oversight

Small Business Administration: Loan Accounting and Other Financial Management Issues Impair Accountability

Published by the Government Accountability Office on 2003-04-29.

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, Government Reform Committee,
                          House of Representatives


For Release on Delivery
Expected at 2 p.m. EDT
April 29, 2003
                          SMALL BUSINESS
                          ADMINISTRATION
                          Loan Accounting and Other
                          Financial Management
                          Issues Impair
                          Accountability
                          Statement of Linda M. Calbom, Director
                          Financial Management and Assurance




GAO-03-676T
                          A
                                                April 29, 2003


                                                SMALL BUSINESS ADMINISTRATION

                                                Loan Accounting and Other Financial
Highlights of GAO-03-676T, a testimony
before the Subcommittee on Government           Management Issues Impair Accountability
Efficiency and Financial Management,
Government Reform Committee, House of
Representatives




Recently, the Small Business                    Since August 1999, SBA held seven loan asset sales, disposing of a total of
Administration’s (SBA) auditors                 $5.8 billion in disaster assistance and business loans. Our review of the
withdrew their unqualified audit                budgeting and accounting for the first five loan sales found errors that could
opinions on SBA's fiscal year 2000              significantly affect the reported results in SBA’s budget and financial
and 2001 financial statements and               statements. We found that SBA (1) incorrectly calculated losses on loan
issued disclaimers of opinion. The
auditors also issued a disclaimer of
                                                sales reported in the footnotes to its financial statements, (2) did not
opinion on SBA's fiscal year 2002               appropriately consider the effect of loan sales on its estimates of the cost of
financial statements. This turn of              the remaining portfolio, which could significantly affect its budget and
events was primarily due to flaws               financial statement reporting, and (3) had significant unexplained declines in
in the way SBA accounted for its                its subsidy allowance for the disaster loan program. As shown in the figure,
loan sales and for the remaining                the subsidy allowance eventually declined to a negative balance, which
portfolio. There were also several              indicated that SBA expected profits on its subsidized disaster loans.
other issues affecting SBA's fiscal
year 2002 audit, including key                  Despite these errors and uncertainties, SBA’s auditor gave unqualified audit
internal control weaknesses and                 opinions on SBA’s fiscal year 2000 and 2001 financial statements. We
systems that did not substantially              discussed these issues with SBA’s auditors, who have since reassessed the
comply with the Federal Financial
Management Improvement Act.
                                                unusual balance in the subsidy allowance account and withdrawn their
The information GAO presents in                 unqualified audit opinions on the fiscal year 2000 and 2001 financial
this testimony, which is discussed              statements. The agency’s inability to properly account for its loans sold and
in greater detail in our January                not sold, combined with several other financial management issues, led the
2003 report, Small Business                     auditors to issue a disclaimer of opinion on SBA’s fiscal year 2002 financial
Administration: Accounting                      statements. Until SBA corrects its financial management deficiencies, the
Anomalies and Limited                           agency’s financial accounting and budgetary reporting will be unreliable.
Operational Data Make Results of                Based on recent discussions with SBA officials, we understand that they are
Loan Sales Uncertain (GAO-03-87),               making progress in identifying the sources of the loan accounting problems
is intended to assist Congress in               and in determining corrective actions.
assessing the current status of
financial accountability at SBA.
                                                SBA Disaster Loans Subsidy Allowance



GAO is not making new
recommendations in this
testimony, but in a past report has
made specific recommendations
aimed at addressing the
deficiencies in the accounting for
loan asset sales and the remaining
portfolio.




www.gao.gov/cgi-bin/getrpt?GAO-03-676T.

To view the full testimony, click on the link
above.
For more information, contact Linda Calbom
at (202) 512-9508 or calboml@gao.gov.           Note: Analysis based on SBA data.
                       Mr. Chairman and Members of the Subcommittee:

                       I am pleased to be here today to discuss the status of financial management
                       at the Small Business Administration (SBA). Recently SBA's auditor
                       withdrew its unqualified audit opinions on SBA's fiscal year 2000 and 2001
                       financial statements and issued disclaimers of opinion. The auditor also
                       issued a disclaimer of opinion on SBA's fiscal year 2002 financial
                       statements. This turn of events was primarily due to flaws we identified in
                       the way SBA accounted for its loan sales and for the remaining portfolio.
                       There were also several other issues affecting SBA's fiscal year 2002
                       financial statement audit, including key internal control weaknesses and
                       systems that did not substantially comply with the Federal Financial
                       Management Improvement Act (FFMIA). I will discuss all of these issues
                       today which, when combined, point to an overall lack of financial
                       accountability at SBA.



SBA’s Accounting for   This January, we reported1 that SBA had sold almost 110,000 loans with an
                       unpaid principal balance of about $4.4 billion in five loan sales from August
Loan Sales and the     1999 through January 2002.2 Our review of the budgeting and accounting
Remaining Portfolio    for these loan sales found errors that could significantly affect the reported
                       results in SBA’s budget and financial statements.
was Flawed




                       1
                         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).
                       2
                         SBA has held two additional loan sales that were not included in our review. In August
                       2002, SBA held its sixth sale, which included about 30,000 loans with an outstanding balance
                       of $657 million. The seventh sale took place in December 2002 and consisted of about
                       29,000 loans with an outstanding balance of $682 million. In all seven sales SBA has sold
                       about 169,000 loans with an outstanding balance of $5.8 billion.




                       Page 1                                                                         GAO-03-676T
                            We found that SBA (1) incorrectly calculated losses on loan sales reported
                            in the footnotes to its financial statements, (2) did not appropriately
                            consider the effect of loan sales on its estimates of the cost of the
                            remaining portfolio, which could significantly affect its budget and
                            financial statement reporting, and (3) had significant unexplained declines
                            in its subsidy allowance3 for the disaster loan program. Until SBA makes
                            the necessary corrections to its procedures to estimate the cost of its credit
                            programs, including the effect of its loan sales, the reliability of the current
                            and future subsidy rates will remain unknown. We understand that SBA is
                            taking steps to address the issues we identified, including working with a
                            consulting firm to perform a detailed analysis of its loan sale accounting
                            and cost estimation procedures.



SBA Improperly Calculated   Accounting records related to SBA’s first five loan sales indicated that
Losses on Loan Sales        losses exceeded $1.5 billion. However, this amount is overstated because
                            of errors in the way SBA calculated the losses. Because of the lack of
                            reliable financial data, we were unable to determine the financial effect of
                            loan sales on SBA’s budget and financial statements. These errors raise
                            serious concerns about the information related to the results of loan sales
                            included in the footnotes to the annual financial statements that SBA
                            provided to the Office of Management and Budget (OMB) and the Congress
                            for decision-making purposes.




                            3
                              For a subsidized loan program, the subsidy allowance account generally represents the
                            subsidized portion – the amount of expected losses related to estimated defaults and
                            financing costs from making below-market rate loans – assumed by the federal government.
                            The subsidy allowance account is subtracted from the loans receivable balance on the
                            balance sheet to arrive at the net loan amount expected to be repaid.




                            Page 2                                                                      GAO-03-676T
For accounting purposes, the gain or loss on a loan sale represents the
difference between the net book value (the outstanding loans receivable
balance minus the subsidy allowance) of the loans sold and the net sale
proceeds.4 The footnotes to SBA’s fiscal year 1999 and 2000 financial
statements reported accounting losses of $75 million and $600 million,
respectively, on its loan sales. SBA did not separately disclose the losses
calculated on the two loan sales that took place during fiscal year 2001.5
According to SBA’s accounting records, the first five sales resulted in total
losses of more than $1.5 billion.

Prior to a loan sale, an estimate of the loans’ current value to the
government or “hold value” is calculated to determine what the loans are
worth to the government in the event that the loans are held to maturity or
some other resolution, such as prepayment or default.6 This hold value is
compared to an estimate of the expected net sale proceeds to determine if
it is advantageous for the loans to be sold.7 After a sale, the hold value is
compared to the actual net sale proceeds to determine whether or not and
by how much the government benefited from the sale. SBA determined
that the first five loan sales resulted in a $606 million benefit to the
government.8 This benefit calculation differs from the accounting gain or
loss because the benefit calculation is not designed to take into
consideration changes in interest rates from the time the loans were
disbursed to the date of the sale, while the accounting gain or loss, if
properly computed, does take these changes into account.



4
  OMB Circular A-11 defines net sale proceeds in the context of loan sales as the amounts
paid by purchasers less all seller transaction costs (such as underwriting, rating agency,
legal, financial advisory, and due diligence fees) that are paid out of the gross sales proceeds
rather than paid as direct obligations by the agency.
5
 SBA also did not disclose any gain or loss on the two loan sales, number 5 and 6, which
took place during fiscal year 2002 in its financial statements for that year.
6
 The hold value is calculated on a present value basis, meaning the worth of a future stream
of returns or costs in terms of money paid immediately. In calculating the hold value,
interest rates from the most recent President’s budget at the time the estimate is prepared
provide the basis for converting future amounts into their “money now,” or present value,
equivalents.
7
  OMB reviews these calculations as part of its approval process for SBA to conduct a loan
sale.
8
 We did not audit the data used to calculate the hold values for each sale, and therefore did
not conclude on the reasonableness of the hold values for any of the sales.




Page 3                                                                            GAO-03-676T
We reviewed the methodology SBA used to calculate the results of its loan
sales for accounting purposes and found significant errors. When
calculating whether loans are sold at a gain or a loss, agencies must
estimate the portion of the subsidy allowance to allocate to each loan sold
in order to calculate the net book value for those loans. Since SBA’s
calculation of the net book value of the loans sold exceeded the net
proceeds from the sales, losses were calculated. Our review of these
calculations found that SBA’s estimates did not consider all the appropriate
cash flows when allocating the subsidy allowance to the sold loans. For
example, when calculating the gains or losses for the disaster loan
program, SBA failed to allocate a portion of the subsidy allowance for
financing costs associated with lending to borrowers at below market
interest rates. Doing so would have reduced the amount of loss that SBA
reported on the loan sales.

In addition, SBA incorrectly allocated the subsidy allowance for the
previously defaulted 7(a) and 504 guaranteed loans, which could materially
distort the gain or loss. SBA used its estimated net default cost, which
considers first the probability of default and then the estimated recovery
rate after default. For example, if a $10,000 guaranteed loan has an
estimated default rate of 10 percent and an estimated recovery rate of 50
percent, the subsidy allowance allocated by SBA would be $500 ([$10,000 x
.10] x .50). Therefore, the net book value calculated for the loan would be
$9,500. However, since guaranteed loans sold have already defaulted, it is
not appropriate to apply the estimated default rate of 10 percent. SBA
should have applied only the estimated recovery rate of 50 percent for
these loans, and the subsidy allowance allocated would be $5,000 ($10,000
x .50) and the net book value calculated for the loan would be $5,000.
Figure 1 illustrates the difference in the calculated gain or loss resulting
from this error if the previously defaulted loan were sold for $6,500. The
left column, based on SBA’s incorrect methodology, shows that the loan
was sold for a $3,000 loss, while the right column appropriately allocates
the allowance based on expected recoveries and results in a $1,500 gain, a
difference of $4,500 for this example of a $10,000 guaranteed loan sold.




Page 4                                                           GAO-03-676T
Figure 1: Gain / Loss Calculation on Previously Defaulted Guaranteed Loans Sold




                                         SBA’s errors in calculating the losses on disaster loans and previously
                                         defaulted guaranteed loans sold both resulted in overestimates of the net
                                         book value of the loans sold and the losses that SBA reported in the
                                         footnotes to its fiscal year 1999 and 2000 financial statements. Because of
                                         the way the results of loan sales are incorporated in the budget and the
                                         financial statements, the reestimates, if done properly, should have
                                         corrected the impact of these errors. However, as I discuss next, the
                                         reestimates were not reliable.



Subsidy Cost Reestimates                 SBA did not conduct key analyses of the loans sold and those remaining in
are Unreliable                           its portfolio so it could determine how the sales affected its reestimates of
                                         program costs for its remaining loans. OMB’s budget guidance directs
                                         agencies to make reestimates for all changes in cash flow assumptions in
                                         order to adjust the subsidy estimate for differences between the original
                                         estimated cash flows and the actual cash flows. SBA officials
                                         acknowledged that analyses of the impact of loan sales on its historical
                                         averages should be done. However, they told us they lacked the
                                         appropriate historical data and resources to perform these analyses.
                                         Because SBA did not assess the effect loan sales would have on its
                                         historical averages of loan performance, such as when loans default or
                                         prepay, the agency did not know whether these averages, which can
                                         significantly affect the estimated cost of a loan program, reasonably predict
                                         future loan performance. As a result, information in both the budget and
                                         financial statements related to the reestimated cost of SBA’s loan programs
                                         cannot be relied upon.

                                         SBA is generally required to update or “reestimate” loan program costs
                                         annually. OMB Circular A-11 directs agencies to do reestimates for all
                                         changes in cash flow assumptions. Thus, reestimates should include all



                                         Page 5                                                            GAO-03-676T
aspects of the original cost estimate, including prepayments, defaults,
delinquencies, and recoveries. These reestimates are done to adjust the
subsidy cost estimate for differences between the original cash flow
projections and the amount and timing of cash flows that are expected
based on actual experience, new forecasts about future economic
conditions, and other events that affect the cash flows.

Even after selling about $4.4 billion of loans, nearly half of its loan
portfolio, SBA had not analyzed the effect of loan sales on the estimated
cost of the remaining loans in its portfolio. SBA officials told us loans are
selected for sale based on certain criteria, such as where the loan is located
or serviced, the type of collateral, or whether the loan is performing. Since
the loan selection process is not random—that is, all loans do not have an
equal chance of being selected—it is likely that the loans sold had different
characteristics than the portfolio’s historical averages prior to sales.
Consequently, the characteristics of the remaining loans may also differ
substantially from the portfolio historical averages prior to the sales. For
example, during our analysis of the loans that were sold, we determined
that 84 percent of the $3.8 billion of disaster loans sold were performing–
meaning that payments were not more than 30 days delinquent. Selling
mostly performing loans could leave a disproportionate level of
nonperforming loans in SBA’s portfolio. Because SBA had not analyzed the
effect of loan sales on the characteristics of its remaining portfolio, it does
not know if the percentages of remaining performing and nonperforming
loans are different from the historical averages prior to the sales. A change
in these percentages could indicate that expected defaults in the remaining
portfolio could be higher or lower than current assumptions, based on
historical data, suggest.

Another important loan characteristic is the stated loan term. This term is
the contractual amount of time borrowers have to repay their loans. SBA’s
estimated costs of the disaster loan program are based on historical
average loan term assumptions of 16 years for business disaster loans and
17 years for home disaster loans. Based on our review of the disaster loans
sold in the first five sales, the average loan term was about 25 years.
However, SBA continued to use average loan term assumptions of 16 and
17 years in its reestimates without doing the appropriate analysis to
determine whether these assumptions were still valid. Based on our recent
discussion with SBA officials, their detailed analysis of the cost estimation
procedures for the disaster loan program found that, among other things,
the average loan term assumption should have been greater. Relatively
minor changes in some cash flow assumptions, such as higher or lower



Page 6                                                              GAO-03-676T
                        default and recovery rates and changes in loan terms, can significantly
                        affect the estimated cost of the loan program and therefore the program’s
                        budget.



The Subsidy Allowance   During our review of the accounting for loan sales, we noted that the
Account Was Misstated   subsidy allowance account for the disaster loan program had an unusually
                        low balance. For a subsidized loan program, the subsidy allowance
                        account is generally the amount of expected losses on a group of loans
                        related to estimated defaults and financing costs from making below-
                        market rate loans. In effect, the subsidy allowance is the cost associated
                        with the loans that SBA does not expect to recover from borrowers. For
                        financial reporting purposes, the subsidy allowance reduces the
                        outstanding loans receivable balance to the amount that SBA expects to
                        collect from borrowers, known as the net loans receivable balance (or net
                        book value), which is shown on the balance sheet.

                        Table 1 summarizes the disaster loan program’s reported outstanding loans
                        receivable balance, the subsidy allowance balance, the net book value, and
                        the subsidy allowance as a percentage of the loans receivable balance for
                        fiscal years 1998 through 2002. The reported subsidy allowance compared
                        to the loans receivable balance decreased significantly in fiscal years 2000
                        and 2001, to the point of showing that the remaining portfolio of the
                        disaster program was expected to generate a profit. This declining trend
                        continued into fiscal year 2002. SBA could not provide support for the
                        balance or explain the reason for this anomaly.



                        Table 1: Reported Loans Receivable Balances of SBA’s Disaster Loan Program

                        Dollars in millions
                                                    Fiscal      Fiscal      Fiscal      Fiscal      Fiscal
                        Disaster loan program    year 1998   year 1999   year 2000   year 2001   year 2002
                        Loans receivable
                        Outstanding                $5,614      $5,659      $5,305      $3,293      $3,110
                        Less / (plus): subsidy
                        allowance balance          $1,502        $929        $505        ($77)      ($522)
                        Net book value             $4,112      $4,730      $4,800      $3,370      $3,632
                        Subsidy allowance as a
                        percentage of loans
                        receivable balance          26.8%       16.4%        9.5%       (2.3%)     (16.8%)
                        Source: SBA.




                        Page 7                                                               GAO-03-676T
Table 1 shows a rapid decrease in the reported subsidy allowance between
fiscal year 2000 and 2001. Most of this decrease actually occurred in fiscal
year 2000, but was masked by an adjustment made during the fiscal year
2000 financial statement audit. Before SBA made the audit adjustment, the
subsidy allowance for the disaster program was about $91 million for fiscal
year 2000. This balance was $838 million, or about 90 percent, less than the
$929 million balance for fiscal year 1999, while loans receivable
outstanding decreased by only $354 million, or about 6 percent.

In order to restore the subsidy allowance to a more reasonable balance at
the end of fiscal year 2000, in agreement with its auditor, SBA increased the
subsidy allowance balance by recording an audit adjustment that was
essentially meant to reflect the expected impact of loan sales on the
reestimates prepared in fiscal year 2000, which did not factor in the effects
of loan sales.9 This increased the reported cost of the disaster loan
program by $414 million in fiscal year 2000. Since the amount of the
adjustment was based on SBA’s erroneous calculations of loan sale losses,
as previously discussed, the amount of the adjustment was incorrect.
During fiscal year 2001, SBA reversed the audit adjustment and revised its
reestimates to include cash flows related to loan sales. Our review of the
fiscal year 2001 disaster loan program reestimates indicated that loan sales
increased the reported cost of the program by about $292 million.
However, this amount is also likely misstated because, as I previously
mentioned, the reestimates did not consider the specific characteristics of
the loans sold or the loans remaining in the portfolio.




9
 Theoretically, had the reestimates factored in the loan sales, the subsidy allowance
account would have been appropriately adjusted, regardless of any errors made in recording
the calculated accounting losses.




Page 8                                                                       GAO-03-676T
The unexplained decline in the subsidy allowance continued in the fiscal
year 2001 financial statements where SBA reported a negative balance in
the subsidy allowance for the disaster loan program. As shown in table 1,
this allowance account no longer reduced the amount SBA expected
borrowers to repay – it actually increased the expected repayments from
borrowers and indicated that the loan program was profitable. However,
because the program is subsidized, with estimated default and financing
costs exceeding the amount of interest borrowers are expected to pay, it
should not show an expected profit, and thus the balance for the subsidy
allowance account appears to be significantly misstated.10 As in the prior
year, SBA could not explain the unusual balance. Based on our review of
SBA’s fiscal year 2002 financial statements, the unexplained trend
continued and the negative balance of the subsidy allowance (expected
profit) increased to $522 million.

While the objective of our work was not to determine the specific cause of
the unusual balance, several possibilities exist. As previously mentioned,
not considering the characteristics of the loans sold or of those remaining
in SBA’s portfolio could contribute to the unusual balance. Another
possibility is that SBA may have underestimated the cost of its disaster loan
program because the cash flow assumptions used to estimate the subsidy
cost did not reflect the true characteristics or performance of its loan
portfolio. For example, as I previously discussed, SBA used average loan
term assumptions of 16 and 17 years to estimate the cost of the disaster
loan program. However, based on recent discussions with SBA officials,
they have found that the average loan term should have been greater.
Underestimating the loan term would mean that SBA did not put enough
into the subsidy allowance account to cover interest costs associated with
these loans and the subsidy allowance would be depleted as these costs
were written off against it until there was a negative balance. From a
budgetary perspective, this could mean that SBA did not request an
appropriation large enough to cover the cost of the loan program.

Despite the significant, unexplained decline in the subsidy allowance and
the errors in calculating the losses on loan sales, SBA received unqualified
or “clean” audit opinions on its fiscal year 2000 and 2001 financial
statements. An unqualified audit opinion indicates that the balances in the


10
  Based on SBA’s reestimates for its fiscal year 2001 financial statements, the subsidy cost of
this program ranged from $17 to $33 for every $100 the federal government lends, depending
on the interest rates in effect when the loans were made.




Page 9                                                                           GAO-03-676T
financial statements are free of significant errors, known as material
misstatements. As previously mentioned, SBA’s auditor attempted to adjust
the anomalies in the subsidy allowance during the fiscal year 2000 financial
statement audit. However, the adjustment was based on the previously
described erroneous loss calculation. For the fiscal year 2001 audit, SBA’s
auditor performed a number of audit procedures related to the disaster
loan program subsidy allowance account. For example, the auditor
evaluated the methodology and formulas used to calculate reestimates,
assessed data used to calculate key cash flow assumptions, and reviewed
various internal controls over the subsidy estimation process. However,
this work did not appear to focus on determining the cause of the unusual
negative balance of the account, which, contrary to the fact that this is a
subsidized loan program, would indicate that these loans were expected to
generate a profit. The auditor’s workpapers indicated that the auditor had
agreed, in discussions with SBA management, that if the “methodology and
data were materially correct, we [the auditor] would conclude that the
resulting subsidy reserve [allowance] would be materially correct for
financial statement reporting purposes.” The workpapers also indicated
that, “whatever the results of the reestimates are, as long as the
methodology is sound and supportable, we [the auditor] would not
consider the balance [of the subsidy allowance] anything other than
‘natural.’”

Although SBA’s auditor may have recognized some of the errors we
identified, they did not determine the cause of the unusual balance and
propose the necessary audit adjustments or modify their audit report as
appropriate. In such situations, when auditors cannot determine whether a
balance is fairly stated because sufficient reliable supporting
documentation is not available, audit standards11 call for auditors to either
qualify their opinion with the noted exception or issue a disclaimer of
opinion, meaning that the auditor was unable to obtain satisfaction that the
financial statements are fairly stated and therefore does not express an
opinion. We discussed these issues with SBA’s auditor and they have since
reevaluated and withdrawn their unqualified audit opinions on SBA’s fiscal
year 2000 and 2001 financial statements and issued disclaimers of opinion.

In response to our findings, SBA contracted with an independent
consulting firm to complete a more detailed analysis of its loan sale
accounting and cost estimation procedures to determine the cause of the


11
     Statements on Auditing Standards, AU §508 paragraphs 22 and 23.




Page 10                                                                GAO-03-676T
                         unusual balance in the subsidy allowance account. We recently met with
                         SBA officials to discuss the steps taken to date to address the issues we
                         identified. We understand that SBA, working with the consultants, has
                         identified a number of issues related to the methods and assumptions used
                         to estimate the cost for the disaster loan program. While we have not had
                         an opportunity to analyze their findings in detail, based on our previous
                         work, several of the issues they identified, including the understated
                         average loan term, appear to be plausible causes of the decline in the
                         subsidy allowance for the disaster loan program.



Results of Fiscal Year   SBA’s inability to account for its loan sales or adequately reestimate the
                         cost of loans not sold, combined with other financial management issues,
2002 Financial           led to the auditors issuing a disclaimer of opinion on SBA’s fiscal year 2002
Statement Audit          financial statements. I will now briefly discuss the disclaimer of opinion,
                         the internal control weaknesses they reflect, and the consequences of these
                         weaknesses regarding compliance with FFMIA.



Disclaimer of Opinion    The disclaimer of opinion for fiscal year 2002 was primarily due to three
                         issues: (1) SBA's disaster loan modeling contained deficiencies and was no
                         longer adequate for determining the costs of disaster loans sold or
                         reestimating the cost of loans not sold, (2) SBA did not present future
                         expected default costs on pre-1992 loan guarantees12 or determine the
                         correct valuation of related balances, and (3) SBA could not ensure that the
                         balance in the Master Reserve Fund13 residual asset or liability was reliable.

                         As I’ve previously discussed, SBA’s inability to determine the cost of loans
                         sold or adequately reestimate the cost of loans not sold could materially
                         affect amounts reported in the budget and the financial statements. SBA
                         and its consultants had not completed their analysis of SBA’s loan sale
                         accounting and cost estimation procedures prior to the completion of the
                         fiscal year 2002 audit. Therefore, SBA was not able to provide sufficient


                         12
                           Pre-1992 loan guarantees are loan guarantees committed prior to October 1, 1991. The
                         accounting standard requires that the liabilities of pre-1992 loan guarantees be recognized
                         when it is more likely than not that the loan guarantees will require a future cash outlaw to
                         pay default claims.
                         13
                           The 7(a) secondary market program, one of SBA’s business loan programs, is administered
                         by an agent of SBA. Payments for this program flow through the Master Reserve Fund.




                         Page 11                                                                         GAO-03-676T
evidence to its auditors to support certain amounts reported and
disclosures made in its fiscal year 2001 and 2002 financial statements,
thereby limiting the scope of the audit and leading to the disclaimer of
opinion.

Additionally, SBA did not present future expected default costs on pre-1992
loan guarantees. SBA made several adjusting entries to both the fiscal year
2002 and fiscal year 2001 financial statements in an effort to correct this.
However, SBA did not have a calculation methodology to determine its
expected future default costs and related liability or to support the
adjustments made. Therefore, SBA could not provide sufficient
documentation that the liability balance of $116 million as of September 30,
2002, was fairly stated.

The final issue contributing to SBA’s disclaimer related to the Master
Reserve Fund. SBA's fiscal and transfer agent maintains the Master
Reserve Fund to facilitate operation of the secondary market program14 for
7(a) Business Loans, a loan guarantee program for small businesses that
would otherwise be unable to obtain financing at reasonable rates. The
Master Reserve Fund receives payments from lenders who have SBA-
guaranteed loans and makes payments to the investors in the secondary
market program. In fiscal year 2002, SBA estimated that there was a
potential future deficit (shortfall resulting from payments to investors
exceeding payments from lenders) in the range of zero to $18.3 million
required to liquidate the obligations in the 7(a) secondary market. This
potential deficit contrasted with fiscal year 2001 where an estimated excess
of $68 million was reported.

According to SBA’s auditor, SBA used samples of Master Reserve Fund
activity for fiscal years 2002 and fiscal year 2001 to estimate the year-end
balances. The samples were small and differed in important respects from
the total population of loans. Thus, the sampling was not entirely
representative of the loan population and did not provide sufficient
evidence that the estimate of the Master Reserve Fund balance was fairly
stated.




14
   The secondary market program was created to increase the attractiveness of small
business lending to the lending community. Through this market, lenders are able to sell the
guaranteed portion of SBA guaranteed loans to investors, thereby improving the lenders’
liquidity and increasing the yield on the nonguaranteed portion of the SBA loan.




Page 12                                                                        GAO-03-676T
Internal Control   The study and evaluation of the system of internal control over financial
Weaknesses         reporting are included as part of the financial statement audit under
                   generally accepted auditing standards. Internal control is an integral
                   component of an agency’s management that provides reasonable assurance
                   that the following objectives are being achieved: (1) effectiveness and
                   efficiency of operations, (2) reliability of financial reporting, and
                   (3) compliance with applicable laws and regulations.15 Internal control
                   serves as the first line of defense in safeguarding assets and in preventing
                   and detecting errors and fraud. As federal policymakers and program
                   managers continually seek to better achieve agencies’ missions and
                   program results, they seek ways to improve accountability. A key factor in
                   achieving these outcomes and minimizing operational problems is the
                   implementation of appropriate internal control.

                   Internal control over financial information is evaluated during the audit,
                   and the auditor is required to communicate to the agency any condition
                   that represents a significant deficiency in internal controls—referred to as
                   a reportable condition.16 A material internal control weakness is a
                   reportable condition that does not reduce to a relatively low level the risk
                   that errors, fraud, or noncompliance involving significant amounts may
                   occur and not be detected in a timely manner by employees in the normal
                   course of performing their assigned functions. SBA’s auditor identified five
                   material weaknesses and one reportable condition.

                   As I previously stated, SBA received a disclaimer of opinion from its
                   auditor in fiscal year 2002 primarily due to three issues, and each of these
                   issues resulted from a material weakness in their internal controls. SBA’s
                   auditor reported material weaknesses relating to (1) disaster loan
                   modeling, (2) the liability for loan guarantees and related accounts for pre-
                   1992 loan commitments, and (3) the Master Reserve Fund, all of which I
                   have discussed. The fourth material weakness related to SBA’s financial
                   reporting process. According to SBA’s auditor, SBA continued to
                   experience widespread difficulties in producing complete, accurate, timely,
                   and adequately supported draft and final financial statements, including

                   15
                    Standards for Internal Control in the Federal Government, (GAO/AIMD-00-21.3.1)
                   Washington, D.C.: November 1999)
                   16
                     A reportable condition is a significant deficiency in the design or operation of internal
                   controls that could adversely affect the organization’s ability to provide reasonable
                   assurance on the reliability of its financial reporting, performance reporting, and
                   compliance with laws and regulations.




                   Page 13                                                                          GAO-03-676T
footnotes. The auditor stated that additional attention is needed to ensure
that a fully effective quality assurance process is documented and in place.
The auditor further stated that SBA's difficulties with financial reporting
may be attributable to devoting insufficient resources to the process,
particularly the quality control process.

The fifth material weakness was due to funds control weaknesses. For
example, the auditor reported that SBA established invalid undelivered
orders in its liquidating funds and did not return all unobligated balances in
its liquidating funds to the general fund at the end of the fiscal year. Also,
SBA did not have sufficient funds controls in place to ensure that payments
for defaulted 7(a) loan guarantees did not exceed authorized amounts or to
ensure that obligations were not incurred against anticipated budgetary
resources. These shortcomings increase the risk that SBA may violate the
Antideficiency Act.17

Finally, while SBA has continued to improve internal controls over its
information system environment in certain areas, the auditor reported that
further improvement is needed to ensure a sound information system
control environment. This internal control deficiency was included as a
reportable condition in the auditor’s 2002 report on internal controls.
Weaknesses were reported in all six categories of general computer
controls.18 General computer controls create the environment in which
application systems and controls operate. During a financial statement
audit, the auditor focuses on general controls for the agency’s major
computer facilities and systems supporting a number of different computer
applications, such as major data processing installations or local area
networks. If general computer controls are weak, as is the case at SBA,
they severely diminish the reliability of controls associated with individual
applications.




17
  The Antideficiency Act, among other things, prohibits the making of expenditures or the
incurring of obligations prior to or in excess of appropriations.
18
  The six general control categories are: (1) entity-wide security program control, (2) access
control, (3) application software development and program change control, (4) system
software control, (5) segregation-of-duty control, and (6) service continuity control.




Page 14                                                                         GAO-03-676T
Federal Financial        SBA’s auditor also concluded that SBA’s systems did not substantially
Management Improvement   comply with the Federal Financial Management Improvement Act of 1996
                         (FFMIA). FFMIA is a measure of an agency’s ability to incorporate into its
Act of 1996              financial management system accounting standards and reporting
                         objectives established for the federal government, so that all assets,
                         liabilities, revenues, expenses, and the full costs of programs and activities
                         can be consistently and accurately recorded, monitored, and uniformly
                         reported. Substantial noncompliance with FFMIA indicates that SBA’s
                         financial management systems do not routinely provide reliable, useful,
                         timely, and consistent information to fulfill its responsibility of being
                         accountable to the public and of providing timely financial information to
                         manage on a day-to-day basis.

                         SBA’s financial management systems in fiscal year 2002 did not
                         substantially comply with all three aspects of FFMIA: (1) federal financial
                         management systems requirements, (2) federal accounting standards, or
                         (3) the U.S. government standard general ledger (SGL) at the transaction
                         level.

                         SBA’s auditor noted that SBA was not in substantial compliance with
                         federal financial management systems requirements because its core
                         financial system is not able to provide complete, reliable, timely and
                         consistent financial information on programs to enable management to
                         fulfill its responsibility to the public and to provide timely information for
                         managing current operations. Also, access control, segregation-of-duties,
                         and other general control weaknesses exist in SBA’s information systems
                         controls. Additionally, funds control deficiencies exist as is evidenced in
                         SBA’s material weakness in that area.

                         The auditor concluded that SBA did not substantially comply with federal
                         accounting standards because it cannot support the reported cost of loans
                         sold, the reestimates of the subsidy for loans not sold, or the liability for
                         pre-1992 loan guarantees. SBA also cannot support the balance in the
                         Master Reserve Fund.

                         Finally SBA’s auditor concluded that SBA’s financial systems did not
                         substantially comply with the SGL at the transaction level. During fiscal
                         year 2002, SBA modified its Financial Reporting Information System but
                         did not detect in a timely manner an error created by the modification.
                         SBA also experienced problems that resulted in the posting of invalid
                         information to the system when it converted to its current Oracle-based
                         administrative accounting system.


                         Page 15                                                             GAO-03-676T
                  In closing, Mr. Chairman, SBA’s financial management deficiencies are
                  quite severe and point to an inability to provide full accountability for
                  taxpayer funds provided to the agency for carrying out its programs. Until
                  these deficiencies are corrected, SBA’s financial accounting and budgetary
                  reporting will be unreliable. In our January 2003 report, we made a number
                  of recommendations to SBA covering these matters related to accounting
                  for loan sales. SBA agreed with our recommendations, and we understand
                  that they are making progress identifying potential causes of these
                  deficiencies and actions to address them. We look forward to assessing the
                  results of these activities.

                  Mr. Chairman, this concludes my statement. I would be happy to answer
                  any questions you or other members of the subcommittee may have.



Contact and       For information about this statement, please contact Linda Calbom,
                  Director, Financial Management and Assurance, at (202) 512-9508, or Julia
Acknowledgments   Duquette, Assistant Director, at (202) 512-5131. You may also reach them
                  by e-mail at calboml@gao.gov or duquettej@gao.gov. Other individuals who
                  made key contributions to this testimony include Marcia Carlsen and Lisa
                  Crye. Numerous other individuals made contributions to the work
                  supporting this testimony.




(190092)          Page 16                                                        GAO-03-676T
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