Financial Management: Challenges Facing the IRS

Published by the Government Accountability Office on 1997-01-09.

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

                          United States General Accounting Office

GAO                       Testimony
                          Before the Commission on Restructuring the
                          Internal Revenue Service

For Release on Delivery
Expected at
10 a.m.
January 9, 1997           MANAGEMENT

                          Challenges Facing the IRS
                          Statement of Gregory M. Holloway
                          Director, Governmentwide Audits
                          Accounting and Information Management Division

                      Messrs. Chairmen and Members of the Commission:

                      I would like to thank you for inviting me to talk with you about the
                      financial management challenges that the Internal Revenue Service (IRS)
                      confronts as it looks to the future. A hearing on this subject is especially
                      timely considering the many efforts across government to improve
                      financial management through implementation of the Chief Financial
                      Officers (CFO) Act.

                      I would like to begin by discussing why it is important for IRS to have good
                      financial management. Then I will discuss the specific financial
                      management problems identified in our audits of IRS’ financial statements,
                      the actions needed by IRS to respond to the financial management
                      challenges and how this Commission can further these efforts to improve
                      IRS’ operations.

                      Without accurate and timely accounting, financial reporting, and auditing,
Good Financial        it is impossible to know how well or poorly IRS has performed in certain
Management Is a Key   facets of its operations such as tax collections. In addition, IRS’
Foundation to         management and the Congress’ ability to make informed decisions that are
                      “fact based” is substantially hindered when the underlying information
Managing IRS’         that provides the basis for decisions is called into question or when
Operations            fundamental information is lacking. Our efforts to audit IRS accounting
                      records have resulted in disclaimers of opinion each year. This means that
                      we were unable to determine whether the amounts reported by IRS in its
                      financial statements were right or wrong. Financial reporting at this level
                      and auditable financial statements, as required by the CFO Act, are
                      fundamental tenets of effective financial management.

                      Our disclaimer of opinion means that you do not know whether IRS
                      correctly reported the amount of tax it collected in total, how much money
                      IRS has collected by type of tax and on accounts receivables, the cost of its
                      operations including tax systems modernization (TSM), or any other
                      meaningful measure of IRS’ financial performance. In essence, poor
                      accounting and financial reporting, especially when combined with the
                      absence of an audit, obscures facts. As a result, users of information
                      reported or taken from the underlying accounting systems, risk making
                      errant decisions—whether for budget purposes or operationally—because
                      they relied on questionable information in making decisions.

                      Page 1                                                        GAO/T-AIMD-97-34
    Four of the more significant reasons IRS needs good financial management
    are to

•   provide for its day to day operations basic accounting that meets the
    minimal financial management goals of the CFO Act for financial reporting,
    implement effective internal control procedures—including safeguarding
    of assets, and ensure IRS’ compliance with pertinent laws and
    regulations—for example, the Anti-deficiency Act and others related to
    budget integrity;
•   ensure accurate accounting for and reporting of revenue collections in
    compliance with the law and help the Congress and others assess the
    impacts of various tax policies on the budget and to offer accountability to
    the American taxpayer;
•   better assess and improve IRS’ operating performance; and
•   improve its image as a fair tax collector that holds itself to the same or
    higher standards than it applies to the taxpaying public.

    Over the 4 years that we have performed financial statement audits at IRS,
    IRS has moved from

•   an agency that did not and could not reconcile its fund accounts (Fund
    Balance With Treasury), akin to a taxpayer’s bank account, to an agency
    that now attempts to reconcile its accounts regularly even though some
    unresolved amounts still exist and
•   an agency that could not support the propriety of amounts recorded in its
    accounting records or that they were recorded in the right accounting
    period to an agency that has developed and is implementing a strategy that
    if properly carried out, should be able to accomplish both.

    If IRS does not achieve and sustain the capacity to perform day to day
    accounting on its over $7 billion in annual appropriations and the more
    than $1.4 trillion in taxes it collects, it will not be able to credibly report on
    the cost and effectiveness of its operations. Furthermore, like any other
    business or individual that may have similar problems, IRS can assert that
    no money is missing and that it is in compliance with the Anti-Deficiency
    Act and other laws; however, if these problems persist, it cannot and does
    not know if its assertion is true.

    The following example shows the implications of poor accounting and
    financial reporting for IRS’ day to day operations.

    Page 2                                                           GAO/T-AIMD-97-34
•   In recent years, IRS has reported the costs of TSM along with projected
    future costs. However, IRS does not know what its TSM costs have been in
    total or by specific project. Its efforts to achieve cost accounting for TSM
    obscure the nature and amount of actual costs of TSM projects through
    grouping large amounts of costs into generic codes as opposed to tracking
    these costs on a project specific basis. In addition, no separate records
    were maintained on TSM costs incurred before 1994. Also, IRS cannot
    readily link costs projected to be incurred in IRS’ investment strategy with
    costs that are recorded in its accounting records. To do so would require
    substantial analysis that would likely require using estimating techniques
    for which results could not be validated. Thus, no credible records exist to
    make cost-benefit analysis of the overall project or to assess each project
    segment as it moves through various stages.

    In addition to day to day accounting and reporting, IRS’ ability to accurately
    account for and report tax collections is critical to the Congress, the
    federal government as a whole, and the American taxpayer. IRS’ inability to
    account for tax collections in total and by type of tax collected reduces the
    Congress’ and others’ ability to (1) fully assess the effectiveness of tax
    policies to achieve their intended goals, (2) know the amount the general
    revenue fund is subsidizing the Social Security Trust Fund, (3) determine
    whether excise taxes are being collected and distributed in accordance
    with legislation, and (4) assess IRS’ collection efforts on unpaid taxes.
    While IRS is making interim efforts to increase its capability to account for
    tax collections, longer term solutions will be needed before IRS will be able
    to provide this information in an accurate and timely manner.

    The following example shows the implications of poor accounting and
    reporting for tax collections.

•   In recent years, IRS has reported collections against accounts receivables
    of about $25 billion annually. However, IRS cannot reliably report cash
    collections on accounts receivable, and the amounts reported are
    estimates. IRS’ financial management system does not include a detailed
    record of debtors who owe taxes (a subsidiary accounts receivable
    record) that tracks these accounts and their related activity from one
    reporting period to the next. As a result, IRS has to employ sampling
    techniques to project estimated collections on accounts receivable. The
    lack of a detailed subsidiary record also severely hampers the ability to
    readily and reliably assess the performance of IRS’ various collection
    efforts because reliable information on accounts receivable activity from
    one period to the next is not readily available.

    Page 3                                                       GAO/T-AIMD-97-34
    The ability to account for day to day operations and tax collections
    accurately is the foundation for any efforts to assess and improve IRS’
    operational performance. Even though IRS reports that it collects over $1.4
    trillion in taxes and processes billions of documents including tax returns,
    refunds, correspondence, and the manifold other things it does as part of
    its tax administration mandate, this reporting does not tell you how well it
    did it or the cost effectiveness of operations. Good financial management
    would include developing a cost accounting system that accurately tracks
    the costs of each part of IRS’ operations. In addition, the related outcomes
    from operational improvement efforts, including additional revenue
    collected and other qualitative performance indicators, would be
    accounted for and linked to the respective operational costs associated
    with accomplishing the outcomes. Right now, IRS does not have the
    capacity to account for its costs and outcomes in a manner consistent with
    good financial management.

    The following example shows the implications of not having good
    financial management accounting and reporting in place.

•   IRSreported, as part of its compliance initiative budget requests, that it
    would achieve certain levels of return in collecting unpaid taxes with the
    additional funding. These requests typically showed past performance
    from compliance initiatives and projected future collections expected
    from the proposed compliance initiative. They also typically showed that a
    substantial return on investment had been and would be achieved from
    compliance initiatives.

    IRS’financial management systems, however, cannot reliably provide
    information that links cash collected on tax accounts with its respective
    programs used to collect unpaid taxes and the program’s related costs,
    including those supported by its compliance initiatives. As a result, the
    information provided as IRS’ performance from compliance initiatives was
    prepared using estimates, selective analysis of information, and
    unvalidated criteria. We found that the reported incremental collections
    and the associated costs were not verifiable. IRS currently has a system
    under development (called the Enforcement Revenue Information System)
    that will attempt to track and correlate this information.

    Finally, IRS needs to have good financial management to show that it does
    not have a double standard for financial management—one that taxpayers
    must adhere to and another that applies to itself. If IRS had to prepare its

    Page 4                                                      GAO/T-AIMD-97-34
                        own tax return, with the many problems we have found during our
                        financial statement audits of IRS, it would not pass the scrutiny of an IRS
                        audit. Many of its expenses would be disallowed because they were
                        unsupported or reported in the wrong year, and the amounts and nature of
                        its revenue would be questioned.

                        As much as any federal agency and more than most, IRS routinely interacts
                        with taxpayers. Taxpayers’ views of the government and on the fairness of
                        tax administration are shaped in a big way by their perception of IRS. For
                        IRS to demand the kind of recordkeeping it requires for taxpayers to
                        support tax returns (a form of financial reporting) and to not be able to
                        sustain a comparable or better set of records to support its own financial
                        reporting does not bode well. These concerns and views have been
                        conveyed in many published articles on the state of financial management
                        at IRS, and these articles clearly show taxpayers’ expectation for IRS to be
                        able to meet the standards that it expects others to meet.

                        The financial management problems I have discussed today are but a few
                        of the challenges that IRS must confront. These, though, must be overcome
                        for IRS to be able to credibly report the results from its operations whether
                        through annually required financial statements or ad hoc reports provided
                        to the Congress and other users on the various aspects of its operations.

                        It is crucial that IRS maintain its capacity to process the billions of
                        documents and handle the multitude of other tax administration
                        challenges that it is responsible for managing. However, as evidenced in
                        the examples I have highlighted for you today, it is comparably crucial that
                        IRS address its many financial management problems so that
                        decisionmakers can make “fact based,” informed decisions on IRS’ staffing
                        levels, tax policies, and other matters based on the verifiable reported
                        results from IRS’ operations.

                        We issued disclaimers of opinion on each of our four annual audits of IRS’
Reasons for GAO’S       financial statements (from fiscal year 1992 through fiscal year 1995).
Disclaimer of Opinion   Notable improvement has occurred across IRS as a result of these audits,
and Actions Needed      which were required by the CFO Act as expanded by the Government
                        Management Reform Act. These two pieces of legislation, and particularly
to Correct Them         their requirement for audited financial statements, have been instrumental
                        in bringing IRS’ top-level management focus to financial management
                        problems that had been neglected for years. Because of our audit efforts,
                        IRS’ management, for the first time, has a fuller understanding of the depth

                        Page 5                                                       GAO/T-AIMD-97-34
    and breadth of the financial management problems that beset the agency
    and has, as a result, begun taking actions to address the problems.

    The reasons for our disclaimers of opinion were IRS’ inability to

•   provide support for its reported over $1.4 trillion in collected revenues in
    total and by type of tax (i.e., income, social security, etc.),
•   accurately identify and provide support for its reported tax receivables
    that were estimated in the tens of billions,
•   reconcile its Fund Balance With Treasury accounts (these accounts
    represent IRS’ remaining approved budgetary spending authority—the
    federal government equivalent of bank accounts), and
•   accurately account for and provide support for significant amounts of its
    almost $3 billion annually in nonpayroll expenses to establish that these
    expenses were appropriately included in the respective years’ reported

    IRShas made progress on addressing some of these problems, and we have
    worked closely with it to identify interim solutions to address the
    problems that can be fixed quicker and partially address the problems that
    will require longer term solutions. IRS has developed an action plan, with
    specific timetables and deliverables, to attempt to address the reasons for
    our audit disclaimer. To date, IRS reported it has

•   identified substantially all of the reconciling items for its Fund Balance
    With Treasury accounts, except for certain amounts that IRS has deemed
    not to be cost-beneficial to research further because they were thought to
    be insignificant or that IRS had exhausted all avenues available to resolve
    the difference and could not;
•   designed an interim solution, until longer term solutions can be identified
    and implemented, to capture the detailed support for revenue and
    accounts receivable; and
•   begun designing a short-term and a long-term strategy to fix the problems
    that contribute to its nonpayroll expenses being unsupported or reported
    in the wrong period.

    We are currently reviewing progress in each of these areas as part of our
    audit of IRS’ fiscal year 1996 financial statements and will report the status
    of these efforts as part of our report that will be issued at the completion
    of this audit.

    Page 6                                                        GAO/T-AIMD-97-34
           In closing, I want to reiterate that preparing auditable financial statements
           and obtaining an unqualified audit opinion on those financial statements
           are basic to good financial management and one indicator of the condition
           of financial management of an entity. While IRS has made progress, the
           catalyst for fixing the problems will be its senior management’s continued
           commitment as well as sustained effective congressional oversight. IRS has
           recognized its problems and essentially knows what needs to be done. It is
           now a matter of carrying out improvement plans.

           This concludes my statement, and I will be glad to answer any questions.

(901751)   Page 7                                                       GAO/T-AIMD-97-34
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