Dr. Felipe Alanis

Commissioner of Education

Texas Education Agency

1701 North Congress Avenue

Austin, Texas 78701-1494

Dear Commissioner Alanis:

This **Final Audit Report** (Control Number ED-OIG/A06-C0034) presents
the results of our audit of the Texas Education Agency's (TEA) treatment
of the costs of unused accrued vacation leave of retiring or separating
employees (terminal leave) for the period September 1, 1999, through
August 31, 2002. The objective of our audit was to determine whether TEA
allocated terminal leave costs[^1] to U.S. Department of Education
(Department) funded activities in accordance with Office of Management
and Budget (OMB) Circular A-87, Cost Principles for State, Local, and
Indian Tribal Governments, Attachment B(11)(d)(3).

A draft of this report was provided to the Texas Education Agency. In
its response, Texas did not completely respond to or agree with our
recommendations. Texas's comments are summarized in the section that
follow the Recommendations. A copy of the complete response is enclosed
with this report.

The TEA, located in Austin, Texas, is the state education agency
responsible for administering primary and secondary public education in
Texas. TEA's functions include overseeing development of statewide
curriculum; administering the statewide assessment system; administering
a data collection system on public school students, staff, and finances;
rating school districts under a statewide accountability system;
operating research and information programs; monitoring for compliance
with State and Federal guidelines; and serving as a fiscal agent for the
distribution of State and Federal funds.

TEA received almost \$1.6 billion in Department funding for its fiscal
year that ended August 31, 2001, including \$26.1 million for
administering Department-funded activities. During that fiscal year, TEA
employed a staff of 824 to administer the State and Federal activities
and to provide services to the 1,040 Texas school districts.

A total of 349 employees separated from TEA during the three-year period
from September 1, 1999, through August 31, 2002. Of the 349 employees,
163 had been working on Department-

funded activities at the time they separated. These separations included
retirements, voluntary separations, dismissals for cause, and transfers
to other State agencies.

TEA did not allocate its terminal leave costs for employees who
separated from Department-funded activities in accordance with OMB
Circular A-87. TEA charged separating employees' terminal leave costs
directly to Department funded activities rather than allocating the
costs as a general administrative expense to all activities of the
agency. For the three-year period ended August 31, 2002, we determined
that TEA inappropriately charged an estimated \$500,512 in terminal
leave costs directly to Department-funded activities for the 163
employees who separated from the agency.

OMB Circular A-87 (Revised 5/4/95, as further amended 8/29/97)
Attachment B, prohibits State, Local, and Indian Tribal Government units
from charging terminal leave costs directly to Federal programs.
Pursuant to OMB Circular A-87, Attachment B(11)(d)(3),

> When a governmental unit uses the cash basis of accounting, the cost
> of leave is recognized in the period that the leave is taken and paid
> for. Payments for unused leave when an employee retires or terminates
> employment are allowable in the year of payment provided they are
> allocated as a general administrative expense to all activities of the
> governmental unit or component.

In its Indirect Cost Rate Agreements with the Department dated December
29, 1999, and January 18, 2001, TEA agreed to comply with this OMB
Circular A-87 requirement. The Department official responsible for
negotiating the agreements informed us that TEA uses the cash basis to
account for the cost of terminal leave. These two agreements, which
provided new indirect cost rates for TEA to use beginning on September
1, 1999, and September 1, 2000, contained the statement "In accordance
with OMB Circular A-87, Attachment B (11)(d)(3), payments to separating
employees for unused leave are treated as indirect costs." Indirect cost
rate agreements for prior periods did not address the terminal leave
requirements.

According to TEA's written procedures, an employee who resigns, is
dismissed, or separated from state employment is entitled to all accrued
vacation leave. The procedures allowed separating employees the option
of receiving their accrued vacation leave in a lump sum payment or
remaining on the payroll after the last day worked to use the vacation
time in lieu of being paid a lump sum. We concluded that either option
would constitute a terminal leave payment for the separating employee.

We determined from TEA records that 163 employees had been assigned to
Department-funded activities at the time of their separation during the
three-year period from September 1, 1999, through August 31, 2002. Based
on a statistical sample review of records for 76 of the 163 employees,
we estimate that TEA inappropriately charged \$500,512[^2] of terminal
leave costs directly to Department-funded activities.

During our random sample review of records for the 76 separated
employees, we also evaluated whether TEA transferred the employees from
non-Department to Department-funded activities in anticipation of their
separation. Our review disclosed no evidence that this occurred.

TEA's Chief of Operations acknowledged that TEA had charged all terminal
leave costs for separating employees in the same manner as it had
charged the employees' salary costs (i.e., directly to the activities on
which the employees were working at the time of their separation). The
Chief of Operations cited the complexity and interconnectivity of the
accounting systems used and the relatively small amount of terminal
leave costs as the reasons TEA had charged terminal leave costs directly
to the activities. At the exit conference, the Chief of Operations
stated that TEA had already decided to change its procedures and that
the new procedures would result in the terminal leave costs of all
employees (State and Federal) being charged to an indirect cost pool
retroactive to September 1, 2002.

We recommend that the Department require TEA to:

1.1. Reverse the \$500,512 of terminal leave costs, which were charged
directly to Department-funded activities from September 1, 1999, through
August 31, 2002, and allocate the costs as general administrative
expenses for those years, recalculate the indirect cost rates for each
of the years, and apply the new indirect cost rate for each year to the
Department-funded activities. Any funding in excess of the corrected
amounts charged to Department-funded activities should be returned to
the Department. As an alternative, the Department could require TEA to
return the \$500,512 to the Department.

1.2. Provide documentation to the Department that the planned changes to
TEA's procedures for allocating terminal leave costs have been
implemented effective September 1, 2002, and that those changes result
in the appropriate charging of terminal leave costs as general
administrative expenses.

[TEA's Comment to Recommendation 1.1]{.underline}

TEA agreed that it could pursue the possibility of reopening and
recalculating the indirect costs for each of the three years in the
audited period. However, TEA believed ". . . that the end result of this
would require great effort with virtually no overall impact on the
dollars and the ultimate Federal usage."

To illustrate its belief, TEA provided information suggesting that if it
complied with the OIG recommendation, the end result would be that TEA
would be entitled to approximately an additional \$18,800 in Federal
funds. TEA added, "However, two years after the fact, there are many
grants that are now closed, both on the State and Federal side, which
would limit our reimbursement possibilities."

TEA concluded that given the relatively immaterial net difference as a
result of complying with the OIG's recommendation, it ". . . would
respectfully request that the Department consider that the optimum
solution -- which would greatly reduce the burden on Agency staff and
the Department's Indirect Cost staff -- is to acknowledge that the
ultimate impact on the years in question essentially should be
considered a 'wash'."

#### OIG's Response

There was nothing in TEA's comments that persuaded us to change our
report finding or Recommendation 1.1.

TEA's comments appeared to suggest that the "Final DOE negotiated rate"
is the result of the division of TEA's "Indirect Cost Pool" by TEA's
"Direct Base". While this may be the factual case, what is allowed into
the Indirect Cost Pool and the Direct Base is open to negotiation.
According to the Department's Indirect Cost staff, the final negotiated
indirect cost rate for the year 2002 has not yet been agreed upon. This
being the case, TEA's projection for 2002 is based upon an assumption
that makes the combined projection for the three award years
questionable. In addition, TEA used dollar figures in its response that
cannot be verified without extensive additional audit fieldwork.

The OIG's Draft Report concluded that terminal leave costs are composed
of the costs from two different groups of employees separating from TEA.
The first group is made up of individuals separating from TEA who choose
to receive their accrued vacation leave in lump sum payments. The second
group is made up of those individuals separating from TEA who chose, in
lieu of being paid a lump sum, to remain on the payroll after their last
day worked to use their accrued vacation leave.

TEA in its response did not appear to address the terminal leave costs
associated with that second group of separating employees. This apparent
situation adds to the questionability of TEA's combined projection for
the three award years.

[TEA's Comment to Recommendation 1.2]{.underline}

TEA stated that, effective September 1, 2002, it successfully
implemented changed procedures to allocate terminal leave cost as
general administrative expenses. TEA describes the new procedures and
provides documentation that purports to illustrate and support the new
procedures. TEA concluded its comment with the statement that "The end
result of these steps is that all lump-sum payments ultimately are
charged to the Indirect Pool."

[OIG's Response]{.underline}

There was nothing in TEA's comments that persuaded us to change our
report finding or Recommendation 1.2.

TEA's comments appeared to agree with the recommendation that its
procedures needed to be changed so that terminal leave costs are
allocated as general administrative expenses. However, the response and
provided documentation appear to address only the group of individuals
separating from TEA who chose to receive their accrued vacation leave in
lump sum payments. There appeared to be no mention of that group
composed of separating employees who chose to remain on the payroll
after their last day worked to use their accrued vacation leave. By not
addressing the terminal leave costs of those who remain on the payroll
to use their accrued vacation leave, TEA did not fully respond to the
recommendation.

The objective of our audit was to determine if TEA allocated terminal
leave costs in accordance with OMB Circular A-87, Attachment B(11)(d)(3)
for the period September 1, 1999, through August 31, 2002. To achieve
our audit objective, we obtained and reviewed background information
about TEA, OMB Circular A-87, Attachment B(11), the Implementation Guide
for OMB Circular A-87, the portion of the Texas statewide OMB Circular
A-133 audit report applicable to TEA for the fiscal year ended August
31, 2001, and applicable TEA Operating Procedures. We also interviewed
TEA officials about TEA's accounting system and procedures for charging
terminal leave costs, TEA's OMB Circular A-133 auditor, and Department
officials.

We reviewed a list provided by the Texas State Comptroller's Office that
showed 349 TEA employees separated during the period from September 1,
1999, through August 31, 2002. We reviewed TEA records for each employee
on the list and identified a universe of 163 employees who worked on
Department-funded activities at the time of their separation. We applied
statistical sampling techniques to the universe of 163 employees by
selecting a random sample of 76 employees. We reviewed the employment
and terminal leave records of the 76 employees

and calculated for each employee the terminal leave costs that were
charged directly to Department-funded activities. Based on our sample
results, we are 90 percent confident that the direct terminal leave
charges for the 163 employees amounted to \$500,512 +/- 17 percent.

We tested the reliability of the computerized list of separated TEA
employees obtained from the Texas State Comptroller's Office by
comparing the list to TEA's Human Resources Division's manually
maintained lists of separated employees. Based on our review, we
concluded that the list provided by Texas State Comptroller's Office was
sufficiently reliable for the purpose of this audit.

We performed fieldwork from September 3 through October 1 and on
December 18, 2002, at TEA's offices in Austin, Texas. We conducted an
exit conference with TEA on December 18, 2002. Our audit was performed
in accordance with generally accepted government auditing standards
appropriate to the scope of the review described above.

As part of our review we gained an understanding of the management
controls, policies, procedures, and practices applicable to TEA's
treatment of terminal leave costs. For the purpose of this report, we
gained an understanding of TEA's definition of terminal leave and their
procedure for allocating terminal leave costs of separating employees.
Because of inherent limitations, a study and evaluation made for the
limited purpose described above would not necessarily disclose all
material weaknesses in the management controls. However, a weakness was
identified in TEA's procedure for charging of separating employees'
terminal leave costs. The weakness and the effect are discussed in the
AUDIT RESULTS section of this report.

If you have any additional comments or information that you believe may
have a bearing on the resolution of this audit, you should send them
directly to the following U.S. Department of Education official, who
will consider them before taking final Departmental action on the audit:

> Jack Martin, Chief Financial Officer
>
> U.S. Department of Education

400 Maryland Avenue, SW

Room 4E313, FB6 Building

Washington, D.C. 20202

Office of Management and Budget Circular A-50 directs Federal agencies
to expedite the resolution of audits by initiating timely action on the
findings and recommendations contained therein. Therefore, we request
receipt of your comments within 30 days.

In accordance with the Freedom of Information Act (5 U.S.C. §552),
reports issued by the Office of Inspector General are available, if
requested, to members of the press and general public to the extent
information contained therein is not subject to the exemptions in the
Act.

If you have any questions or wish to discuss the contents of this
report, please contact me at 214-880-3031. Please refer to the control
number in all correspondence related to this report.

Sincerely,

Sherri L. Demmel

Regional Inspector General

for Audit

[]{.mark}

Attachment

[^1]: Terminal leave costs include salary, fringe benefits, and related
    indirect costs.

[^2]: Based on our statistical sample, we are 90 percent confident that
    the inappropriate charges total \$500,512 +/- 17 percent.