faces an unprecedented
                     demographic challenge. A nation that has prided itself on its youth will
                     become older. Between now and 2035, the number of people who are 65
                     years old or over will double. As the share of the population over 65
                     climbs, federal spending on the elderly will absorb larger and ultimately
                     unsustainable shares of the federal budget. Federal spending on health and
                     entitlement programs for the elderly is expected to surge as people live
                     longer and spend more time in retirement. In addition, advances in medical
                     technology are likely to keep pushing up the cost of providing health care.
                     Moreover, the baby boomers will have left behind fewer workers to support
                     them in retirement, prompting a slower rate of economic growth from
                     which to finance these higher costs. Absent substantive reform of related
                     entitlement programs and/or dramatic changes in tax or discretionary
                     spending policies, we will face large, escalating, and persistent deficits.

                     3
                      U.S. General Accounting Office, Budget Issues: Long-Term Fiscal Challenges, GAO-02-
                     467T (Washington, D.C.: Feb. 27, 2002) and U.S. General Accounting Office, Budget Issues:
                     Effective Oversight and Budget Discipline are Essential—Even in a Time of Surplus,
                     GAO/T-AIMD-00-73 (Washington, D.C.: Feb. 1, 2000).




                     Page 4                                                                      GAO-03-572T
These trends have widespread implications for our society, our economy,
and the federal budget.

On March 17, 2003, the Trustees of the Social Security and Medicare trust
funds reported on the current and projected status of these programs over
the next 75 years. The Trustees report that the fundamentals of the
financial status of both Social Security and Medicare remain highly
problematic. However, they stated that Medicare faces financial difficulties
that are more severe than those confronting Social Security because costs
of the Medicare program are projected to rise faster than costs of the Social
Security program. The projections show a 20 percent increase to about
$6.2 trillion over the prior year in the Present Value of Resources Needed
Over the 75-Year Projection Period for Federal Hospital Insurance
(Medicare Part A), while the Social Security projection showed an 8
percent increase to about $4.9 trillion. Once again, the Trustees state that
action to address the financial difficulties facing Social Security and
Medicare must be taken in a timely manner and that the sooner these
financial challenges are addressed, the more varied and less disruptive the
solutions can be.

Early action to change these programs would yield the highest fiscal
dividends for the federal budget and would provide a longer period for
prospective beneficiaries to make adjustments in their own planning.
Waiting to take action entails risks. First, we lose an important window
where today’s relatively large workforce can increase saving and enhance
productivity, two elements critical to growing the future economy. Second,
we lose the opportunity to reduce the burden of interest in the federal
budget, thereby creating a legacy of higher debt as well as elderly
entitlement spending for the relatively smaller workforce of the future.
Third, and most critically, we risk losing the opportunity to phase in
changes gradually so that all can make the adjustments needed in private
and public plans to accommodate this historic shift.

We prepare long-term budget simulations that seek to illustrate the likely
fiscal consequences of the coming demographic tidal wave and rising
health care costs. Our latest long-term budget simulations reinforce the
need for change in the major cost drivers—Social Security and health care
programs. As shown in figure 1, by midcentury, absent reform of these
entitlement programs, projected federal revenues may be adequate to pay
little beyond interest on the debt and Social Security benefits. Further, the
shift from surplus to deficit means that the nation will move into the future
in a weaker fiscal position than was previously the case.



Page 5                                                            GAO-03-572T
Figure 1:

                 Composition of Spending as a Share of GDP
           Assuming Discretionary Spending Grows with GDP after 2003
                     and the 2001 Tax Cuts Do Not Sunset

50     Percent of GDP


40


30                   Revenue


20


10


  0
                 2000                       2015                 2030                 2050
                                                   Fiscal year

      Net interest             Social Security       Medicare & Medicaid        All other spending

Source: GAO’s March 2003 analysis.



Note: Assumes currently scheduled Social Security benefits are paid in full throughout the simulation
period.


Although the need for structural change in Social Security is widely
recognized, this change would not be sufficient to overcome the long-term
fiscal challenges confronting the nation. For example, the long-term fiscal
imbalance would not come close to being eliminated even if Social Security
benefits were to be limited to currently projected trust fund revenues,
because Medicare and Medicaid—spending for which is driven by both
demographics and rising health care costs—present an even greater
problem.

While addressing the challenges of Social Security and Medicare is key to
ensuring future fiscal flexibility, a fundamental review of major programs,
policies, and operations can create much-needed fiscal flexibility to
address emerging needs. As I have stated previously, it is healthy for the
nation periodically to review and update its programs, activities, and
priorities.4 Many federal programs and policies were designed years ago to
respond to earlier challenges. Ultimately, the federal government should
strive to hand to the next generation the legacy of a government that is
effective and relevant to a changing society—a government that is as free



Page 6                                                                                 GAO-03-572T
                           as possible of outmoded commitments and operations that can
                           inappropriately encumber the future.

                           A reexamination of existing programs and policies could help weed out
                           items that have proven to be outdated or persistently ineffective or
                           alternatively could prompt us to update and modernize activities through
                           such actions as improving program targeting and efficiency, consolidation,
                           or reengineering of processes and operations. Such a review should not be
                           limited to only spending programs but should include the full range of tools
                           of governance that the federal government uses to address national
                           objectives. These tools include loans and loan guarantees, tax
                           expenditures, and regulations.

                           In the last decade the Congress put in place a series of laws designed to
                           improve information about cost and performance. This framework and the
                           information it provides can help structure and inform the debate about
                           what the federal government should do. In addition, GAO has identified a
                           number of areas warranting reconsideration based on program
                           performance, targeting, and costs.

                           The events of the past few years have served to highlight the benefits of
                           fiscal flexibility. Addressing the long-term drivers in the budget is essential
                           to preserving any flexibility in the long term. In the nearer term, a
                           fundamental review of existing programs and policies can also create
                           much-needed fiscal flexibility. In this regard, the federal government must
                           determine how best to address the necessary structural challenges in a
                           reasonably timely manner in order to identify specific actions that need to
                           be taken. As steward of the nation’s future, the federal government must
                           begin to prepare for tomorrow.



Need for New Metrics and   Today’s budget decisions shape, in part, the choices and resources
Mechanisms                 available to future decision makers and taxpayers. Accordingly, today’s
                           budget decisions involve tradeoffs between meeting current needs and
                           fulfilling stewardship responsibilities. The government undertakes a wide
                           range of responsibilities, programs, and activities that may call for future
                           spending or create an expectation for such spending. Figure 2 illustrates
                           some of these claims on future federal resources.


                           4
                            GAO/T-AIMD-00-73.




                           Page 7                                                              GAO-03-572T
Figure 2:




            Page 8   GAO-03-572T
A better understanding and more transparency about these “fiscal
exposures” is needed. The budget needs to employ new metrics and
measures and processes—relying more on long-term estimates and present
value concepts in making resource allocation decisions. Neither current
budget reporting nor financial statements are designed to promote the
recognition and explicit consideration of all of these exposures. Our
nation’s fiscal exposures cover a wide range: from explicit liabilities to
implicit promises embedded in current policy or public expectations.
Some, like accounts payable and loan guarantees, are included in both the
budget and financial statements and some are not. Others, such as liability
for environmental cleanup, are reported in the financial statements, but
only a single year’s figures are in the budget. Some implicit exposures,
such as future Social Security and Medicare benefits, are not included in
the budget or reported as liabilities in the financial statements5 but are
captured in long-range budget projections. Other implicit exposures, such
as the risk assumed by insurance programs, may not be captured in either
budget or financial reporting.

The failure to understand and address these fiscal exposures can have
significant consequences, encumbering future budgets and reducing fiscal
flexibility. Further, the failure to capture the long-term costs of a proposal
or decision limits the Congress’s ability to control fiscal exposures at the
time it is being asked to make the decision.

As the figure makes clear, there is wide diversity in the nature of these
fiscal exposures. This diversity suggests that it would be most useful to
look at different types of fiscal exposures and tailor metrics and changes to
address each type. We recently recommended6 that OMB report annually
on fiscal exposures, including a concise list and description and cost
estimates where possible. We also recommended that, where possible,
OMB report the estimated costs associated with certain exposures as a new
budget concept—“exposure level”—as a notational item in the President’s
budget. These two steps would help alert both the public and policy
makers about the long-term implications of programs, policies and
activities.


5
 The stewardship information section of the U.S. government’s consolidated financial
statements presents the present value of long-range actuarial projections for the Social
Security and Medicare programs, together with related information.
6
U.S. General Accounting Office, Fiscal Exposures: Improving the Budgetary Focus on
Long-Term Costs and Uncertainties, GAO-03-213 (Washington, D.C.: Jan. 24, 2003).




Page 9                                                                         GAO-03-572T
It is important to recognize that for trust funds, greater transparency and
fuller disclosure means going beyond trust fund balances or solvency
measures. For federal trust funds the balances do not provide meaningful
information about program sustainability. These balances do not increase
the government’s ability to meet long-term commitments. Nor do they
necessarily represent the full future cost of existing promises. For example,
the projected exhaustion date of the Hospital Insurance (HI) Trust Fund is
a commonly used indicator of HI’s financial condition. Under the Trustees’
2003 intermediate estimates, the HI Trust Fund is projected to exhaust its
assets in 2026. Long before that, however, HI’s program outlays will exceed
program tax revenues. Under the Trustees’ 2003 intermediate estimates,
this will begin in 2013. To finance program cash deficits, HI will need to
draw on the special-issue Treasury securities acquired during the years of
cash surpluses. For HI to “redeem” its securities, the government will need
to obtain cash through some combination of increased taxes, spending
cuts, and/or increased borrowing from the public (or, if the unified budget
is in surplus, less debt reduction than would otherwise have been the case).
HI’s negative cash flow will place increased pressure on the federal budget
to raise the resources necessary to meet the program’s ongoing costs.

Ultimately, the critical question is not how much a trust fund has in assets,
but whether the government as a whole and the economy can afford the
promised benefits now and in the future and at what cost to other claims on
available resources. Extending a trust fund’s solvency without reforms to
make the underlying program more sustainable can create a false sense of
security and delay needed reform. Because the balances can be
misleading, we need to reconsider how trust funds, and the nonmarketable
federal government securities contained therein, are treated in both the
budget and the federal government’s financial statements.

Today the Congress and President Bush face the challenge of sorting out
these many claims on the federal budget without the budget enforcement
mechanisms or fiscal benchmarks that guided the federal government
through the years of deficit reduction.7 However, it is still the case that the
federal government needs a decision-making framework that permits it to
evaluate choices against both today’s needs and the longer-term fiscal
future that will be handed to future generations. More complete, visible,


7
  We have recently issued a report offering some suggestions on how to better improve
information about the long-term cost implications of various programs and activities. See
GAO-03-213.




Page 10                                                                      GAO-03-572T
                         and transparent reporting of fiscal exposures can better position decision
                         makers to do this.



Highlights of Major      As I mentioned earlier, as has been the case for the past 5 fiscal years, the
                         federal government continues to have a significant number of material
Issues Relating to the   weaknesses related to financial systems, fundamental recordkeeping and
U.S. Government’s        financial reporting, and incomplete documentation. Several of these
                         material weaknesses (referred to hereafter as material deficiencies)
Consolidated Financial   resulted in conditions that continued to prevent us from expressing an
Statements for Fiscal    opinion on the U.S. government’s consolidated financial statements for the
Years 2002 and 2001      fiscal years ended September 30, 2002 and 2001.8 There may also be
                         additional issues that could affect the consolidated financial statements
                         that have not been identified.

                         Major challenges include the federal government’s inability to

                         • properly account for and report property, plant, and equipment and
                           inventories and related property, primarily at the Department of Defense
                           (DOD);

                         • reasonably estimate or adequately support amounts reported for certain
                           liabilities, such as environmental and disposal liabilities and related
                           costs at DOD, and ensure complete and proper reporting for
                           commitments and contingencies;

                         • support major portions of the total net cost of government operations,
                           most notably related to DOD, and ensure that all disbursements are
                           properly recorded;

                         • fully account for and reconcile intragovernmental activity and balances;
                           and

                         • properly prepare the federal government’s financial statements,
                           including fully ensuring that the information in the consolidated
                           financial statements is consistent with the underlying agency financial
                           statements, balancing the statements, adequately reconciling the results


                         8
                          We previously reported that material deficiencies prevented us from expressing an opinion
                         on the fiscal years 1997, 1998, 1999, and 2000 consolidated financial statements.




                         Page 11                                                                      GAO-03-572T
                               of operations to budget results, and eliminating transactions between
                               governmental entities.

                            In addition, we identified material weaknesses in internal control related to
                            loans receivable and loan guarantee liabilities, improper payments, tax
                            collection activities, and information security.

                            I would now like to discuss in more detail the material deficiencies
                            identified by our work.



Property, Plant, and        The federal government could not satisfactorily determine that all such
Equipment and Inventories   assets were included in the consolidated financial statements, verify that
                            certain reported assets actually exist, or substantiate the amounts at which
and Related Property        they were valued. A significant portion of the property, plant, and
                            equipment and the vast majority of inventories and related property are the
                            responsibility of DOD. DOD did not maintain adequate systems or have
                            sufficient records to provide reliable information on these assets. Other
                            agencies, most notably NASA, reported continued weaknesses in internal
                            control procedures and processes related to property, plant, and
                            equipment.



Liabilities and             The federal government could not reasonably estimate or adequately
Commitments and             support amounts reported for certain liabilities. For example, the federal
                            government was not able to reliably estimate key components of DOD’s
Contingencies
                            environmental and disposal liabilities and could not support its estimate of
                            military postretirement health benefits liabilities included in federal
                            employee and veteran benefits payable. Further, the federal government
                            could not determine whether commitments and contingencies, including
                            those related to treaties and other agreements entered into to further the
                            U.S. government’s interest, were complete and properly reported.



Cost of Government          The previously discussed material deficiencies in reporting assets and
Operations and              liabilities, material deficiencies in financial statement preparation, as
                            discussed below, and the lack of adequate disbursement reconciliations at
Disbursement Activity
                            certain federal agencies affect reported net costs. As a result, the federal
                            government was unable to support significant portions of the total net cost
                            of government operations, most notably related to DOD. As it relates to
                            disbursement reconciliations, some federal agencies did not adequately



                            Page 12                                                           GAO-03-572T
                               reconcile disbursements to Treasury’s records of disbursements, which is
                               intended to be a key control to detect and correct errors and other
                               misstatements in financial records in a timely manner. We have seen
                               progress in this area over the past 6 years. However, for fiscal years 2002
                               and 2001 there were unsupported adjustments and unreconciled
                               differences between federal agencies’ and Treasury’s records of
                               disbursements totaling billions of dollars.



Accounting for and             OMB and Treasury require CFO Act agencies to reconcile selected
Reconciliation of              intragovernmental activity and balances with their “trading partners”9 and
                               to report on the extent and results of intragovernmental activity and
Intragovernmental Activity
                               balances reconciliation efforts. However, a substantial number of the CFO
and Balances                   Act agencies did not fully perform such reconciliations for fiscal years 2002
                               and 2001. For both of these years, amounts reported for federal agency
                               trading partners for certain intragovernmental accounts were significantly
                               out of balance. I will discuss these issues further later in this testimony, as
                               well as certain related corrective actions being taken.



Preparation of Consolidated    The federal government did not have adequate systems, controls, and
Financial Statements           procedures to properly prepare its consolidated financial statements.
                               Specifically, we identified problems with compiling the consolidated
                               financial statements, such as adequately ensuring that the information for
                               each federal agency that was included in the consolidated financial
                               statements was consistent with the underlying agency financial statements.
                               In addition, we identified problems with the elimination of
                               intragovernmental activity and balances. Later in this testimony, these
                               matters are discussed further, along with certain corrective actions being
                               taken. Also, disclosure of certain financial information was not presented
                               in the consolidated financial statements in conformity with U.S. generally
                               accepted accounting principles.



Ineffective Internal Control   In addition to the material deficiencies noted above, we found four other
                               material weaknesses in internal control as of September 30, 2002: (1)
                               several federal agencies continue to have significant deficiencies in the


                               9
                                Trading partners are U.S. government agencies, departments, or other components
                               included in the consolidated financial statements that do business with each other.




                               Page 13                                                                       GAO-03-572T
                            processes and procedures used to estimate the costs of their lending
                            programs and value their loan receivables; (2) most federal agencies have
                            not estimated or reported the magnitude of improper payments in their
                            programs; (3) material internal control weaknesses and systems
                            deficiencies continue to affect the federal government’s ability to
                            effectively manage its tax collection activities; and (4) federal agencies
                            have not yet institutionalized comprehensive information security
                            management programs.

Loans Receivable and Loan   Prior to fiscal year 2001, we cited accounting for loans receivable and loan
Guarantee Liabilities       guarantee liabilities as a material deficiency contributing to our disclaimer
                            of opinion because certain key federal credit agencies could not reliably
                            estimate the costs of their lending programs or determine the net loan
                            amounts expected to be collected. In fiscal year 2001, due to significant
                            improvements at USDA, we removed this area from the list of issues
                            contributing to our disclaimer. Nevertheless, several federal agencies
                            continue to have significant deficiencies in the processes and procedures
                            used to estimate the costs of their lending programs and value their loan
                            receivables.

                            In a recent report on SBA's loan asset sale program,10 we reviewed SBA’s
                            budgeting and accounting for loan sales and found that SBA incorrectly
                            calculated the accounting losses on the loan sales and lacked reliable
                            financial data to determine the overall financial impact of the sales.
                            Further, because SBA did not analyze the effect of loan sales on its
                            remaining portfolio, its reestimates of loan program costs for the budget
                            and financial statements may contain significant errors. In addition, SBA
                            could not explain significant declines in its loss allowance account for
                            disaster loans. SBA’s inspector general and its independent auditor agreed
                            with our findings, and the independent auditor withdrew its unqualified
                            audit opinions on SBA’s fiscal years 2001 and 2000 financial statements.
                            Until SBA corrects these errors and determines the cause of the precipitous
                            decline in the loss allowance account for disaster loans, SBA’s financial
                            statements cannot be relied upon. Further, the reliability of current and
                            future subsidy cost estimates will remain unknown. These errors and the
                            lack of key analyses also mean that congressional decision makers are not



                            10
                             U.S. General Accounting Office, Small Business Administration: Accounting Anomalies
                            and Limited Operational Data Make Results of Loan Sales Uncertain, GAO-03-87
                            (Washington, D.C.: Jan. 3, 2003).




                            Page 14                                                                 GAO-03-572T
                    receiving accurate financial data to make informed decisions about SBA’s
                    budget and the level of appropriations the agency should receive.

                    In addition, we again noted that certain other federal credit agencies
                    continue to require significant adjustments to the estimates of program
                    costs, net loan amounts to be collected, and related notes. Auditors for
                    these agencies reported related material internal control weaknesses.

Improper Payments   Across the federal government, improper payments occur in a variety of
                    programs and activities, including those related to health care, contract
                    management, federal financial assistance, and tax refunds. 11 Many
                    improper payments occur in federal programs that are administered by
                    entities other than the federal government. In general, improper payments
                    often result from a lack of or an inadequate system of internal controls.
                    While estimates of improper payments disclosed in federal agency financial
                    statements totaled approximately $20 billion for both fiscal years 2002 and
                    2001, the federal government did not estimate the full extent of improper
                    payments. The President’s Management Agenda includes addressing
                    erroneous payments (a term we consider synonymous with improper
                    payments) as one of the key elements for improving financial performance.

                    The Department of Health and Human Services (HHS) has been reporting a
                    national estimate of improper Medicare fee-for-service payments as part of
                    its annual financial statements since fiscal year 1996. In fiscal year 2002,
                    HHS reported estimated improper Medicare fee-for-service payments of
                    approximately $13.3 billion, or about 6.3 percent of such benefits. HHS’s
                    Centers for Medicare and Medicaid Services (CMS) has initiated projects to
                    improve the precision of Medicare fee-for-service improper payment
                    estimates and aid in the development of corrective actions to reduce
                    improper payment losses. For example, CMS developed a comprehensive
                    error-testing program that will produce contractor-, provider-, and benefit-
                    specific error rates. These error rates can be aggregated to add greater
                    precision to the national Medicare fee-for-service error rate estimates.

                    However, most federal agencies have not estimated or reported the
                    magnitude of improper payments in their programs and comprehensively


                    11
                      Improper payments include inadvertent errors, such as duplicate payments and
                    miscalculations, payments for unsupported or inadequately supported claims, payments for
                    services not rendered, payments to ineligible beneficiaries, and payments resulting from
                    fraud and abuse by program participants and/or federal employees.




                    Page 15                                                                    GAO-03-572T
                            addressed this issue in their annual performance plans under the
                            Government Performance and Results Act (GPRA) of 1993. For example,
                            IRS follows up on only a portion of the suspicious Earned Income Tax
                            Credit (EITC) claims it identifies, although the EITC has historically been
                            vulnerable to high rates of invalid claims. In February 2002, IRS estimated
                            that taxpayers filed returns for tax year 1999 claiming at least $8.5 billion in
                            invalid EITCs, of which only $1.2 billion (14 percent) either was recovered
                            or was expected to be recovered through compliance efforts. Although the
                            full extent of refunds resulting from invalid EITCs is unknown, IRS has not
                            routinely estimated the potential magnitude of invalid refunds and has not
                            disclosed an annual estimate of improper payments in its financial reports.
                            As a result, the amount of improper payments included in the almost $28
                            billion IRS disbursed for EITCs for fiscal year 2002 is unknown.

                            Without systematically measuring the extent of improper payments, federal
                            agency management cannot determine (1) whether problems exist that
                            merit agency action, (2) what mitigation strategies are appropriate and the
                            amount to invest in them, and (3) whether efforts implemented to reduce
                            improper payments are successful. OMB, which has shown leadership in
                            this area, now requires annual submissions on improper payments from 15
                            federal agencies. Specifically, OMB requires actual and projected
                            information on erroneous payment rates and the status of actions taken to
                            reduce improper payments. Further, the Improper Payments Information
                            Act of 200212 requires federal agencies to (1) annually review programs and
                            activities that they administer to identify those that may be susceptible to
                            significant improper payments, (2) estimate improper payments in
                            susceptible programs and activities, and (3) provide reports to the
                            Congress that include such information as the status of actions to reduce
                            improper payments for programs and activities with estimated improper
                            payments of $10 million or more.

Tax Collection Activities   Material internal control weaknesses and systems deficiencies continue to
                            affect the federal government’s ability to effectively manage its tax
                            collection activities.13 This situation continues to result in the need for
                            extensive, costly, and time-consuming ad hoc programming and analyses,
                            as well as material audit adjustments, to prepare basic financial


                            12
                                 Pub. L. No. 107-300, 116 Stat. 2350 (Nov. 26, 2002).
                            13
                             U.S. General Accounting Office, Financial Audit: IRS's Fiscal Years 2002 and 2001
                            Financial Statements, GAO-03-243 (Washington, D.C.: Nov. 15, 2002).




                            Page 16                                                                   GAO-03-572T
information. As further discussed later in this testimony, this approach
cannot be used to prepare such information on a timely, routine basis to
assist in ongoing decision making. Additionally, the severity of the system
deficiencies that give rise to the need to resort to such procedures for
financial reporting purposes, as well as deficient physical safeguards, result
in burden on taxpayers and lost revenue.

The lack of appropriate subsidiary systems to track the status of taxpayer
accounts and material weaknesses in financial reporting affect the
government’s ability to make informed decisions about collection efforts.
Due to errors and delays in recording activity in taxpayer accounts,
taxpayers were not always being credited for payments made on their tax
liabilities. In addition, the federal government did not always follow up on
potential unreported or underreported taxes and did not always pursue
collection efforts against taxpayers owing taxes to the federal government.
This could result in billions of dollars not being collected and adversely
affect future compliance.

The federal government continues to be vulnerable to lost tax revenue due
to weaknesses in controls intended to maximize the government’s ability to
collect what is owed and to minimize the risk of payment of improper
refunds. The federal government identifies billions of dollars of potentially
underreported taxes and improper refunds each year. However, due in
large part to perceived resource constraints, the federal government
selects only a portion of the questionable cases it identifies for follow-up
investigation and action. In addition, the federal government often does
not initiate follow-up on the cases it selects until months after the related
tax returns have been filed and any related refunds disbursed, affecting its
chances of collecting amounts due on these cases. Consequently, the
federal government is exposed to potentially significant losses from
reduced revenue and disbursements of improper refunds. Finally,
continued weaknesses in physical controls over cash, checks, and sensitive
data received from taxpayers increase both the federal government’s and
the taxpayers’ exposure to losses and increases the risk of taxpayers
becoming victims of crimes committed through identity fraud.

IRS senior management continues to be committed to addressing many of
these operational and financial management issues and has made a number
of improvements to address some of these weaknesses. Successful
implementation of long-term efforts to resolve these serious problems will
require the continued commitment of IRS management as well as
substantial resources and expertise.



Page 17                                                            GAO-03-572T
Information Security   GAO has reported information security over computerized operations as a
Weaknesses             governmentwide high-risk area since February 1997.14 Information security
                       weaknesses are placing enormous amounts of federal government assets at
                       risk of inadvertent or deliberate misuse, financial information at risk of
                       unauthorized modification or destruction, sensitive information at risk of
                       inappropriate disclosure, and critical operations at risk of disruption. The
                       federal government is not in a position to estimate the full magnitude of
                       actual damage and loss resulting from federal information security
                       weaknesses because it is likely that many such incidents are either not
                       detected or not reported. Although progress has been made, federal
                       agencies have not yet institutionalized comprehensive security
                       management programs, which are critical to resolving information security
                       problems and managing information security risk on an ongoing basis.

                       The information security weaknesses continue to cover the full range of
                       information security controls. For example, access controls were not
                       effective in limiting or detecting inappropriate access to information
                       resources, such as ensuring that only authorized individuals can read, alter,
                       or delete data. In addition, software change controls were ineffective in
                       ensuring that only properly authorized and tested software programs were
                       implemented. Further, duties were not appropriately segregated to reduce
                       the risk that one individual could conduct unauthorized transactions
                       without being detected. Finally, sensitive operating system software was
                       not adequately controlled, and adequate steps had not been taken to ensure
                       continuity of operations.




                       14
                        U.S. General Accounting Office, High-Risk Series: An Update, GAO-03-119 (Washington,
                       D.C.: January 2003).




                       Page 18                                                                   GAO-03-572T
                          Through the recently enacted Federal Information Security Management
                          Act of 2002 (FISMA),15 the Congress has continued its efforts to improve
                          federal information security by permanently authorizing and strengthening
                          the information security program, evaluation, and reporting requirements
                          established by federal government information security reform
                          legislation.16 This information security reform legislation has been a
                          significant step in improving federal agencies’ information security
                          programs and addressing their serious, pervasive information security
                          weaknesses, and, among other benefits, has increased management
                          attention to and accountability for information security. FISMA will further
                          strengthen federal information security by requiring the National Institute
                          of Standards and Technology to develop mandatory minimum information
                          security requirements.

                          The administration has also taken actions to improve information security.
                          For example, OMB created an annual reporting process that includes
                          federal agency preparation of corrective action plans to track progress in
                          correcting identified weaknesses. Further, in February 2003, the President
                          issued the National Strategy to Secure Cyberspace, which sets national
                          priorities for reducing threats from and vulnerabilities to cyberattacks and
                          improving the nation’s response to cyberincidents.



Providing Sustained       Over the past year, the JFMIP Principals continued our efforts, begun in
                          August 2001, to accelerate progress in financial management reform. This
Leadership and            involved our personal commitment to provide the leadership necessary to
Oversight for Effective   address pressing governmentwide financial management issues. Also,
                          President Bush has implemented the President’s Management Agenda to
Implementation of         provide direction to, and to closely monitor, management reform across
Financial Management      government, which encompasses improved financial performance. Actions
Reform                    such as these are important elements of ensuring the government’s full and
                          effective implementation of the federal financial management reforms
                          enacted by the Congress.




                          15
                               Pub. L. No. 107-347, Title III, 116 Stat. 2946 (Dec. 17, 2002).
                          16
                           Floyd D. Spence National Defense Authorization Act for Fiscal Year 2001, Pub. L. No. 106-
                          398, Title X, Subtitle G, 114 Stat. 1654A-266 (Oct. 30, 2000).




                          Page 19                                                                      GAO-03-572T
The JFMIP Principals’   Since August 2001, the JFMIP Principals have established an excellent
Initiative              working relationship, a basis for action, and a sense of urgency through
                        which significant and meaningful progress can be achieved. In fiscal year
                        2002, JFMIP Principals continued the series of regular, deliberative
                        meetings that focused on key financial management reform issues such as

                        • defining success measures for financial management performance that
                          go far beyond an unqualified audit opinion on financial statements and
                          include measures such as financial management systems that routinely
                          provide timely, reliable, and useful financial information and no material
                          internal control weaknesses or material noncompliance with laws and
                          regulations and Federal Financial Management Improvement Act of
                          1996 (FFMIA) requirements;17

                        • restructuring the Federal Accounting Standards Advisory Board’s
                          (FASAB) composition to enhance the independence of the Board and
                          increase public involvement in setting standards for federal financial
                          accounting and reporting;

                        • significantly accelerating financial statement reporting to improve
                          timeliness for decision making and to discourage costly efforts designed
                          to obtain unqualified opinions on financial statements without
                          addressing underlying systems challenges;

                        • establishing audit advisory committees for selected major federal
                          agencies; and

                        • addressing difficult accounting and reporting issues, including
                          impediments to an audit opinion on the U.S. government's consolidated
                          financial statements and reporting updated social insurance financial
                          information in the U.S. government’s consolidated financial statements.

                        Continued personal involvement of the JFMIP Principals is critical to the
                        full and successful implementation of federal financial management reform
                        and to providing greater transparency and accountability in managing


                        17
                          FFMIA requires auditors, as part of CFO Act agencies’ financial statement audits, to report
                        whether agencies’ financial management systems substantially comply with (1) federal
                        financial management systems requirements, (2) applicable federal accounting standards
                        (U.S. generally accepted accounting principles), and (3) the federal government’s SGL at the
                        transaction level.




                        Page 20                                                                        GAO-03-572T
                    federal programs and financial resources. At the end of fiscal year 2002, I
                    ended my 2-year term as Chair of the JFMIP Principals, and the Chair
                    rotated to Office of Management and Budget Director Daniels. I look
                    forward to working with the new Chair, Treasury Secretary Snow, and
                    Office of Personnel Management Director James in the upcoming months
                    to continue this important dialogue and build on the strong working
                    relationships that we have established.



The President’s     President Bush has established an agenda for improving the management
Management Agenda   and performance of the federal government that targets the most apparent
                    deficiencies where the opportunity to improve performance is the greatest.
                    It is no accident that the President’s Management Agenda has a strong
                    correlation to GAO’s high-risk list. This is just one example of how GAO
                    and OMB have worked constructively to identify key issues deserving
                    increased attention throughout government. As stated in the President’s
                    Management Agenda—and we wholeheartedly agree—there are few items
                    more urgent than ensuring that the federal government is well run and
                    results-oriented.

                    The President’s Management Agenda, which is a starting point for
                    management reform, includes improved financial management
                    performance as one of the five governmentwide management goals. Other
                    governmentwide initiatives of the President’s Management Agenda include
                    strategic management of human capital, competitive sourcing, expanded
                    electronic government, and budget and performance integration.

                    In particular, the improved financial management performance initiative is
                    aimed at ensuring that federal financial systems produce accurate and
                    timely information to support operating, budget, and policy decisions.
                    Also, this initiative focuses special attention on addressing erroneous
                    payments, credit card abuse in the federal government, and asset
                    management, areas for which we have reported problems and challenges.18




                    18
                      U.S. General Accounting Office, Financial Management: Coordinated Approach Needed
                    to Address the Government’s Improper Payments Problems, GAO-02-749 (Washington,
                    D.C.: Aug. 9, 2002); Government Purchase Cards: Control Weaknesses Expose Agencies to
                    Fraud and Abuse, GAO-02-676T (Washington, D.C.: May 1, 2002); High-Risk Series: Federal
                    Real Property, GAO-03-122 (Washington, D.C.: January 2003).




                    Page 21                                                                   GAO-03-572T
                       Under the improved financial management performance initiative, agencies
                       are expected to improve the timeliness, enhance the usefulness, and ensure
                       the reliability of financial information. The expected result is integrated
                       financial and performance management systems that routinely produce
                       information that is (1) timely, to measure and effect performance
                       immediately, (2) useful, to make more informed operational and investing
                       decisions, and (3) reliable, to ensure consistent and comparable trend
                       analysis over time and to facilitate better performance measurement and
                       decision making. This result is a key to successfully achieving the goals set
                       out by the Congress in the CFO Act and other federal financial management
                       reform legislation.

                       Central to effectively addressing the federal government’s management
                       problems and providing a solid base for successful transformation efforts is
                       recognition that the five governmentwide initiatives cannot be addressed in
                       an isolated or piecemeal fashion from other major management challenges
                       and high risks facing federal agencies. Rather, these efforts are mutually
                       reinforcing and must be addressed in an integrated way to ensure that they
                       drive a broader transformation of the cultures of federal agencies.



The Executive Branch   The administration is using the Executive Branch Management Scorecard
Management Scorecard   to highlight federal agencies’ progress in achieving management and
                       performance improvements embodied in the President’s Management
                       Agenda. The Executive Branch Management Scorecard grades selected
                       federal agencies’ performance regarding the five governmentwide
                       initiatives by using broad standards and a red-yellow-green coding system
                       to indicate the level at which agencies are meeting the standards.




                       Page 22                                                           GAO-03-572T
In the financial management area, while recognizing the importance of
achieving an unqualified opinion from auditors on financial statements, the
scorecard focuses on the fundamental and systemic issues that must be
addressed in order to generate timely, accurate, and useful financial
information. The scorecard also measures whether agencies have any
material internal control weaknesses or material noncompliances with
laws and regulations, and whether agencies meet FFMIA requirements.
The December 31, 2002, scorecard’s results show dramatically the extent of
work remaining across government to improve financial and other
management areas. For financial performance, most of the selected federal
agencies were scored in the red category. This is not surprising,
considering the well-recognized need to transform financial management
and other business processes at federal agencies such as DOD, the results
of our analyses under FFMIA, and the various financial management
operations we have designated as high risk.19 Some of the selected
agencies improved their scores from the initial baseline evaluation as of
September 30, 2001; however, other agencies’ scores declined, reflecting
increased challenges.

The focus that the administration’s scorecard approach brings to improving
management and performance, including financial management
performance, is certainly a step in the right direction. The value of the
scorecard is not in the scoring per se, but in the degree to which scores
lead to sustained focus and demonstrable improvements. This will depend
on continued efforts to assess progress and maintain accountability to
ensure that agencies are able to, in fact, improve their performance. It will
be important that there be continuous rigor in the scoring process in order
for this approach to be credible and effective in providing the proper
incentives that produce lasting results. Also, it is important to recognize
that many of the challenges the federal government faces, such as
improving financial management, are long-standing and complex, and will
require sustained attention.




19
 As reported in GAO-03-119, we have identified financial management as a high-risk area at
DOD, Treasury’s IRS, USDA’s Forest Service, and the Department of Transportation’s
Federal Aviation Administration.




Page 23                                                                      GAO-03-572T
Building on the          Building on the success that has been achieved in obtaining unqualified
                         audit opinions, federal agency management must continue to work toward
Success of Unqualified   fully resolving the pervasive and generally long-standing material
Audit Opinions           weaknesses that have been reported for the past 6 fiscal years. The
                         underlying causes of these issues are significant financial management
                         systems weaknesses, problems with fundamental recordkeeping and
                         financial reporting, incomplete documentation, and weak internal control.
                         In identifying improved financial management performance as one of its
                         five governmentwide initiatives, the President’s Management Agenda
                         stated that a clean (unqualified) financial audit opinion is a basic
                         prescription for any well-managed organization. It recognized that “most
                         federal agencies that obtain clean audits only do so after making
                         extraordinary, labor-intensive assaults on financial records.” Further, the
                         President’s Management Agenda stated that without sound internal control
                         and accurate and timely financial information, it is not possible to
                         accomplish the President’s agenda to secure the best performance and
                         highest measure of accountability for the American people.

                         Irrespective of the unqualified opinions on their financial statements, many
                         federal agencies do not have timely, accurate, and useful financial
                         information and sound controls with which to make informed decisions
                         and to ensure accountability on an ongoing basis. While federal agencies
                         have continued to make progress in obtaining unqualified audit opinions on
                         annual financial statements, many of these opinions were obtained by
                         expending significant resources on extensive ad hoc procedures and
                         making billions of dollars in adjustments to derive the financial statements
                         months after the end of a fiscal year. Several examples follow. The need
                         for such resource-intensive procedures primarily results from inadequate
                         financial management systems.

                         • After receiving a disclaimer of opinion for fiscal year 2001, NASA was
                           able to produce auditable financial statements for fiscal year 2002;
                           however, the auditors reported that significant weaknesses still existed
                           in NASA’s internal controls related to accounting for the International
                           Space Station and for equipment and materials held by contractors.
                           Because of these control weaknesses, the auditors found numerous
                           errors in property records and had to significantly expand the scope of
                           their testing. To correct auditor-identified errors, NASA had to make
                           about $11 billion of adjustments to its records. The auditors also
                           identified a material weakness related to NASA’s process for preparing
                           its financial statements and performance and accountability report.



                         Page 24                                                          GAO-03-572T
   Deficiencies included errors made in recording significant adjustments
   to the statements and reports. Auditors attributed the errors to
   insufficient resources to address the volume of work needed to compile
   the financial statements, lack of an integrated financial management
   system, lack of understanding by NASA staff of new federal reporting
   requirements, and lack of quality controls over financial reporting.

• After 8 consecutive years of disclaimers of opinion, USDA received an
  unqualified opinion on its fiscal year 2002 financial statements. While
  we consider this a positive step toward achieving financial
  accountability, it took extraordinary efforts outside the normal business
  processes by the department and its auditors, particularly at the Forest
  Service. The USDA Office of Inspector General’s transmittal letter for
  the fiscal year 2002 Forest Service audit report stated that “the Forest
  Service does not yet operate as an effective, sustainable, and
  accountable financial management organization. The fiscal year 2002
  ending account balances were primarily derived from a 2-year audit
  effort on beginning balances and numerous statistical samples of fiscal
  year 2002 transactions. As a result of these efforts, multiple adjustments
  were processed to the general ledger and/or subsidiary ledgers. For
  example, the financial statement line item General Property, Plant and
  Equipment, Net, was reduced by over $1 billion based on audit coverage.
  The achievement of an unqualified opinion, therefore, did not
  necessarily result from improvement in underlying financial
  management systems, but rather as an extensive ad hoc effort.” If USDA
  is to achieve and sustain financial accountability, it must fundamentally
  improve its underlying internal controls, financial management systems,
  and operations to allow for the routine production of accurate, relevant,
  and timely data to support program management.

• Our unqualified opinions on IRS’s fiscal years 2002 and 2001 financial
  statements were made possible by the extraordinary efforts of IRS
  senior management and staff to develop processes to compensate for
  serious internal control and systems deficiencies. As noted earlier in
  this testimony, IRS made significant progress during fiscal year 2002.
  Nonetheless, it continued to require costly, resource-intensive
  processes; statistical projections; external contractors; substantial
  adjustments; and monumental human efforts to derive reliable year-end
  balances for its financial statements. For example, IRS still does not
  have a detailed record, or subsidiary ledger, for taxes receivable to allow
  it to track and manage amounts due from taxpayers. To enable it to
  report a reliable taxes receivable balance in the absence of a subsidiary



Page 25                                                           GAO-03-572T
   ledger, IRS has, for the last 6 years, relied on a complex statistical
   sampling approach that requires substantial human and financial
   resources to conduct, takes months to complete, and yields tens of
   billions of dollars of adjustments. Similarly, while progress has been
   made, IRS does not have an integrated property management system
   that appropriately records property and equipment additions and
   disposals as they occur and links costs on the accounting records to the
   property records.

It will be increasingly difficult for federal agencies to continue to rely on
significant costly and time-intensive manual efforts to achieve or maintain
unqualified opinions until automated, integrated processes and systems are
implemented that readily produce the necessary information. As a result,
many federal agencies must accelerate their efforts to improve underlying
financial management systems and controls, which is consistent with
reaching the financial management success measures envisioned by the
JFMIP Principals and called for by the President’s Management Agenda.

FFMIA requires auditors, as part of CFO Act agencies’ financial statement
audits, to report whether agencies’ financial management systems
substantially comply with (1) federal financial management systems
requirements, (2) applicable federal accounting standards (U.S. generally
accepted accounting principles), and (3) the federal government’s Standard
General Ledger (SGL) at the transaction level. For fiscal year 2002,
auditors for 19 CFO Act agencies reported that the agencies’ financial
management systems did not comply substantially with one or more of
these three FFMIA requirements. For the remaining 5 CFO Act agencies,
auditors provided negative assurance, meaning that nothing came to their
attention indicating that these agencies’ financial management systems did
not substantially meet FFMIA requirements. The auditors for these 5
agencies did not definitively state whether these agencies’ systems
substantially complied with FFMIA requirements, as is required under the
statute. Meeting the requirements of FFMIA has presented long-standing,
significant challenges. These challenges will be resolved only through
time, investment, and sustained emphasis on correcting deficiencies in
federal financial management systems. GAO plans to report to the
Congress by October 1, 2003, on CFO Act agencies’ FFMIA implementation
for fiscal year 2002, as required by the act.

While federal agencies continue to make progress in addressing
weaknesses in their financial management systems, the serious
shortcomings reported for these systems result in the lack of reliable



Page 26                                                           GAO-03-572T
financial information needed for making operating decisions day to day,
managing the federal government’s operations more efficiently and
effectively, measuring program performance, executing the budget,
maintaining accountability, and preparing financial statements.

For example, federal agency financial management systems are required to
produce information on the full cost of programs and projects. This is not a
new expectation—the requirement for managerial cost information has
been in place for more than a decade, since 1990 under the CFO Act and
since 1998 stemming from applicable accounting standards. Currently,
some federal agencies are only able to provide cost accounting information
at the end of the fiscal year through periodic cost surveys. Some federal
agencies, such as the Department of the Interior’s Bureau of Land
Management, are experimenting with methods of accumulating and
assigning costs to obtain the managerial cost information needed to
enhance programs, improve processes, establish fees, develop budgets,
prepare financial reports, and report on performance. Having such
financial information is the goal of FFMIA and the CFO Act, necessary for
implementing GPRA, and critical to the transition to a more results-
oriented federal government as envisioned in the President’s Management
Agenda.

To remedy financial management systems weaknesses and carry out the
President’s Management Agenda for improving financial management,
OMB, and the CFO Act agencies will need to aggressively and rigorously
collaborate. Our work to identify financial management best practices in
world-class organizations20 has identified key factors for successfully
modernizing financial systems, including (1) reengineering business
processes in conjunction with implementing new technology, (2)
developing systems that support the partnership between finance and
operations, and (3) translating financial data into meaningful data. We
identified other financial management best practices as well, such as
(1) providing clear, strong executive leadership, (2) making financial
management an entitywide priority, and (3) building a culture of control
and accountability.

The size and complexity of many federal agencies and the discipline
needed to overhaul or replace their financial management systems present


20
 U.S. General Accounting Office, Executive Guide: Creating Value Through World-class
Financial Management, GAO/AIMD-00-134 (Washington, D.C.: April 2000).




Page 27                                                                   GAO-03-572T
                         a significant challenge—not simply a challenge to overcome a technical
                         glitch, but a demanding management challenge that requires attention from
                         the highest levels of the federal government along with sufficient human
                         capital resources to effect lasting change. This will be a particular
                         challenge at the new Department of Homeland Security (DHS), where
                         federal agencies, many of which have ongoing challenges in their systems,
                         processes, or internal controls over financial information, are becoming
                         part of the new department. DHS, along with other federal agencies, has a
                         stewardship obligation to prevent fraud, waste, and abuse, to use tax
                         dollars appropriately, and to ensure financial accountability to the
                         President, the Congress, and the American people. In addition to
                         addressing incoming agencies’ challenges, DHS will need to focus on
                         building future systems as part of its enterprise architecture approach to
                         ensure an overarching framework for the agency’s integrated financial
                         management processes. Plans must be developed and implemented to
                         bridge the many financial environments in which incoming agencies
                         currently operate to an integrated DHS system.

                         We recognize that it will take time, investment, and sustained emphasis on
                         correcting deficiencies to improve federal financial management systems
                         at DHS and other federal agencies to the level required by FFMIA. The
                         JFMIP Principals’ leadership, commitment, and oversight will be important
                         to provide the needed impetus to meet this challenge.



Addressing Major         As I mentioned earlier, for the past 6 fiscal years, the federal government
                         has been required to prepare, and have audited, consolidated financial
Impediments to an        statements. Successfully meeting this requirement is tightly linked to the
Opinion on               requirement for the 24 CFO Act agencies to also have audited financial
                         statements. This has stimulated extensive cooperative efforts and
Consolidated Financial   considerable attention by agency chief financial officers, inspectors
Statements               general, Treasury and OMB officials, and GAO. With the benefit of several
                         years’ experience by the federal government in having the required
                         financial statements subjected to audit, the time has come to focus even
                         more intensified attention on the most serious obstacles to achieving an
                         opinion on the U.S. government’s consolidated financial statements. In this
                         regard, the JFMIP Principals have discussed plans and strategies for
                         addressing impediments to an opinion on the U.S. government’s
                         consolidated financial statements. Three major impediments to an opinion
                         on the consolidated financial statements are (1) serious financial
                         management problems at DOD, (2) the federal government’s inability to
                         fully account for and reconcile billions of dollars of transactions between



                         Page 28                                                         GAO-03-572T
                      federal entities, and (3) the federal government’s inability to properly
                      prepare the consolidated financial statements.



Reforming Financial   Essential to achieving an opinion on the consolidated financial statements
Management at DOD     is resolution of the serious financial management problems at DOD, which
                      we have designated as high risk since 1995. In accordance with provisions
                      of the National Defense Authorization Act for fiscal year 2002,21 DOD
                      reported that the department’s financial management systems were not
                      able to provide adequate evidence supporting material amounts in its fiscal
                      year 2002 financial statements. DOD asserted that it is unable to comply
                      with applicable financial reporting requirements for (1) property, plant, and
                      equipment, (2) inventory and operating materials and supplies, (3) military
                      retirement health care actuarial liability, (4) environmental liabilities, (5)
                      intragovernmental eliminations and related accounting adjustments, and
                      (6) cost accounting by suborganization/responsibility segment and major
                      program. Based largely on DOD’s assertion, the DOD inspector general
                      again disclaimed an opinion on DOD’s financial statements for fiscal year
                      2002 as it had for the previous 6 fiscal years.

                      To date, none of the military services or major DOD components has
                      passed the test of an independent financial audit because of pervasive
                      weaknesses in DOD’s financial management systems, operations, and
                      internal control, including an inability to compile financial statements that
                      comply with generally accepted accounting principles. The department
                      has made progress in a number of areas but is far from solving a range of
                      serious financial management problems. Their resolution, however, is key
                      to having auditable consolidated financial statements because DOD had
                      budget authority of $385 billion for fiscal year 2002, or about 18 percent of
                      the entire federal budget; is accountable for a vast amount of government
                      assets worldwide; and incurs a substantial amount of the reported
                      liabilities.




                      21
                       Section 1008 of the National Defense Authorization Act for fiscal year 2002, Pub. L. No.
                      107-107, 115 Stat. 1012 (Dec. 28, 2001), provides a framework for redirecting the
                      department’s resources from the preparation and audit of financial statements to
                      improvement of DOD’s financial management systems and financial management policies,
                      procedures, and internal controls. Under this legislation, the department will also be
                      required to report to the Congress on how resources have been redirected and the progress
                      that has been achieved.




                      Page 29                                                                     GAO-03-572T
DOD’s financial management deficiencies adversely affect not only the
department’s ability to prepare auditable financial statements, but also its
ability to control costs, ensure basic accountability, anticipate future costs
and claims on the budget (such as for health care, weapons systems, and
environmental liabilities), measure performance, maintain control of funds,
prevent fraud, and address pressing management issues. For example, we
recently reported on fundamental flaws in DOD’s systems, processes, and
overall internal control environment, such as those related to

• pervasive purchase and travel card breakdowns that resulted in
  numerous instances of potentially fraudulent, improper, and abusive
  transactions and increased DOD’s vulnerability to theft and misuse of
  government property;

• adjustments to DOD’s closed appropriations that resulted in about $615
  million in adjustments that should not have been made, including $146
  million that were illegal; and

• accountability over critical items, such as chemical and biological
  protective garments, that resulted in DOD’s excessing and selling
  unused garment sets for about $3 each, while simultaneously procuring
  hundreds of thousands of similar garment sets for over $200 per set.

As discussed in our recent reporting22 on the management challenges
facing the government, overhauling DOD’s financial management
operations represents a major challenge that goes far beyond financial
accounting to the very fiber of the department’s range of business
operations and management culture. In prior years, DOD expended
significant resources and made material amounts of adjustments to derive
its financial statements. However, such statements were determined to be
unauditable. In this regard, as previously mentioned, section 1008 of the
National Defense Authorization Act for fiscal year 2002 provides a
framework for redirecting the department’s resources from the preparation
and audit of financial statements to improving DOD’s financial
management systems and financial management policies, procedures, and
internal controls. Administrations over the past 12 years have attempted to
address these problems in various ways but have largely been unsuccessful
despite good intentions and significant effort.


22
 U.S. General Accounting Office, Major Management Challenges and Program Risks:
Department of Defense, GAO-03-98 (Washington, D.C.: January 2003).




Page 30                                                                GAO-03-572T
As we testified in March 2002 and highlighted in our more recent reports,
four underlying causes of problems have impeded past reform efforts at
DOD:

   • The lack of accountability and sustained top-level leadership hinders
     DOD’s ability to meet its performance goals. Major improvement
     initiatives must have the direct, active support and involvement of
     the Secretary and Deputy Secretary of Defense to ensure that daily
     activities throughout the department remain focused on achieving
     shared, agencywide outcomes and success. Furthermore, sustaining
     commitment by top leadership to performance goals is a particular
     challenge for DOD because the average tenure of DOD’s top political
     appointees is only 1.7 years. Based on our survey of best practices of
     world-class financial management organizations, it is clear that
     strong executive leadership is essential to (1) making financial
     management an entitywide priority, (2) redefining the role of finance,
     (3) providing meaningful information to decision makers, and (4)
     building a team of people that delivers results.

   • Cultural resistance to change and stovepiped operations have
     impeded DOD’s ability to implement broad-based management
     reforms. We found that the effectiveness of the Defense Management
     Council, established in 1997, was impaired because members were
     not able to put aside their particular military services’ or DOD
     agencies’ interests to focus on departmentwide approaches. DOD’s
     stovepiped approach is most evident in its current financial
     management systems environment, which DOD recently estimated to
     include 1,800 systems and system development projects—many of
     which were developed in piecemeal fashion and evolved to
     accommodate different organizations, each with its own policies and
     procedures.

   • Lack of clear, linked goals and performance measures impedes
     DOD’s ability to attain strategic goals with the risk that units are
     operating autonomously, rather than collectively. In our assessment
     of DOD’s fiscal year 2000 Financial Management Improvement
     Plan—its most recent plan—we found that it presented the military
     services’ and DOD components’ individual improvement initiatives
     but did not clearly articulate how their individual efforts would result
     in a collective, integrated DOD-wide approach to financial
     management improvement. In addition, the plan did not include
     performance measures to assess DOD’s progress in resolving



Page 31                                                           GAO-03-572T
      financial management problems. Furthermore, while DOD plans to
      invest billions of dollars in modernizing its financial management
      systems, it is in the initial stages of developing an overall blueprint,
      or enterprise architecture, to guide and direct these investments.

   • Lack of incentives to change existing “business-as-usual” processes,
     systems, and structures contributes to DOD’s inability to carry out
     needed fundamental reform. Traditionally, DOD has focused more
     on justifying its need for more funding and moving programs and
     operations through the process than on achieving better program
     outcomes. It does not (1) reward behaviors that contribute to DOD-
     wide and congressional goals, (2) develop motivational incentives for
     decision makers to guide them toward better program outcomes, or
     (3) provide congressional focus on more results-oriented and
     resource allocation decisions.

On September 10, 2001, Secretary of Defense Rumsfeld recognized the far-
reaching nature of DOD’s financial management problems and announced a
broad, top-priority initiative intended to “transform the way the department
works and what it works on.” This new broad-based business
transformation initiative, led by DOD’s Senior Executive Council and the
Business Initiative Council, incorporates a number of defense reform
initiatives begun under previous administrations but also encompasses
additional fundamental business reform proposals. In announcing his
initiative, Secretary Rumsfeld recognized that transformation would be
difficult and expected the needed changes would take 8 or more years to
complete. The Secretary’s initiative is consistent with the findings of an
independent study he commissioned that concluded that DOD would have
to undergo “a radical financial management transformation” and that it
would take more than a decade to achieve. Secretary Rumsfeld recently
included improving DOD’s financial management as one of his top 10
priorities, and DOD has already taken a number of actions intended to
address its serious financial management problems. In addition, as I
previously mentioned, DOD has a major effort under way to develop a DOD
enterprise architecture that is intended to prescribe a blueprint for
operational and technological changes in its financial and related business
systems operations. While DOD has a long way to go, its efforts over the
past year represent important progress. The level of top leadership that
has been brought to bear on this challenge will have to be sustained with a
goal of achieving lasting improvement that truly transforms DOD’s business
systems and operations and enables the department to meet the mandate of




Page 32                                                             GAO-03-572T
                             the CFO Act and achieve the President’s Management Agenda’s goal of
                             improved financial management performance.



Addressing                   OMB and Treasury require CFO Act agencies to reconcile selected
Intragovernmental            intragovernmental activity and balances with their “trading partners” and
                             to report on the extent and results of intragovernmental activity and
Transactions                 balances reconciliation efforts. The inspectors general reviewed these
                             reports and communicated the results of their reviews to OMB, Treasury,
                             and GAO. A substantial number of the CFO Act agencies did not fully
                             perform the required reconciliations for fiscal years 2002 and 2001, citing
                             reasons such as (1) trading partners not providing needed data, (2)
                             limitations and incompatibility of agency and trading partner systems, and
                             (3) human resource issues. For both of these years, amounts reported for
                             federal agency trading partners for certain intragovernmental accounts
                             were significantly out of balance. In addition, significant differences in
                             other intragovernmental accounts, primarily related to appropriations, will
                             need to be resolved.

                             As we reported last year, the heart of the intragovernmental transactions
                             issue is that the federal government lacked clearly articulated business
                             rules for these transactions so that they would be handled consistently by
                             agencies. To address certain issues that contributed to the out of balance
                             condition for intragovernmental activity and balances, OMB has
                             established a set of standard business rules for governmentwide
                             transactions among trading partners and is requiring quarterly
                             reconciliations of intragovernmental activity and balances beginning in
                             fiscal year 2003. For example, in accordance with one of the business
                             rules, beginning in fiscal year 2003 for intragovernmental investments with
                             Treasury’s Bureau of the Public Debt (BPD), BPD and trading partner
                             agencies are required to use the same method for recording amortization
                             on market-based notes, bonds, and zero coupon securities. In the past,
                             differences in the amortization methods being used have caused out of
                             balance conditions for related intragovernmental activity and balances.
                             Resolving the intragovernmental transactions problem remains a difficult
                             challenge and will require a commitment by the CFO Act agencies and
                             continued strong leadership by OMB.



Preparing the Consolidated   The federal government did not have adequate systems, controls, and
Financial Statements         procedures to properly prepare its consolidated financial statements, as
                             described below. Also, disclosure of certain financial information was not


                             Page 33                                                         GAO-03-572T
                         presented in the consolidated financial statements in conformity with U.S.
                         generally accepted accounting principles.

Consolidated Financial   Due to the current financial statement compilation process, the federal
Statement Compilation    government could not adequately ensure that the information for each
                         federal agency included in the consolidated financial statements was
                         consistent with the underlying agency financial statements. This process
                         also requires significant human and financial resources and does not
                         adequately leverage the existing work and work products resulting from
                         federal agencies’ audited financial statements. The problems are further
                         compounded by the need for broad changes in the structure of the
                         government’s SGL accounts and the process for maintaining the SGL.

                         The net position reported in the consolidated financial statements is
                         derived by subtracting liabilities from assets, rather than through balanced
                         accounting entries. To make the fiscal years 2002 and 2001 consolidated
                         financial statements balance, Treasury recorded a net $17.1 billion and
                         $17.3 billion decrease to net operating cost, respectively, on the Statement
                         of Operations and Changes in Net Position, which it labeled unreconciled
                         transactions. An additional net $12.5 billion and $3.9 billion of
                         unreconciled transactions were improperly recorded in net cost for fiscal
                         years 2002 and 2001, respectively. Treasury attributes these net
                         unreconciled transaction amounts primarily to the federal government’s
                         inability to properly identify and eliminate transactions between
                         governmental entities, federal agency adjustments that affected net
                         position, and other errors. Treasury was unable to adequately identify and
                         explain the gross components of such amounts. Unreconciled transactions
                         also may exist because the federal government does not have effective
                         controls over reconciling net position.

                         The federal government did not have an adequate process to reconcile the
                         operating results, which for fiscal year 2002 showed a net operating cost of
                         $364.9 billion, to the budget results, which for the same period showed a
                         unified budget deficit of $157.7 billion.23




                         23
                          Statement of Federal Financial Accounting Standards No. 24, Selected Standards for the
                         Consolidated Financial Report of the United States Government, issued January 2003,
                         requires the federal government to provide a financial statement that reconciles net
                         operating revenue (or cost) and the annual unified budget surplus (or deficit).




                         Page 34                                                                     GAO-03-572T
                                 Treasury is currently developing a new system and procedures to prepare
                                 the consolidated financial statements beginning with fiscal year 2004.
                                 These actions are intended to, among other things, directly link information
                                 from federal agencies’ audited financial statements to amounts reported in
                                 the consolidated financial statements and facilitate the reconciliation of net
                                 position. Resolving the consolidated financial statement compilation
                                 process issues will require continued strong leadership by Treasury
                                 management.

Elimination of                   Consolidated financial statements are intended to present the results of
Intragovernmental Activity and   operations and financial position of the components that make up a
Balances from the Consolidated   reporting entity as if the entity were a single enterprise. When preparing
Financial Statements             the consolidated financial statements, the preparer must eliminate
                                 intragovernmental activity and balances between the federal agencies.
                                 Because of federal agencies’ problems in handling their intragovernmental
                                 transactions, Treasury’s ability to eliminate these transactions is impaired.
                                 Significant differences reported in intragovernmental accounts, as noted
                                 above, have been identified. To help federal agencies better perform their
                                 reconciliations, Treasury recently began providing agencies with detailed
                                 trading partner information. Intragovernmental activity and balances are
                                 “dropped” or “offset” in the preparation of the consolidated financial
                                 statements rather than eliminated through balanced accounting entries.
                                 This contributes to the federal government’s inability to determine the
                                 impact of these differences on amounts reported in the consolidated
                                 financial statements. The continued strong leadership of Treasury will be
                                 important to resolving the issues surrounding the elimination of
                                 intragovernmental activity and balances from the consolidated financial
                                 statements.



Protecting the Public            Two audit matters have come to the fore and are key to protecting the
                                 public interest. One matter involves auditors’ responsibilities for reporting
Interest                         on internal control, and the other concerns auditor independence.




                                 Page 35                                                            GAO-03-572T
Auditors’ Responsibilities   We have long believed that auditors have an important responsibility to
for Reporting on Internal    provide an opinion on the effectiveness of internal control over financial
                             reporting and compliance with laws and regulations. Currently, this is not
Control                      required by American Institute of Certified Public Accountants (AICPA)
                             auditing standards or by OMB in its guidance24 to auditors conducting
                             federal agency financial statement audits.

                             For financial statements audits that we conduct—which include the U.S.
                             government’s consolidated financial statements, the financial statements of
                             the IRS, the Schedules of Federal Debt managed by the Bureau of the
                             Public Debt, and the financial statements of the Federal Deposit Insurance
                             Corporation Funds and numerous small entities’ operations and funds—we
                             issue a separate opinion on the effectiveness of internal control over
                             financial reporting and compliance with laws and regulations.

                             For years we have provided opinions on internal control effectiveness
                             because of the importance of internal control to protecting the public’s
                             interest. Our reports have engendered major improvements in internal
                             control. As you might expect, as part of the annual audit of our own
                             financial statements, we practice what we recommend to others and
                             contract with an independent public accounting firm for both an opinion on
                             our financial statements and an opinion on the effectiveness of our internal
                             control over financial reporting and compliance with laws and regulations.

                             Although OMB requires testing of these internal controls, auditors are not
                             required to provide an opinion on internal control effectiveness. However,
                             we found that 3 of the 24 CFO Act agency auditors (those for the General
                             Services Administration, SSA, and the Nuclear Regulatory Commission)
                             provided an opinion on the effectiveness of internal control as of
                             September 30, 2002. Our hope is that all CFO Act agencies and the new
                             DHS will follow suit in future years. In this regard, last year, in response to
                             major breakdowns in corporate accountability, auditing, and corporate
                             governance in the private sector, the Congress passed the Sarbanes-Oxley
                             Act of 200225 to, among other things, improve quality and transparency in
                             financial reporting and independent audits of publicly traded companies
                             (“issuers”). In the area of internal control reporting, issuers are required to


                             24
                              Office of Management and Budget, Audit Requirements for Federal Financial
                             Statements, Bulletin 01-02 (Washington, D.C.: Oct. 19, 2000).
                             25
                                  Sarbanes-Oxley Act of 2002, Pub. L. No. 107-204, 116 Stat. 745 (July 30, 2002).




                             Page 36                                                                                GAO-03-572T
                           establish and maintain adequate internal control structure and procedures
                           for financial reporting and include in the annual report a statement of
                           management’s responsibility for and management’s assessment of the
                           effectiveness of those controls and procedures. In addition, an issuer’s
                           auditor is required to attest to, and report on, the assessment made by the
                           management of the issuer on the effectiveness of internal control over
                           financial reporting. In other words, an issuer’s auditor will provide an
                           attestation, or opinion, on management’s assertions about the effectiveness
                           of internal controls over financial reporting.

                           “Internal controls and procedures for financial reporting” is generally
                           defined as controls that pertain to the preparation of external financial
                           statements that are fairly presented in conformity with generally accepted
                           accounting principles. Specifically, controls over financial reporting
                           include the objectives of ensuring that transactions are properly recorded,
                           processed, and summarized to permit the preparation of financial
                           statements in conformity generally accepted accounting principles.

                           GAO strongly believes that auditor reporting on internal control is a critical
                           component of monitoring the effectiveness of an organization’s internal
                           control and accountability. By giving assurance about internal control,
                           auditors of federal financial statements can better serve their clients and
                           other financial statements users and better protect the public interest by
                           having a greater role in providing assurances of the effectiveness of
                           internal control in deterring fraudulent financial reporting, protecting
                           assets, and providing an early warning of internal control weaknesses.



Auditor Independence and   The independence of auditors—both in fact and appearance—is critical to
Government Auditing        the credibility of financial reporting. Auditors have the capability of
                           performing a range of valuable services for their clients, and providing
Standards
                           certain nonaudit services can ultimately be beneficial to federal entities.
                           However, in some circumstances, it is not appropriate for auditors to
                           perform both audit and certain nonaudit services for the same client. In
                           these circumstances, the auditor, the client, or both will have to make a
                           choice as to which of these services the auditor will provide.




                           Page 37                                                            GAO-03-572T
These concepts, which I continue to strongly believe are in the public
interest, were reflected in the revisions to auditor independence
requirements for government audits,26 which GAO issued last year as part
of Government Auditing Standards.27 The standard, among other things,
strengthens the rules associated with providing nonaudit services and
includes a principle-based approach to addressing this issue, supplemented
with certain safeguards. The two overarching principles in the standard for
nonaudit services are that

• auditors should not perform management functions or make
  management decisions, and

• auditors should not audit their own work or provide nonaudit services
  in situations where the amounts or services involved are significant or
  material to the subject matter of the audit.

In making judgments on independence under Government Auditing
Standards and applying the independence standard’s principles and
safeguards, audit organizations should take a “substance over form”
approach and consider the nature and significance of the services provided
to the audited entity—the facts and circumstances. Before an audit
organization agrees to perform nonaudit services, it should carefully
consider the need to avoid situations that could lead reasonable third
parties with knowledge of the facts and circumstances to conclude that the
auditor is not able to maintain independence in conducting audits. It is
imperative that auditors always be viewed as independent in fact and
appearance.




26
 U.S. General Accounting Office, Government Auditing Standards, Amendment No. 3,
Independence, GAO-02-388G (Washington, D.C.: January 2002).
27
 Government Auditing Standards was first published in 1972 and is commonly referred to
as the “Yellow Book.” It covers federal entities and organizations that receive federal funds.
Various laws require compliance with the standards in connection with audits of federal
entities and funds. Further, many states and local governments and other entities, both
domestically and internationally, have voluntarily adopted these standards.




Page 38                                                                         GAO-03-572T
                   Understandably, GAO received many inquiries about the new independence
                   standard due to its significant effect on auditors in connection with audits
                   of those who are required to use or have adopted the use of Government
                   Auditing Standards. Working with the Comptroller General’s Advisory
                   Council on Government Auditing Standards28 and other interested parties,
                   we issued further guidance in the form of questions and answers related to
                   the independence standard’s implementation time frame, underlying
                   concepts, and application in specific nonaudit circumstances.29

                   The independence standard and the recently issued question and answer
                   document are the initial steps in GAO’s continuing efforts to enhance
                   Government Auditing Standards and educate auditors on revisions to
                   these standards and on implementation issues surrounding the
                   independence standard. Within the next several months, GAO will issue
                   revisions to Government Auditing Standards to help ensure that the
                   standards continue to meet the needs of the audit community and the
                   public it serves. The revision will expand and change (1) the types of
                   audits and services that can be performed under the standards and (2) the
                   application of the standards, where relevant, to be consistent with the
                   various types of audits. Changes are also being made to enhance the
                   understandability of the standards. To educate the audit community about
                   the revised standards as well as the independence standard, GAO
                   continues to provide many presentations to government auditors and
                   private practitioners, in addition to answering hundreds of questions
                   regarding implementation issues.



Closing Comments   Our report on the U.S. government’s consolidated financial statements for
                   fiscal years 2002 and 2001 highlights the need to continue addressing the
                   government’s serious financial management weaknesses. Looking beyond
                   current progress by federal agencies in attaining unqualified opinions on
                   financial statements, it will be essential for the federal government to begin
                   moving away from the extraordinary efforts many federal agencies
                   continue to use to prepare financial statements and toward giving


                   28
                    The Advisory Council includes 21 experts in financial and performance auditing and
                   reporting—drawn from all levels of government, academia, private enterprise, and public
                   accounting—who advise the Comptroller General on Government Auditing Standards.
                   29
                    U.S. General Accounting Office, Government Auditing Standards, Answers to
                   Independence Standard Questions, GAO-02-870G (Washington, D.C.: July 2002).




                   Page 39                                                                     GAO-03-572T
prominence to strengthening the government’s financial systems, reporting,
and controls. This approach becomes even more critical as the federal
government progresses to an accelerated financial statement reporting
time frame, and it is the only way the government can meet the end goal of
making timely, accurate, and useful financial information routinely
available to the Congress, other policymakers, and the American public.

The requirement for timely, accurate, and useful financial and performance
management information is greater than ever, as the Congress and the
administration prepare to meet tomorrow’s fiscal challenges. This type of
financial information is central to managing the federal government’s
operations more efficiently, effectively, and economically and in supporting
GPRA. Moreover, meaningful financial and performance information can
form the basis for reconsidering the relevance or “fit” of any federal
program or activity in today’s world and for the future.

In closing Mr. Chairman, I want to underscore the importance of the
additional impetus provided by President Bush through his President’s
Management Agenda and the Executive Branch Management Scorecard for
coming to grips with federal financial management problems, indeed
management problems across the board. Regarding DOD in particular,
Secretary of Defense Rumsfeld’s vision and approach for transforming the
department’s full range of business processes is serious and encouraging.
These efforts will be key to fulfilling the President’s Management Agenda
and addressing the largest obstacle to an opinion on the U.S. government’s
consolidated financial statements. The cooperative efforts spearheaded by
the JFMIP Principals have been most encouraging in developing the short-
and long-term strategies and plans necessary to address many of the
problems I have discussed this morning. In addition, GAO has probably
never had a better working relationship with OMB and cabinet level and
other key officials on a range of “good government issues” that are of
critical importance and are inherently non-partisan in nature. While these
and other factors provide an enhanced likelihood for success, in the end it
is results that count.

Finally, I want to reiterate the value of sustained congressional interest in
these issues, as demonstrated by this hearing and those the former
Subcommittee on Government Efficiency, Financial Management, and
Intergovernmental Relations held over the past several years to oversee
financial management reform. It will also be key that the appropriations,
budget, authorizing, and oversight committees hold agency top leadership




Page 40                                                           GAO-03-572T
           accountable for resolving these problems and that they support
           improvement efforts.



Contacts   For further information regarding this testimony, please contact Jeffrey C.
           Steinhoff, Managing Director, and Gary T. Engel, Director, Financial
           Management and Assurance, at (202) 512-2600.




           Page 41                                                          GAO-03-572T
Appendix I

CFO Act Agencies: Fiscal Year 2002 Audit
Results, Principal Auditors, and Number of
Other Audit Contractors                                                                                                                      Append
                                                                                                                                                  x
                                                                                                                                                  Ii




                                                                                                                             Number of
                                                                                                                              other audit
24 CFO Act agencies                    Audit results                   Principal auditor                                     contractors
                                                   a
Agency for International Development   Qualified                       Inspector General                                                    1
Agriculture                            Unqualified                     Inspector General                                                    2
Commerce                               Unqualified                     KPMG LLP                                                             1
Defense                                Disclaimer                      Inspector General                                                    1
Education                              Unqualified                     Ernst & Young LLP                                                    0
Energy                                 Unqualified                     KPMG LLP                                                             4
Environmental Protection Agency        Unqualified                     Inspector General                                                    0
Federal Emergency Management Agency    Unqualified                     KPMG LLP                                                             0
General Services Administration        Unqualified                     PricewaterhouseCoopers LLP                                           0
Health and Human Services              Unqualified                     Inspector General                                                    4
Housing and Urban Development          Unqualified                     Inspector General                                                    1
Interior                               Unqualified                     KPMG LLP                                                             0
Justice                                Unqualified                     PricewaterhouseCoopers LLP                                           2
Labor                                  Unqualified                     Inspector General                                                    5
National Aeronautics and Space         Unqualified                     PricewaterhouseCoopers LLP                                           1
Administration
National Science Foundation            Unqualified                     KPMG LLP                                                             0
Nuclear Regulatory Commission          Unqualified                     R. Navarro & Associates, Inc.                                        0
Office of Personnel Management         Unqualified                     KPMG LLP                                                             0
Small Business Administration          Disclaimer                      Cotton & Company LLP                                                 0
Social Security Administration         Unqualified                     PricewaterhouseCoopers LLP                                           0
State                                  Unqualified                     Leonard G. Birnbaum and Company, LLP                                 0
Transportation                         Unqualified                     Inspector General                                                    2
Treasury                               Unqualified                     Inspector General                                                    6b
Veterans Affairs                       Unqualified                     Deloitte & Touche LLP                                                0
                                       a
                                        Qualified for the Statement of Net Cost; unqualified for all other statements.
                                       b
                                        In addition, GAO audited the Internal Revenue Service’s financial statements and the Schedules of
                                       Federal Debt Managed by the Bureau of the Public Debt.




(198183)                               Page 42                                                                               GAO-03-572T
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