United States General Accounting Office

GAO Report to the Commissioner of Internal

Revenue 

October 1998 INTERNAL REVENUE

SERVICE

Immediate and

Long-Term Actions

Needed to Improve

Financial Management

GAO/AIMD-99-16

GAO United States

General Accounting Office

Washington, D.C. 20548

Accounting and Information

Management Division

B-280501 

October 30, 1998

Mr. Charles O. Rossotti

The Commissioner of Internal Revenue

Dear Mr. Rossotti:

This letter is a follow-up to our report on the results of our audit of the

custodial financial statements of the Internal Revenue Service (IRS) for

fiscal year 1997.1

 For the first time since we began auditing IRS’ financial

statements in fiscal year 1992,2

 we were able to conclude that IRS’ fiscal

year 1997 custodial financial statements were reliable in all material

respects. In issuing an unqualified opinion on these statements, we

reported that the over $1.6 trillion in tax revenue, $142 billion in tax

refunds, and $28 billion in net taxes receivable reported by the IRS were

fairly stated.

However, as we pointed out in our audit report and in subsequent

congressional testimony,3

 serious weaknesses in IRS’ internal controls and

financial management systems continue to exist. This report outlines what

we believe needs to be done to address these problems. It details our

findings and presents conclusions and recommendations for

improvement.4

Background Because of the volume and sensitivity of tax collections and refunds, the

adequacy of IRS’ financial systems deserves careful attention. Federal tax

revenues, which represent over 90 percent of the federal government’s

revenues, dwarf most other financial activities undertaken by any single

entity, public or private, in the world. Therefore, it is imperative that IRS

establish strong financial management and internal controls to effectively

carry out its mission.

1

Financial Audit: Examination of IRS’ Fiscal Year 1997 Custodial Financial Statements

(GAO/AIMD-98-77, February 26, 1998).

2

See list of related GAO products at the end of this report.

3

Internal Revenue Service: Remaining Challenges to Achieve Lasting Financial Management

Improvements (GAO/T-AIMD/GGD-98-139, April 15, 1998).

4

During our audit of IRS’ fiscal year 1997 custodial financial statements, we identified six material

weaknesses, one reportable condition representing a significant deficiency in IRS’ internal controls,

and one instance of noncompliance with laws and regulations. One of the material weaknesses we

reported—controls over computer security—is being dealt with in a separate report.

Page 1 GAO/AIMD-99-16 IRS Financial Management
B-280501 

In accordance with the Chief Financial Officers Act of 1990, as expanded

by the Government Management Reform Act of 1994, we audited IRS’ fiscal

year 1997 custodial financial statements. These custodial financial

statements report the assets, liabilities and results of activities related to

IRS’ responsibilities for implementing federal tax legislation, including

collecting federal tax revenues, refunding overpayments of taxes, and

pursuing collections of amounts owed. Its fiscal year 1997 administrative

financial statements, which were audited by the Treasury Inspector

General, report on the financial position and results of operations related

to the administration of IRS funded by appropriations and reimbursements

from other agencies, state and local governments, and the public.

Prior to fiscal year 1997, we were unable to conclude that IRS’ custodial

financial statements were fairly stated, mainly because weaknesses in IRS’

internal controls and financial management systems prevented it from

producing reliable financial information.5

 Therefore, our ability to

conclude that the fiscal year 1997 custodial financial statements were

reliable was a mark of progress. However, this came only after IRS applied

extensive ad hoc programming and analysis to develop balances, which

subsequently required material adjustments to produce the financial

statements. Thus, many of the original internal control weaknesses still

exist. Fixing these weaknesses represents an additional and critical step

that IRS must take to meet its accountability goals and effectively achieve

its mission. To help IRS accomplish this, we made a total of 30

recommendations in our previous audits to assist IRS in addressing the

internal control and system weaknesses associated with its custodial

responsibilities, which are discussed in appendix II.6

 However, critical

recommendations have not been implemented.

Results in Brief IRS’ internal control system remains plagued by weaknesses that adversely

affect the agency’s ability to safeguard assets from material loss, ensure

material compliance with relevant laws and regulations, and ensure that

material misstatements do not occur in its financial statements. In the

aggregate, we reported these issues as a material weakness in our report

on the fiscal year 1997 consolidated financial statements of the U.S.

5

For fiscal year 1996, we were able to determine for the first time that total net revenue collections as

reported in IRS’ financial statements were reliable. However, we still could not conclude that IRS

correctly classified tax receipts and refunds by tax type because IRS could not provide sufficient

evidence supporting its classification. As in prior years, we also could not determine the reliability of

reported net federal tax receivables.

6

GAO has also made 29 recommendations related to IRS’ administrative responsibilities which are not

discussed in this report.

Page 2 GAO/AIMD-99-16 IRS Financial Management
B-280501 

government.7 Left uncorrected, these weaknesses significantly increase

the risk that future financial statements of both IRS and the entire federal

government as well as other IRS reports may not be reliable and that losses

to the government could occur.

Based on the internal control weaknesses we identified in our fiscal year

1997 audit, we are making 11 new recommendations. In summary, the

weaknesses we identified and our key recommendations are as follows:

• Detailed accounting for unpaid assessments. IRS’ general ledger cannot

distinguish categories of unpaid assessments to determine the portion that

represents actual taxes receivable of the federal government. IRS also does

not have a detailed listing, or subsidiary ledger, for tracking and

accumulating unpaid assessments. These weaknesses resulted in IRS

pursuing collection from taxpayers even after amounts owed had been

paid. Lacking such capabilities, IRS must rely on computer programs to

extract data from its master files to prepare its financial statements, a

process which still resulted in tens of billions of dollars in adjustments to

correct misclassifications and eliminate duplicate transactions. IRS also

continues to lack adequate documentation to support its unpaid

assessments. In the short-term, we recommend that IRS (1) improve the

accuracy of the master file extraction programs used to prepare the

financial statements and (2) establish minimum documentation standards

for its unpaid assessment files to facilitate its classification and collection

efforts. In the long-term, we recommend that IRS’ system improvement

efforts include permanent solutions to its internal control deficiencies

over unpaid assessments.

• Controls over service center receipts. The volume and nature of IRS’

operations renders it highly vulnerable to losses of taxpayer and

government funds. IRS’ current controls over service center cash and

checks received directly from taxpayers are not sufficient to adequately

reduce the exposure to loss. Between 1995 and 1997, IRS identified

$5.3 million in actual or alleged embezzlement by service center

employees. In the short-term, we recommend that IRS consider instituting a

number of physical security controls, including installing surveillance

cameras and prohibiting personal belongings in the receipts processing

areas by providing and requiring the use of lockers, to reduce the exposure

of cash and checks to theft or loss.

• Controls over refunds. Some refunds should not have been issued and

some refunds were issued for incorrect amounts in fiscal year 1997.

7

Financial Audit: 1997 Consolidated Financial Statements of the United States Government

(GAO/AIMD-98-127, March 31, 1998).

Page 3 GAO/AIMD-99-16 IRS Financial Management
B-280501 

Control deficiencies also make IRS vulnerable to issuing duplicate refunds

to the same person. To reduce the number of inappropriate refunds issued,

IRS should in the short-term study the cost-benefit of manually comparing

third party wage and other data to tax returns at the time they are

processed. In the long-term, IRS should ensure that its systems

improvement efforts provide for the capability to compare tax returns to

other third party-supplied information prior to issuing refunds.

• Detailed revenue accounting and reporting. IRS is unable to determine the

specific amount of revenue it collects for three of the federal government’s

four largest revenue sources—Social Security, Medicare, and individual

income taxes—at time of collection because it does not obtain the

information necessary to do so. In addition, during fiscal year 1997, IRS did

not distribute excise tax receipts to the relevant trust funds based on

collections as required by the Internal Revenue Code. IRS officials have

indicated that they implemented a method in June 1998 for certifying

excise tax distributions based on collections.

• General ledger system. IRS’ general ledger cannot routinely generate

reliable and timely financial information. As a result, in fiscal year 1997 IRS’

systems did not comply with the Federal Financial Management

Improvement Act (FFMIA) of 1996.8

 We recommend that IRS implement the

first step of its systems modernization plan as soon as possible and ensure

that the resulting system can routinely generate timely and reliable

financial management reports.

These weaknesses and resultant recommendations illustrate the extent to

which IRS still has extensive work ahead of it to fully address and resolve

its internal control and financial management system deficiencies. Left

uncorrected, the internal control weaknesses identified will continue to

hinder IRS from adequately managing its financial operations and create

situations in which taxpayers have to expend unnecessary efforts to

rectify problems created by IRS errors. In addition, IRS will not regularly be

able to prepare reliable, timely financial reports.

Objectives, Scope,

and Methodology

As part of our audit of IRS’ fiscal year 1997 custodial financial statements,

we conducted an evaluation of IRS’ internal controls and its compliance

with selected provisions of laws and regulations. Our first objective was to

determine whether IRS management’s assertion about the effectiveness of

internal controls in meeting the following objectives was fairly stated:

(1) safeguarding assets from material loss, (2) assuring material

8

FFMIA requires agencies to implement and maintain financial management systems that comply

substantially with federal financial management systems requirements, applicable federal accounting

standards, and the U.S. Government Standard General Ledger at the transaction level.

Page 4 GAO/AIMD-99-16 IRS Financial Management
B-280501 

compliance with laws governing the use of budget authority and with

other relevant laws and regulations, and (3) assuring that there were no

other material misstatements in the custodial financial statements. Our

second objective was to identify any internal control weaknesses that

prevented IRS from achieving its three objectives. The purpose of this

report is to discuss the internal control and compliance findings from our

fiscal year 1997 audit in more detail and to present our conclusions and

recommendations for improvement. Appendix I provides further details on

our scope and methodology.

We performed our work from May 1997 through February 1998 in

accordance with generally accepted government auditing standards and

Office of Management and Budget (OMB) Bulletin 93-06. We requested

comments on a draft of this report from the Commissioner of Internal

Revenue or his designee. The Commissioner provided us with written

comments, which are discussed in the “Agency Comments and Our

Evaluation Section” and reprinted in appendix III.

Lack of Detailed

Accounting

Information and

Documentary Support

Impairs IRS’ Ability to

Manage Unpaid

Assessments

IRS’ general ledger—the primary structure of the accounting

system—cannot separate categories of unpaid assessments to determine

the portion that represents taxes receivable. The general ledger also does

not have a detailed listing, or subsidiary ledger, which tracks and

accumulates unpaid assessments on an ongoing basis and provides

support for the general ledger. Because it cannot readily determine the

amount of taxes receivable, IRS also cannot routinely analyze its taxes

receivable to determine the portion that is estimated to be collectible.

Such weaknesses in IRS’ management of its unpaid assessments resulted in

IRS pursuing collection from taxpayers even after amounts owed had been

paid. In addition, IRS continues to experience problems locating and

providing supporting documentation for unpaid assessments, primarily

due to the age of the items. Without either a general or subsidiary ledger

that can accurately categorize, track and accumulate unpaid assessments

or adequate documentation to support these amounts, IRS’ ability to

effectively manage its unpaid assessments is significantly impaired.

IRS’ General Ledger

System Cannot Separate

Categories of Unpaid

Assessments

Unpaid assessments consist of taxes that IRS has recorded as due to the

government from taxpayers for which payment has not yet been received.

Page 5 GAO/AIMD-99-16 IRS Financial Management
B-280501 

Based on federal accounting standards,9 unpaid assessments are placed in

one of the following three categories:

• taxes receivable, which are amounts due from taxpayers for which IRS can

support the existence of a receivable through taxpayer agreement (such as

the filing of a tax return) or a court ruling favorable to IRS;

• compliance assessments, for which neither the taxpayer nor the court has

affirmed that the amounts are owed, such as an assessment resulting from

an audit of the taxpayer; and

• write-offs, which are any unpaid assessments for which IRS does not

expect further collections due to factors such as the taxpayer’s

bankruptcy, insolvency, or death.

Of these three, only taxes receivable are reportable in the principal

financial statements, with compliance assessments and write-offs

presented as supplemental information to the financial statements. GAO’s

Standards for Internal Controls in the Federal Government requires that

transactions and other significant events be promptly recorded and

properly classified to maintain their relevance and value to management in

controlling operations and making decisions.10 Transactions and events

are to be properly classified in the summary records from which reports

and financial statements are prepared. Therefore, it is essential for IRS’

records to classify its unpaid assessments into these three categories in

order to present reliable information in its financial statements and to

enable management to make informed business decisions based on this

complete and reliable information.

However, IRS’ general ledger system cannot distinguish those unpaid

assessment amounts which represent taxes receivable from those which

represent either compliance assessments or write-offs. To compensate, IRS

has to utilize specialized computer programs to extract the universe of

unpaid assessments from its master files—its only detailed database of

taxpayer information—and classify these into the three categories that

make up total unpaid assessments. IRS then analyzes those unpaid

assessments classified as taxes receivable to estimate the amount deemed

to be collectible (the net taxes receivable). However, this approach has

flaws. For example, the amounts produced by this approach for the fiscal

year 1997 financial statements still required material adjustments totaling

9

Statement of Federal Financial Accounting Standards No. 7, Accounting for Revenue and Other

Financing Sources and Concepts for Reconciling Budgetary and Financial Accounting, May 10, 1996.

10GAO’s Standards for Internal Control in the Federal Government, issued in 1983, contains the internal

control standards to be followed by executive agencies in establishing and maintaining systems of

internal control as required by the Federal Managers’ Financial Integrity Act of 1982.

Page 6 GAO/AIMD-99-16 IRS Financial Management
B-280501 

tens of billions of dollars. As figure 1 shows, total unpaid assessments

extracted from the fiscal year 1997 master files required material

reductions in the amounts of taxes receivable and compliance

assessments, and material increases in write-offs, in order to arrive at

reliable amounts.

Figure 1: Comparison of Unpaid

Assessments Before and After Audit

Adjustments at September 30, 1997

Billions of dollars

0

10

20

30

40

50

60

70

80

90

100

110

120

130

140

Taxes receivable Compliance

assessments

Write-offs

Before audit adjustments

After audit adjustments

Note: The adjusted balance of taxes receivable presented above represents the gross taxes

receivable (i.e., does not include the allowance for doubtful accounts). Additionally, the original

unpaid assessment balance of $236 billion was adjusted to $214 billion, due primarily to

duplicate assessments.

Source: IRS masterfiles and IRS fiscal year 1997 custodial financial statements.

The most significant adjustments related to amounts originally identified

as taxes receivable or compliance assessments but which were really

write-offs. In fact, 149 of the 626 cases we sampled—about

24 percent—that were initially identified as taxes receivable in the master

files were actually write-offs and consisted primarily of corporate income

Page 7 GAO/AIMD-99-16 IRS Financial Management
B-280501 

and payroll taxes11 owed by corporations that had been defunct for years.

Similarly, 23 percent of the compliance assessments we sampled were also

write-offs.

These adjustments were necessary due to limitations in the initial criteria

IRS used in its master file extraction programs to account for federal

payroll taxes owed by bankrupt and defunct businesses. For example, IRS’

criteria for identifying write-offs did not include bankrupt taxpayers that

owed federal payroll taxes. In many cases we reviewed, the taxpayer was

deceased, bankrupt, a defunct business, or incarcerated, yet the items

were still identified as taxes receivable or compliance assessments. In

these cases, we determined that the items should be classified as

write-offs and IRS subsequently agreed. Had IRS expanded its master file

extraction criteria for identifying write-offs to include such characteristics

as bankrupt employers owing payroll taxes, it may not have had to make

material adjustments to the balances extracted.

The process of extracting the information from the master files is labor

intensive and time-consuming and thus, vulnerable to error. The computer

programs used to extract information from the master files and classify

unpaid assessments are critical because they provide the only feasible

means for determining the portion of unpaid assessments that belong in

each of the three categories and thus, the portion that should be reported

in IRS’ financial statements. However, the extensive reliance IRS must place

on ad hoc procedures to identify its taxes receivable and the significant

adjustments necessary to make these data reliable raise serious questions

about the integrity of unaudited IRS information and the ability of IRS to

effectively manage its unpaid assessments.

Historically the full amount of unpaid assessments has been considered

receivables. Therefore, it is significant to note that after several years of

audit scrutiny, IRS has finally been able to determine that only $28 billion

of its $214 billion in total unpaid assessments—about 13 percent—actually

represent collectible taxes receivable. Thus, while the Congress and IRS

may have been making management and budgeting decisions based on a

presumed level of taxes receivable, in fact only a small portion of that

balance represented receivables for which collection could reasonably be

expected. While such information is necessary for IRS to prepare reliable

financial statements, on a broader level, good reliable financial data are

11Payroll tax withholdings are comprised of individual income tax withholdings and employer and

employee withholdings for Federal Insurance Contribution Act (FICA), which include Social Security

and Hospital Insurance taxes.

Page 8 GAO/AIMD-99-16 IRS Financial Management
B-280501 

essential for management to accurately measure and report on IRS’

performance and for the Congress to make its budget decisions.

IRS Does Not Have a

Subsidiary Ledger to

Routinely Track and

Monitor Unpaid

Assessment Activities

IRS also lacks a subsidiary ledger to track and accumulate unpaid

assessments on an ongoing basis. Such a subsidiary ledger could have

compensated for the general ledger’s inability to separate unpaid

assessments, and would improve IRS’ ability to manage its unpaid

assessments. According to Federal Financial Management Systems

Requirements,12 an agency’s core financial system should be supported by

a general ledger account structure that complies with the U.S. Government

Standard General Ledger.

13 To support the account balances in these

Standard General Ledger accounts, the general ledger should be supported

by either detailed subsidiary accounts or additional data elements.

Specifically, IRS’ subsidiary ledger system should be able to routinely

provide information useful for managing unpaid assessments and

assessing collectibility, such as a history of payments and defaults,

payment terms, and account status. As we have previously reported, IRS’

general ledger structure does not include the required subsidiary support.

As a result, IRS cannot (1) ensure that all parties liable for certain

assessments get credit for payments made on those assessments and

(2) assess the effectiveness of its collection activities.

For example, when a company does not pay IRS the taxes that it has

withheld from employee’s wages, such as Social Security or individual

income tax withholdings, IRS has the authority to assess the responsible

officers individually for the amount withheld from employees. Thus, IRS

may record assessments against several individuals each for the employee

withholding component of the payroll tax liability in an effort to collect

the total tax liability of the business. While these assessments—known as

“trust fund recovery penalties”—are a necessary enforcement tool, IRS’

current systems cannot automatically link each of the multiple

assessments made related to one tax liability. This is due to the fact that

the corporation’s tax liability is maintained in IRS’ business master files,

while the trust fund recovery penalties assessed against the corporation’s

officers are maintained in the individual master files. These are two

12These requirements are detailed in the Financial Management Systems Requirements series issued by

the Joint Financial Management Improvement Program, OMB circular A-127, Financial Management

Systems, and OMB’s September 9, 1997 guidance for the implementation of FFMIA.

13The U.S. Government Standard General Ledger establishes a standard chart of accounts, including

account titles, definitions, and uses. The primary purpose is to standardize federal agency accounting,

to support the external reports and financial statements required by OMB and Treasury, and to provide

comparable information among agencies.

Page 9 GAO/AIMD-99-16 IRS Financial Management
B-280501 

separate databases, each of which is independent of the other, and they

are not integrated.

As a result, we found instances where all parties liable for one assessment

were not given credit for payments received from other liable parties. In

fact, in 53 of 83 trust fund recovery penalty cases reviewed involving

multiple assessments for unpaid payroll tax withholdings, we found that

payments were not accurately recorded to reflect each responsible party’s

tax liability reduction. In one case, two of three officers were due a refund

for at least a portion of the $1.5 million in trust fund recovery penalties

they paid, because the bankrupt corporation subsequently settled its

payroll tax liabilities. More than 2 years after the corporation paid, IRS

records still show multimillion dollar balances on these three officers’

accounts and liens on their personal property, despite the fact that it

appears these accounts should be reduced to zero. In cases such as this,

incorrect accounting creates unnecessary effort, or burden, by taxpayers

to demonstrate that they are no longer liable for the debt and to get the

liens on their personal property removed. If IRS had a detailed subsidiary

ledger to properly manage its unpaid assessments, payments like these

could be matched against the tax liability of all affected accounts and thus

prevent IRS from pursuing collections on tax liabilities that no longer exist.

In addition to ensuring that individual tax liabilities are appropriately

reduced, a proper subsidiary ledger for unpaid assessments would also

give management complete, up-to-date information about the amounts due

from each taxpayer, so that managers will be in a position to make

informed decisions about collection efforts and collectibility estimates.

Without readily available information at the detailed subsidiary level, IRS

cannot routinely assess the effectiveness of current collection practices

and refine its collection strategies to maximize collections. By developing

a subsidiary ledger system which makes readily available to management

information such as the amount, nature, and age of all unpaid assessments

outstanding by tax liability and taxpayer, IRS could improve the efficiency

and effectiveness of its collection activity by targeting taxpayer accounts

with the greatest chance of collection, and lessen the risk of pursuing

erroneous collections due to reliance on faulty information regarding the

taxpayer’s status. It should be noted that, despite the fact that certain

taxpayer accounts have little likelihood of collection, IRS would generally

continue some efforts to collect, to reinforce continued compliance by

those taxpayers who appropriately report and pay their tax obligations

and to increase compliance by taxpayers who are not compliant with

respect to reporting and paying their tax obligations.

Page 10 GAO/AIMD-99-16 IRS Financial Management
B-280501 

IRS is developing a “Modernization Blueprint” to outline its long-term plan

and process for upgrading and integrating its computer systems over

several years.14 Part of the plan is to implement an accounting system that

will ultimately meet federal financial management system requirements

and accounting standards. To meet this goal, IRS has developed a six-phase

plan to move from its current systems to a target systems environment.

The first phase of this transition, Phase 0 (phase zero), is intended to

enhance its existing systems. However, Phase 0 does not include a

subsidiary ledger for unpaid assessments and will not identify and track

duplicate assessments associated with trust fund recovery penalties.

Although IRS officials stated the new target system will have capabilities

similar to those of a subsidiary ledger to track these assessments, the

details on how that capability will be provided and what information it will

contain have not yet been developed. In addition, its target system overall

is a long-term solution which likely will not be fully implemented for over

a decade.15

Documentation for Unpaid

Assessments Remain

Inadequate

IRS continues to experience problems locating supporting documentation

for its unpaid assessments, primarily due to the age of the items. Some of

the supporting documentation for transactions we reviewed, such as tax

returns, offers-in-compromise, financial statements, installment

agreements, or past collection history, could not be located, had been

destroyed in accordance with IRS record retention and destruction policy,

or may not have been obtained. For example, estate case files we reviewed

generally did not include audited financial statements or an independent

appraisal of the estate’s assets—information that would greatly assist in

determining the potential collectibility and potential underreporting of

these cases.

GAO’s Standards for Internal Controls in the Federal Government requires

that all transactions and other significant events be clearly documented,

and the documentation be readily available for examination. This

documentation should be complete and accurate and should facilitate

tracing the transaction or event and related information from the time it

occurs, while it is in process, to after it is completed. Lacking such

14Tax Systems Modernization: Blueprint is a Good Start But Not Yet Sufficiently Complete to Build or

Acquire Systems (GAO/AIMD/GGD-98-54, February 24, 1998).

15IRS’ modernization blueprint is not yet complete and thus, the actual time it will take to fully

implement its target system is unknown. Although IRS is planning to implement its new system in six

phases, each phase is composed of up to five system releases. As the primary financial management

features—such as the integrated tracking of financial data—are not planned for implementation until

the fifth phase, it will likely take at least a decade for these needed system improvements to be made.

Page 11 GAO/AIMD-99-16 IRS Financial Management
B-280501 

documentation, IRS cannot clearly support or trace the transactions and

events pertinent to specific unpaid assessments, making it difficult for IRS

and its auditors to routinely assess the classification and collectibility of

its unpaid assessments.

The lack of adequate documentation to support the underlying

assessments could also affect IRS’ ability to effectively pursue collection

from taxpayers for amounts owed. For example, IRS must maintain on its

books most types of unpaid assessments for at least 10 years, and

collection can be pursued at any time throughout that period. Therefore, it

is important that IRS prepare and maintain an adequate standardized

taxpayer file similar to a bank loan file for each receivable and compliance

assessment16 in order to ensure that IRS collections staff have consistent

background information concerning past collection activities from which

to assess collectibility and pursue collection. This is particularly important

when staff turnover occurs, such as that of the revenue officers who are

responsible for pursuing collection and who are thus familiar with the

cases. Well-organized, complete files will minimize the negative impact of

revenue officer turnover.

When IRS conducts an income tax audit, or examination, of a taxpayer, IRS

examiners are required to meet minimum workpaper standards to assure

there is documentary support for the examiner’s report and conclusions.

IRS’ audit workpaper standard requires fully disclosing the audit trail;

assuring workpapers are clear, concise, legible and organized; and

adequately documenting the audit activity records summarizing the

auditor’s contacts with the taxpayers and/or their representatives.

However, we saw no evidence during our audit that IRS has similar

documentation standards for its collection cases. This is inconsistent,

because IRS needs adequate documentation to properly pursue collection

of taxes receivable and compliance assessments as much as it needs

adequate documentation to determine and support its conclusions on

amounts that may become receivables. Many of the collection files we

reviewed (1) did not contain a clear audit trail of documents that provide

useful information about collection prospects (such as appraisals, asset

searches, etc.), contacts made, and conclusions reached regarding the

collectibility of the case, (2) were not well-organized, and (3) did not

contain adequate or consistent documentation for review.

16In the case of write-offs, IRS has already determined that there is no future collection potential.

Therefore, IRS does not continue to gather documentation once that determination has been made.

Page 12 GAO/AIMD-99-16 IRS Financial Management
B-280501 

Because IRS’ current financial systems do not adequately track and classify

unpaid assessments, maintaining complete and consistent documentation

related to taxes receivable is vital. Without it, IRS will continue to

experience problems determining the proper classification and

collectibility of its taxes receivable and pursuing collection over time.

IRS Has Not Effectively

Addressed Unpaid

Assessment Problems

Previously Identified

As just described, despite IRS’ ability to produce reliable information in its

fiscal year 1997 financial statements, serious internal control weaknesses

over its unpaid assessments continue to exist. We previously identified

problems in IRS’ ability to identify and classify its unpaid assessments in

prior audits, and recommended that IRS act to ensure the accuracy of the

net receivables balance reported in its financial statements.17 In the

long-term, this would require IRS to modify its financial systems so that

they are capable of (1) identifying which unpaid assessments represent

taxes receivables and (2) designating new assessments that should be

included in the receivables balance as they are recorded. Until these

capabilities were implemented, we recommended that IRS rely on

statistical sampling to determine what portion of its assessments represent

taxes receivables.

In response to our recommendations, IRS developed computer programs to

identify and extract unpaid assessments from its master files and to

classify these accounts by taxes receivable, compliance assessments, and

write-offs. However, even these extractions required tens of billions of

dollars in adjustments. IRS then used statistical sampling to determine the

portion of receivables that were estimated to be collectible. Although IRS

was able to make some short-term fixes that enabled it to present reliable

information regarding taxes receivable on its fiscal year 1997 financial

statements, it still must address its longer-term financial management

needs through its systems modernization plan. Significant financial

management system changes are needed to ensure that IRS can routinely

identify, monitor, and report on both taxes receivable and other unpaid

assessments and effectively manage amounts owed by taxpayers. This is

particularly important since we found instances in which IRS’ financial

system problems caused it to inappropriately pursue collection from

taxpayers even after the corresponding tax liability had been paid.

Recommendations While certain systems improvements are needed to improve IRS’ basic

accounting and tracking of its unpaid assessments, such changes may take

17See appendix II, recommendation 1.

Page 13 GAO/AIMD-99-16 IRS Financial Management
B-280501 

over a decade to implement. In the meantime, other short-term actions are

needed to begin making more immediate improvements to IRS’

management and reporting of its unpaid assessments.

Short-term Recommendations To improve the accuracy of the information on unpaid assessments

contained in the master files, we recommend IRS manually review and

eliminate duplicate or other assessments that have already been paid. This

would ensure that all accounts related to a single assessment are

appropriately credited for payments received.

To better ensure that IRS can prepare timely, reliable financial statements,

we recommend that IRS improve the accuracy of its master file extraction

programs used to classify unpaid assessments so that once the extractions

are made, any subsequent adjustments needed would not be material. At a

minimum, IRS should consider the nature of the adjustments made to the

fiscal year 1997 amounts extracted and adjust the extraction programs in

future years accordingly.

To address its longstanding deficiencies with respect to documentary

support for its unpaid assessments, we recommend that IRS establish

minimum documentation standards or checklists for its collection files.

These standards or checklists should include minimum documentation

and file organization requirements for all receivable and compliance

assessment cases, specifying the types of documentation required,

standard file organization, and the retention period that will ensure such

documents are maintained until the statute of limitations for collection has

expired.

Long-term Recommendations To address the system deficiencies affecting IRS’ ability to effectively

manage and report on its unpaid assessments, we recommend that the IRS

Commissioner ensure that IRS’ modernization blueprint include plans to

develop a subsidiary ledger to accurately and timely identify, classify,

track, and report all IRS unpaid assessments by amount and taxpayer. This

subsidiary ledger must also have the capability to distinguish unpaid

assessments by category in order to identify those assessments that

represent taxes receivable versus compliance assessments and write-offs.

In cases involving trust fund recovery penalties, the subsidiary ledger

should ensure that (1) the trust fund recovery penalty assessment is

appropriately tracked for all taxpayers liable, but counted only once for

reporting purposes, and (2) all payments made are properly credited to the

accounts of all individuals assessed for the liability.

Page 14 GAO/AIMD-99-16 IRS Financial Management
B-280501 

Vulnerabilities in Cash

Receipt Controls

Expose IRS and

Taxpayers to Potential

Losses

During our fiscal year 1997 audit, we identified weaknesses in controls

over cash and checks received directly from taxpayers at IRS service

centers. Specifically, we found (1) insufficient deterrent controls at service

centers, (2) mail containing receipts being sent unopened to units outside

of the Receipt and Control Branch, and (3) inappropriate receipt of

payments in a service center lobby area. These control weaknesses over

receipts expose both government and taxpayer funds to risk of loss, and

can lead to increased taxpayer burden. GAO’s Standards for Internal

Controls in the Federal Government18 require that access to resources be

limited to authorized individuals, and accountability for the custody of

resources be assigned and maintained to help reduce the risk of

unauthorized use or loss to the government. We recognize that because of

the volume of cash and checks received at service centers, vulnerability to

embezzlement and loss is inevitable. However, there are a number of steps

IRS can take to improve controls and better ensure that receipts are

properly credited to taxpayer accounts and deposited to Treasury’s

general revenue fund.19

Insufficient Deterrent

Controls at Service Centers

The Receipt and Control Branch at each IRS service center is responsible

for the receipt and up front processing of mail containing tax returns and

receipts (cash or checks) delivered to the service centers.20 It is located in

a controlled and restricted area with access limited to authorized

personnel. However, during our review of controls in the Receipt and

Control Branch at 4 of IRS’ 10 service centers, we found several

vulnerabilities and control weaknesses that expose IRS and taxpayers to

potential losses.

One key vulnerability exists because mail sent directly from taxpayers to

IRS service centers was not logged or otherwise recorded by mail room

personnel at the point of receipt or by the mail extraction unit during mail

extraction.21 In fact, receipts were not counted nor dollar amounts verified

18See footnote 10.

19Payments made via the Federal Tax Deposit system, the Electronic Federal Tax Payment System, or

to a lockbox bank are not received at service centers but instead are deposited directly to a federal

reserve bank for credit to the Treasury general revenue fund.

20At some service centers, the Remittance Processing Unit—which is responsible for entering receipt

data and endorsing taxpayers’ checks—may not be part of the Receipt and Control Branch

organizationally. However, the unit will still be located in a restricted access area with other Receipt

and Control Branch units.

21The mail extraction unit is responsible for removing, or “extracting,” the contents of the mail after it

has been opened, sorting the contents, and routing them to the appropriate units.

Page 15 GAO/AIMD-99-16 IRS Financial Management
B-280501 

until they reached the Remittance Processing Unit22 within the Receipt and

Control Branch, which can be the third or fourth stop in the process. Once

at the Remittance Processing Unit, the systems that process receipts

assign each check a document locator number23 which can be used for

tracking that receipt. Before reaching this unit, however, receipts are

handled by several units, as illustrated in figure 2.

22IRS uses the terms “remittances” and “receipts” interchangeably to refer to taxpayers’ payments

against their tax liabilities. To the taxpayer, such amounts are remittances (payments), but to IRS they

are receipts.

23The document locator number is a 14-digit control number assigned to every document input through

IRS’ systems. It is used to control, identify, and locate documents as they are processed.

Page 16 GAO/AIMD-99-16 IRS Financial Management
B-280501 

Figure 2: Initial Handling of Service Center Mail

Mail Room

Extraction Unit

Perfection Unit

Receipt 

Processing Units

Returns with cash 

or checks

Sorts and 

distributes mail

Opens, extracts, 

and sorts mail

If errors are 

identified, 

performs 

corrections

Enters returns 

and receipts 

into system

No log to track individual receipts

No count of receipts received

No surveillance device

No log to trace individual receipts

No dual controls over opening of mail

No surveillance device

No count of receipts received and 

extracted

No log to track individual receipts

No count of receipts processed

No surveillance device

Specific control number assigned to 

individual receipts

Checks encoded and endorsed

Inventory sheet created for all receipts 

processed through system

Unit Function Status of Internal Controls 

(Figure notes on next page)

Page 17 GAO/AIMD-99-16 IRS Financial Management
B-280501 

Note: At different service centers, the actual names of the units may vary. Therefore, the figure

reflects the primary function performed by different units, which may or may not correspond to the

actual name of the unit depending on the service center. In addition, “Receipt Processing Units”

encompasses both the manual and automated receipt processing units.

While the service centers do not establish immediate accountability for

cash and checks received, such as immediately logging in receipts and/or

assigning a document locator number to each check upon receipt, we

recognize that doing so is not feasible given the service centers’ current

systems and processes. For example, the tremendous volume of receipts

the service centers process daily—which can exceed $400 million a day at

a service center during the peak filing season—makes it impractical to log

in every check upon receipt. The current automated systems for

processing receipts cannot assign a document locator number until the

checks have been extracted and sorted, and the volume of transactions

precludes IRS from manually assigning a document locator number to each

receipt. As a result, until accountability is established, vulnerability to

embezzlement is heightened.

This vulnerability thus underscores the need for effective deterrent

controls to aid in reducing the service centers’ exposure to theft. However,

we found that IRS has less stringent deterrent controls for receipts

processed at service centers than it requires of third party lockbox

depositories that process receipts for IRS. For example, to reduce

vulnerabilities over handling cash and checks at lockbox depositories, IRS

requires lockbox depositories to use surveillance cameras to monitor staff

when they open mail containing cash and checks. Further, lockbox receipt

handlers are not permitted to bring in handbags, briefcases, duffle bags,

bulky outerwear, etc., into the receipt processing areas. However,

comparable controls were not found at the 4 service centers where we

reviewed controls over cash receipts. At these locations, IRS allowed

individuals to open and sort through the mail unobserved by surveillance

cameras, and relied on them to accurately report any cash or checks

received. Personal belongings were also allowed in the receipt processing

areas, further increasing the service centers’ vulnerability to theft. In fact,

an IRS internal review24 noted that 9 of the 80 theft cases IRS identified from

January 1995 through July 1997 involved employees who put stolen

receipts in duffle bags, purses, or lunch boxes.

24Review of Remittance Processing Activities, Reference No. 082503, March 24, 1998, prepared by IRS’

Internal Security and Internal Audit.

Page 18 GAO/AIMD-99-16 IRS Financial Management
B-280501 

In addition, we found that personnel in the extraction unit did not always

identify checks that were attached to documents when opening and

sorting the mail. Clerks in the Receipt and Control Branch are responsible

for examining tax returns and other documents received in the mail for

any attached checks to ensure that the checks are properly and promptly

processed and deposited. However, some checks attached to documents

were overlooked by the extraction staff and inadvertently forwarded to

units outside of the Receipt and Control Branch. In fact, we found that at

one service center, 14 checks totaling about $171,000 were overlooked by

the extraction unit in one day. An IRS study performed at one service

center found that over a 4-week period, 330 checks totaling over $864,000

were overlooked. These overlooked checks increase IRS’ exposure to loss

or theft, because accountability for these checks is not established at the

point of receipt and thus, there is no record that the checks were received

by the service center at this point.

As a result, IRS must rely on individuals from these other units to record

the discovery of these receipts and send the checks back to the Receipt

and Control Branch to be deposited. These units typically have less

accountability over receipts than the Receipt and Control Branch. For

example, at one service center, we noted that a unit outside the Receipt

and Control Branch that did not have restricted access had received mail

containing receipts. As a result, these overlooked receipts are more

susceptible to theft.

Mail Containing Cash and

Checks Sent Unopened to

Units Outside of Receipt

and Control

In some cases, mail that contains receipts is routed to units outside of the

Receipt and Control Branch before being opened. At the service centers

we reviewed, unopened mail was routed to numerous units outside the

Receipt and Control Branch, thus increasing the vulnerability of taxpayers’

checks and cash—which may be contained in such unopened mail—to

loss or theft.

For example, certain units such as the Offer-in-Compromise unit are

authorized to receive unopened mail directly due to the need to minimize

processing time. “Administrative mail,” such as mail addressed to the

service center Director’s office, is also authorized to be sent unopened

directly to units located outside the Receipt and Control Branch. However,

administrative mail is typically sent to a post office box that is shared by

multiple units. At one service center, over 100 units were authorized to

receive administrative mail. Consequently, such mail—which may contain

taxpayer checks or cash—may be accessible to units outside the Receipt

Page 19 GAO/AIMD-99-16 IRS Financial Management
B-280501 

and Control Branch. In addition, some units with off-site addresses also

receive unopened mail without the authorization to do so.

Since these outside units are not located within the Receipt and Control

Branch, they have fewer controls in place. For example, access to these

units is not restricted and individuals can easily remove mail that is

sometimes left unattended on desks. Furthermore, depositing of receipts

opened by other units is generally delayed 3 to 5 days, costing the

government interest income. An IRS study at one service center found that

over a 4-week period, this time delay resulted in about $1 million interest

lost on deposits.

Inappropriate Receipt of

Payments in Lobby Area

At one service center, we observed that payments of checks and cash were

being accepted in the lobby area by the security guard, who should not

have been authorized to accept receipts. We also observed the guard did

not log in the payments or provide the taxpayers with a receipt.

Consequently, lost or stolen payments would be difficult to trace. In fact,

we observed one instance where a taxpayer complained to the guard that

her account was in default status because a hand delivered payment given

to a security guard was returned to her by mail with postage due.

As a result of the vulnerabilities and weaknesses discussed above, IRS and

taxpayers are subject to potential losses and additional taxpayer burden.

For example, from 1995 through July 1997, IRS identified instances of

actual or alleged embezzlement of receipts totaling about $5.3 million.

These resulted from various schemes, such as a check “cloning”25 scheme

where a taxpayer’s check for $590,000 was stolen from a service center

and reprinted into several checks. These cloned checks were made

payable in smaller amounts to avoid raising suspicion. In this case, several

of these checks were cashed before being discovered by the taxpayer and

reported to the IRS. In another scheme, an IRS employee and his

co-conspirators altered a taxpayer check to change the payee from “I.R.S.”

to “I.R. Smith” and deposited the altered check into a personal checking

account. Such embezzlement cases result in additional burden to the

taxpayer. For example, taxpayers who identify that a problem exists may

spend time and incur costs to research and report the problem and to

close their bank accounts and open new ones; follow up to ensure that the

problem is resolved; ensure that they receive appropriate credit for the tax

assessments they intended to pay; and ensure that they receive restitution

25Once a perpetrator obtains information such as the bank and account number from a valid check,

that information can be used to “clone” or duplicate the original check into multiple fraudulent blank

checks. These blank checks are then filled out to different payees, and signed with a forged signature.

Page 20 GAO/AIMD-99-16 IRS Financial Management
B-280501 

of stolen funds. These cases underscore the need for IRS to reduce its

vulnerability to employee fraud and embezzlement in its cash receipts

processing activities.

Due to the nature of IRS’ receipt processing operations, the volume of

transactions processed, and the number of employees involved, there is no

internal control system, no matter how well designed and operated, that

can completely eliminate the potential for embezzlement or theft. We also

recognize that establishing immediate accountability for all cash and

checks received in the service centers is not feasible. However, there are a

number of steps that IRS can take immediately to reduce the risk of loss

and provide better safeguarding of assets at its service centers.

Short-term

Recommendations

To reduce IRS’ vulnerabilities in its receipt processing activities, we

recommend that the IRS Commissioner examine and consider options to

increase deterrent controls at service centers. Some options IRS should

examine and consider include

• installing surveillance cameras to monitor staff when they are opening,

extracting and sorting the mail, and when they are processing receipts,

• restricting personal items that can be brought into the receipt processing

areas, such as handbags, briefcases, and bulky outerwear, and

• providing lockers and require their use for storing personal belongings

outside of the receipt processing areas.

To limit the number of checks overlooked by the extraction staff and thus

inadvertently routed to units outside of the Receipt and Control Branch,

IRS should provide adequate training and monitoring of extraction unit

staff to ensure staff are informed and properly trained on the necessary

procedures, and that the procedures are being followed.

To reduce the cash and checks that may be forwarded to units outside the

Receipt and Control Branch, we recommend that IRS limit the units that

may receive unopened mail directly to only those units which require

confidentiality due to the nature of their work, such as the Inspections

unit. At a minimum, mail addressed to off-site locations should be routed

through the service center first to identify mail that may contain taxpayer

receipts.

Page 21 GAO/AIMD-99-16 IRS Financial Management
B-280501 

To further reduce the exposure of taxpayer cash or checks to loss or theft,

we recommend that IRS ensure that security guards and other unauthorized

service center personnel do not receive walk-in payments from taxpayers.

Weak Controls Over

Refunds Resulted in

Inappropriate

Payments

IRS issues billions of dollars in refunds each year.26 In fiscal year 1997

alone, IRS issued $142 billion in refunds. However, IRS does not have

sufficient preventive controls in place to ensure that inappropriate refunds

are not issued. Specifically, IRS does not have matching procedures to

identify inaccurate refund claims when they are received. As a result, we

found that some improper refunds or refunds issued for incorrect amounts

were made during fiscal year 1997. In addition, IRS lacks adequate controls

to prevent duplicate refunds. These control weaknesses over refunds

expose the government to risk of loss. This exposure is further

demonstrated by several instances IRS has identified of alleged employee

embezzlement of refunds.

Controls to Identify

Inappropriate Refund

Claims Were Lacking

IRS has insufficient verification procedures in place to identify

inappropriate refund claims when they are received. As a result,

inappropriate refunds were disbursed during fiscal year 1997. For

example, we found that in nine instances out of 220 refund cases we

reviewed, refunds were improperly disbursed or disbursed for improper

amounts. Three of the improper refunds were issued because IRS

procedures did not require comparing the tax returns to the attached W-2

(Wage and Tax Statement) forms when the returns were initially

processed. Three other improper refunds were issued because the

associated tax returns were filed electronically and thus were not

reviewed by IRS staff because the actual W-2 forms were mailed in later by

the taxpayer. Such comparisons of the W-2 form against the tax return

would have identified the errors we noted in these six cases. Of the

remaining improper refunds we identified, two were inappropriate

because the tax returns did not contain valid social security numbers. An

additional refund was issued for an improper amount due to an undetected

taxpayer math error.

IRS procedures require that IRS staff review the W-2 form and compare it to

the tax return under specific circumstances. For example, the W-2 should

be compared to the return if (1) a W-2 is attached to the return and the line

on which income is to be reported on the tax return is blank or (2) an

26While technically IRS does not actually issue the refunds, it must authorize Treasury’s Financial

Management Service to issue a refund before the funds can be disbursed.

Page 22 GAO/AIMD-99-16 IRS Financial Management
B-280501 

Earned Income Credit (EIC) is claimed, in which case the IRS reviewer is

required to search the W-2 for nontaxable income amounts. In three of the

six cases mentioned above, the nontaxable income amount reported on

the W-2 form, such as voluntary salary deferrals for 401(k) plans, was not

included in the taxpayer’s EIC calculation to determine the amount of

allowable credit.27 Although IRS procedures normally require reviewing the

W-2 form for nontaxable income in EIC cases, these particular cases

involved tax returns that had been filed electronically. Because the

taxpayer must mail in the actual W-2 form later for electronically filed

returns, such returns are not subject to this review. As a result, the refunds

disbursed for these cases were greater than they should have been.

Except as discussed above, IRS procedures generally do not require that IRS

staff compare, at time of processing, the income amounts on the attached

W-2 forms to the amount of income reported on the tax return. As a result,

IRS did not detect that the amount of income on the W-2 forms did not

match the amounts reported on the accompanying tax returns in the other

three of the six cases we identified. Such inconsistencies generally go

undetected until IRS completes its document matching program, a

“post-refund” control, which is generally not completed until 7 months or

more after a return is due. This program involves matching tax return

information with information provided by third parties—such as W-2 wage

data, form 109928 income data, and other applicable information—to

identify any unreported income or other inconsistencies for further

investigation. Thus, while an error may be detected several months later, it

may be too late to recover the improper refund.

The inappropriate refunds we identified are indicative of internal control

weaknesses which increase IRS’ exposure to refund fraud and theft. IRS

identified 11 cases of employee embezzlement of refunds that occurred

during fiscal years 1995-1997, at both service centers and district offices.

In these cases, employees attempted to provide false information, such as

false returns to the IRS, in order to fraudulently obtain refunds. In one case

an IRS tax examiner who had access to taxpayer payments and the ability

to adjust taxpayer accounts, refunded taxpayer payments to herself by

issuing approximately 10 manual refund checks totaling over $269,000 in

27Although nontaxable income is not included in the calculation of a taxpayer’s gross income, it is

required to be included in the EIC calculation. By not including non-taxable income in the EIC

calculation, the credit is improperly inflated.

28Various types of IRS 1099 forms are used to report interest income, dividend distributions, and other

miscellaneous income. Note that form 1099s are not required to be submitted by the taxpayer at the

time of filing, unlike the W-2s. Consequently, verification of interest, dividends, and other

miscellaneous income cannot be performed at the time of filing under current processes.

Page 23 GAO/AIMD-99-16 IRS Financial Management
B-280501 

her maiden name. These cases illustrate IRS’ vulnerability with respect to

its refund processing and underscore the need for sound controls over this

process.

Other Refund Issues

Identified

As we have reported in prior years, IRS is vulnerable to the issuance of

duplicate refunds made possible by gaps in IRS’ controls. Specifically, IRS’

automated and manual refund systems are not adequately coordinated to

prevent duplicate refunds. IRS reported this condition as a material

weakness in its fiscal year 1997 Federal Managers’ Financial Integrity Act

report.29

Most refunds are authorized automatically when IRS’ computing system

identifies a taxpayer payment which exceeds the taxpayer’s assessment or

liability. The system then automatically generates a refund for the

overpayment. However, manual refunds may be issued for several reasons.

For example, if a large refund is due, IRS may authorize issuance of a

manual refund in order to ensure that the refund is made promptly and

thus, avoid paying interest to the taxpayer. However, unless appropriate

entries are posted to the taxpayer’s account on the master file to reflect

this, the system will not know a manual refund is already in process and

may automatically authorize a duplicate refund.

IRS has taken actions to correct this weakness which it plans to have

completed by December 1998. These actions include implementing

procedures that require IRS staff to (1) check the master file and other

systems to determine if another refund—manual or automated—has

already been issued before initiating a manual refund for the same claim

and (2), if necessary, take steps to prevent a duplicate refund from being

generated. IRS is developing computer programs to automatically generate

a report showing the transactions and account status for taxpayers with

two or more refunds processed for the same tax type and period. Staff

processing manual refunds are to review this report to determine if both

refunds are proper or if one is a duplicate. If one of the refunds is a

duplicate, IRS staff are to prevent the duplicate refund payment from being

issued. We plan to continue to monitor IRS’ progress in implementing these

actions during our fiscal year 1998 IRS financial audit.

29The Federal Managers’ Financial Integrity Act of 1982 requires the head of each agency to report

annually on whether the agency’s internal accounting and administrative controls comply with

prescribed standards and, if not in compliance, to report on any material weaknesses identified and

the plans and schedule for correcting such weaknesses.

Page 24 GAO/AIMD-99-16 IRS Financial Management
B-280501 

IRS Has Not Effectively

Addressed Problems

Concerning Inappropriate

Refunds

While we recognize that IRS must balance the need to issue refunds quickly

against the time it takes to ensure that the refunds are proper, additional

controls to identify improper refund claims before they are paid could

significantly reduce the amount of inappropriate refund payments issued.

In 1993, GAO recommended that IRS give priority to earlier matching of

income and withholding information on W-2s submitted by individuals and

third parties.30 If such matching is performed prior to issuing refunds,

fewer inappropriate refund payments would be made. According to IRS’

Action Plan For GAO Recommendations dated January 15, 1998, IRS

implemented changes that cut in half the time it took for taxpayer notices

resulting from the matching program to be issued, from 14 months to 7 - 8

months after the return due date. However, this action plan notes that

attempting to further accelerate the matching program under IRS’ current

technology would result in errors and produce little, if any, revenue while

increasing costs and taxpayer burden. IRS reported that performing the

matching process more rapidly is not possible until it completes its

systems modernization efforts, which could take over a decade. Therefore,

IRS considers this recommendation closed. IRS also reported that routine

comparisons of tax returns with supporting documentation, such as W-2s

and other information, at the time returns are initially processed, is not

cost effective.

We are not aware of any study IRS has performed to determine the actual

cost effectiveness of such comparisons. Moreover, although IRS does not

plan to perform the matching process more rapidly until it completes its

systems modernization efforts, determining that improper refunds were

sent out 7 or more months after the payment has been made is likely to

result in low collection rates for these inappropriate payments. After

improper refunds have been issued, IRS is compelled to expend both the

time and expense to attempt to recover them, with dubious prospect of

success.

Recommendations Both short-term and long-term changes are needed to improve IRS’ controls

over its refund processing.

Short-term Recommendation To address the problem of inappropriate refund payments, we recommend

that the Commissioner conduct a cost-benefit study to evaluate whether

preventive controls, such as manually comparing W-2 information to both

paper and electronically filed tax returns at the time returns are received

rather than many months later, would be cost beneficial. This study should

30See appendix II, recommendation 7.

Page 25 GAO/AIMD-99-16 IRS Financial Management
B-280501 

include a complete analysis of the projected costs and associated benefits

of increases to preventive controls over the issuance of refunds. If such

controls are determined to be beneficial, IRS should implement them to the

extent practical to reduce the amount of inappropriate refund payments.

Long-term Recommendation We recommend that, as part of a longer term solution to preventing

improper refund payments, the Commissioner ensure that IRS’ systems

modernization plan includes the capability to compare W-2 and other third

party information to both paper and electronically filed tax returns as they

are processed to prevent improper refunds from being issued.

IRS Is Unable to

Determine Actual

Revenue Collected for

Specific Trust Funds

and Withheld

Individual Income

Taxes

IRS cannot determine, on a current basis, the specific amount of revenue it

actually collected for the Social Security and Hospital Insurance31 trust

funds, nor can it accurately report revenue collected for individual income

taxes. One of the reasons for this weakness is that IRS does not obtain the

detailed payment information necessary to allocate tax payments among

the proper trust funds and individual income tax categories until the

taxpayers file their returns, which can be received as late as 9 months after

the payments are submitted. As a result, IRS had to combine Federal

Insurance Contributions Act (FICA)32 and individual income tax collections

on its Statement of Custodial Activity for fiscal year 1997. In addition, until

recently, IRS certified amounts to be distributed to selected excise

tax-related trust funds based on taxes assessed, as reflected on the

relevant tax forms, rather than actual collections. As a result, in fiscal year

1997 IRS’ certification process did not comply with specific provisions of

the Internal Revenue Code.

Tax Deposit System Does

Not Obtain Needed

Information

IRS is unable to specifically identify revenue actually collected for certain

trust funds and for individuals at the time of collection in part because the

current Federal Tax Deposit (FTD) system, the primary method of

obtaining payment data from taxpayers, does not acquire the necessary

detail from taxpayers to enable payments to be recorded by these

categories. The recently implemented Electronic Federal Tax Payment

31The Hospital Insurance Trust Fund and the Supplemental Medical Insurance Trust Fund comprise

the accumulated funds of the Medicare program. Of these two trust funds, only the Hospital Insurance

Trust Fund receives distributions from the Treasury’s general revenue fund.

32FICA taxes include both employer and employee contributions. Based on information certified by

IRS and the Social Security Administration, Treasury distributes FICA tax revenue—also referred to as

social security taxes—to three specific trust funds established to finance the federal government’s

principal Social Security programs: the Federal Old Age and Survivors Insurance Trust Fund; the

Federal Disability Insurance Trust Fund; and the Federal Hospital Insurance Trust Fund.

Page 26 GAO/AIMD-99-16 IRS Financial Management
B-280501 

System (EFTPS), which allows taxpayers to make their federal tax deposits

electronically, can capture the detailed payment data necessary to record

collections by trust fund. However, IRS does not require taxpayers to

provide the detailed data and, thus, does not use this capability for

revenue accounting purposes. In addition, IRS’ custodial general ledger

system is not programmed to capture this level of detail to effectively use

it.

Taxpayers make FTD payments using either paper FTD coupons33 or by

making electronic payments through EFTPS. The FTD coupon system

requires taxpayers to identify the deposit by selecting one of 11 categories,

which IRS’ revenue accounting system then records into one of six tax

classes. However, several of the coupon categories combine payments

intended for more than one specific tax type, and detailed information for

the specific subcategories is not requested at time of collection. For

example, the “941” FTD coupon category combines FICA tax payments and

federal income taxes withheld from employees into one aggregate figure.

This is because the corresponding tax return, Form 941 -Employer’s

Quarterly Federal Tax Return, is filed by employers to report all employee

taxes withheld, whether for FICA or for employee federal income taxes.

Similarly, the “720” coupon category is used to combine payments for

about 50 different excise taxes, reported by taxpayers filing Form 720 -

Quarterly Federal Excise Tax Return. As a result, the FTD coupon does not

provide, at time of collection, actual amounts of revenue collected for

various specific categories such as Social Security and Hospital Insurance.

Figure 3 is an example of an FTD coupon.

33In some cases, FTD coupon information may be submitted on magnetic tape, rather than on paper

coupons.

Page 27 GAO/AIMD-99-16 IRS Financial Management
B-280501 

Figure 3: Sample FTD Coupon

Although the majority of fiscal year 1997 FTD payments were made using

the paper coupon method, EFTPS represents a growing tax payment

method. Legislation requires phasing in EFTPS participation by taxpayers.

To meet the phase-in requirements, all taxpayers who had employment tax

obligations of over $50,000 in 1995 were originally required to begin

making federal tax deposit payments electronically in January 1997, later

extended to January 1998.34 Unlike the paper FTD coupon, EFTPS is capable

of capturing the detailed information necessary to enable IRS to determine

actual trust fund collections more promptly. For example, EFTPS provides

the taxpayer with the ability to directly enter specific payment amounts

associated with each of the approximately 50 specific excise taxes.

Similarly, EFTPS allows employers submitting FICA tax payments to indicate

34If a taxpayer’s employment or other tax deposits during 1997 exceeded $50,000, the taxpayer is

required to begin depositing electronically for tax return periods beginning on or after January 1, 1999.

However, no penalties for failure to deposit electronically have yet been imposed on such taxpayers,

and IRS currently will not impose such penalties before January 1, 1999. IRS and the Treasury

Department have concluded at this time that the statutory requirement for 1999 and subsequent years

will be satisfied without the need to reduce the mandatory threshold below $50,000.

Page 28 GAO/AIMD-99-16 IRS Financial Management
B-280501 

the specific amounts designated for the Social Security and Medicare trust

funds as well as federal income tax withheld for employees. The banks

which process EFTPS payments on behalf of the Treasury prepare daily and

quarterly report files that summarize payments received by these

subcategories, which are available to IRS on-line.

Despite EFTPS’ ability to capture and summarize more specific trust

fund-related accounting data, IRS does not require taxpayers to provide the

detailed subcategories of aggregate tax payments. Instead, IRS only

requests that taxpayers voluntarily provide detailed payment information.

However, due to technological constraints, IRS’ revenue accounting system

is currently unable to post even the voluntarily supplied trust fund-related

payment data. Specifically, the system is programmed to account for

transactions by aggregate tax class which, as already discussed, combines

several tax types (e.g. trust fund categories) into one category. Although

the tax returns do contain the details of amounts owed by subcategory, the

returns are not required to be filed until as late as 9 months after the

quarterly tax deposits are made.

In its initial response to our fiscal year 1997 custodial financial statement

audit report, IRS asserted that legislation would have to be changed in

order to require taxpayers to provide payment breakdown information by

trust fund in order to allocate tax receipts at the time of receipt.35 IRS also

asserted that this is a taxpayer burden issue, in that requiring the

additional detail could impose an undue reporting burden on taxpayers.

We disagreed that IRS was legally precluded from requiring taxpayers to

provide such detailed payment information. We also questioned whether

providing such detailed payment information would be a burden, as

presumably taxpayers must determine the payment amount for each of the

subcategories (e.g., Social Security, Hospital Insurance, and specific

excise taxes) in deriving their total tax payment.

Subsequently, in response to our report, IRS initiated a study to examine

whether it should require taxpayers to provide the additional detailed

information necessary when the taxpayers remit payment to IRS. The

study’s scope includes identifying the government entities that need

detailed tax type information at time of collection, the volume of taxpayers

that currently provide the detailed information through EFTPS, and the

efforts that might be needed to encourage taxpayers to provide such

detail. According to the proposal, once the study is concluded, a decision

35See Financial Audit: Examination of IRS’ Fiscal Year 1997 Custodial Financial Statements

(GAO/AIMD-98-77, February 26, 1998).

Page 29 GAO/AIMD-99-16 IRS Financial Management
B-280501 

can then be made on whether a change in IRS’ procedures is warranted. We

will continue to work with IRS to monitor the status and outcome of this

study as it progresses.

Unless IRS’ collection systems are improved to enable it to capture

collection data by specific tax type and properly account for it, such as

capturing details on the amounts collected and to be credited to specific

recipient trust funds, IRS will not be able to provide complete and timely

data on collections by tax type. OMB’s requirements for the form and

content of the governmentwide consolidated financial statements36

currently require separate reporting of Social Security, Hospital Insurance,

and individual income taxes collected. Since FICA and individual income

taxes are the largest sources of income to the federal government, IRS’

inability to separately identify tax revenue collected by these categories in

fiscal year 1997 resulted in 83 percent of total revenues being reflected in

one category on the financial statements, while the remaining six revenue

categories reflected only 17 percent of tax revenues. Given IRS’ current

systems and the manner in which tax payment information is currently

submitted to IRS, the agency will not be able to comply with OMB’s

reporting requirements. OMB has begun discussions with the Federal

Accounting Standards Advisory Board and with IRS to allow aggregate

reporting of Social Security, Hospital Insurance, and individual income

taxes collected. We will continue to monitor these discussions to

determine what effect the outcome may have on our fiscal year 1998 and

future years’ audits.

IRS’ Certification of Excise

Taxes Did Not Comply

With Legal Requirements

Until recently, IRS certified excise taxes for distribution to trust funds

based on assessed amounts reflected on tax returns rather than actual

collections. This method of distribution did not comply with the Internal

Revenue Code, which requires IRS to certify the distribution of excise taxes

based on actual collections. As discussed above, IRS does not obtain the

details necessary at the time of collection to be able to do this. IRS recently

developed a methodology to certify actual collections quarterly. IRS

officials said they implemented this in June 1998.

All excise tax receipts are classified in one summary category at time of

collection, regardless of which or how many of the approximately 50

specific excise taxes the payment may relate. Treasury’s Financial

Management Service (FMS) distributes monies to the various excise

tax-related trust funds, based on estimates calculated by the Office of Tax

36Form and Content of the Financial Statements of the U.S. Government (September 2, 1997).

Page 30 GAO/AIMD-99-16 IRS Financial Management
B-280501 

Analysis. Until recently, for each quarter IRS certified the final amounts to

be distributed to each individual trust fund based on assessments

determined from filed tax returns. Due to the time that it takes IRS to

receive, process, summarize and review the tax returns, the agency does

not certify the amounts designated for specific trust funds until about 6

months after the end of a quarter. Once IRS certifies the actual amount to

be distributed, FMS must then reconcile the difference between the Office

of Tax Analysis estimates and the IRS certified amounts, and make any

needed adjustments to the amounts already distributed. In contrast, if the

detailed data were provided at time of collection, IRS would have the

information available to readily calculate and certify the amounts to be

distributed to the trust funds based on actual amounts collected, thus

eliminating the need for Office of Tax Analysis estimates for the initial

distribution and the subsequent FMS reconciliations and adjustments.

We also found several deficiencies in IRS’ process of certifying excise tax

distributions to the appropriate trust funds. These deficiencies in controls

over the certification process, which we will detail in a separate report on

excise taxes, relate primarily to the lack of fundamental verification and

review procedures which, in fiscal year 1997, resulted in errors made in

the distributions. As a result of these weaknesses, trust funds may not

have received the proper amount of excise tax revenue during fiscal year

1997.

Past Actions by IRS Not

Sufficient to Resolve

Problems

We first reported that IRS’ systems do not maintain, and thus cannot report,

the amounts of specific excise and social security taxes collected in our

audit of IRS’ fiscal year 1992 financial statements.37 We also reported this

condition in 199338 and recommended that IRS develop a means of

capturing information on the specific taxes collected for trust funds so

that the amounts collected by trust fund are readily determinable and

excise tax receipts can be distributed as required by law.39 IRS officials

stated that the EFTPS system currently has the capability of capturing the

detailed information needed at time of collection but, as discussed above,

IRS does not obtain the necessary information from the taxpayers at the

time of collection.

37Financial Audit: Examination of IRS’ Fiscal Year 1992 Financial Statements (GAO/AIMD-93-2,

June 30, 1993).

38Financial Management: Important IRS Revenue Information is Unavailable or Unreliable

(GAO/AIMD-94-22, December 21, 1993).

39See appendix II, recommendation 3.

Page 31 GAO/AIMD-99-16 IRS Financial Management
B-280501 

In this regard, IRS recently developed a method to allocate total excise tax

collections to specific excise tax-related trust funds based on the related

taxpayer returns, consistent with a previous GAO recommendation. Rather

than certifying total assessments for distribution as it did in fiscal year

1997, IRS would certify total collections for distribution, but use the

assessment data to determine the proportion of collections that should be

allocated to each trust fund. IRS officials indicated they used this method

beginning in June 1998 with the certification of distributions for the first

quarter of fiscal year 1998.40 We will review their methodology and its

implementation during our fiscal year 1998 audit.

IRS’ General Ledger

System Cannot

Routinely Generate

Reliable and Timely

Financial Information

IRS’ general ledger system was not designed to readily support the

preparation of financial statements. As a result, IRS’ general ledger system

is not able to routinely generate reliable and timely financial information

for internal and external users. Specifically, the general ledger does not

• capture or properly identify tax receivables reported in the Statement of

Custodial Assets and Liabilities, and

• classify revenue receipts activity by type of tax at the detail transaction

level to support IRS’ Statement of Custodial Activity and to facilitate the

accurate distribution of excise tax collections to the appropriate trust

funds in accordance with the Internal Revenue Code.

As a result of these weaknesses, IRS’ general ledger does not comply with

federal financial management system requirements established to enable

the general ledger to provide a complete audit trail for recorded

transactions and to produce the basic documents needed for the

preparation of financial statements in the required formats. These

problems also prevent IRS from producing financial statements on a

monthly or quarterly basis as a management tool, which is standard

practice in private industry and in some federal entities. As a result, IRS’

systems do not substantially comply with the Federal Financial

Management Improvement Act of 1996, which requires agency financial

management systems to comply with Federal Financial Management

Systems Requirements, applicable federal accounting standards, and the

U.S. Government Standard General Ledger at the transaction level.

40Although IRS certifies excise taxes for distribution quarterly, the amounts certified each quarter are

for tax collections from two prior quarters because of the time it takes for the tax returns to be

processed and the information to be posted to the master files.

Page 32 GAO/AIMD-99-16 IRS Financial Management
B-280501 

General Ledger Cannot

Produce Information to

Prepare Financial

Statements

Due to the general ledger system weaknesses, IRS cannot properly report

the correct amount of taxes receivable and revenue receipts at the detail

transaction level—the two most significant components of the financial

statements—and therefore prepare its financial statements without

bypassing the general ledger and relying on alternative sources, extensive

manual intervention and audit adjustments. As we noted earlier in our

discussion of unpaid assessments, IRS’ general ledger cannot capture or

properly identify taxes receivable reported in the Statement of Custodial

Assets and Liabilities. In addition, as noted in our discussion of revenue

accounting, IRS’ general ledger system cannot sufficiently identify tax

revenues collected by specific type of tax. While IRS is making some

improvements to its general ledger system to better identify revenue

receipts by type of tax, it is still unable to identify the specific amounts

collected for FICA and individual income taxes.

Furthermore, refund activity is still only provided in the aggregate in the

general ledger system. As a result, IRS had to extract detailed taxpayer

information from its master files to derive the refund amounts by tax type

presented in supplemental information to the financial statements.

Beginning in fiscal year 1998, federal accounting standards41 require IRS to

disclose refunds by tax type in the notes to the financial statements.

As noted earlier in the discussion of unpaid assessments, IRS’ method of

extracting information from the master files is very laborious and requires

extensive manual procedures and analyses. Moreover, the amounts

produced by this approach still required significant adjustments. In

addition to these issues with respect to unpaid assessments, our review of

IRS’ fiscal year 1997 revenue reconciliations identified numerous

adjustments made by IRS to the general ledger to reconcile it to the master

file. For example, in order to properly reflect FTD payments, such as

employee withholdings, by tax class on the general ledger, IRS had to make

manual adjusting entries totaling over $1.6 billion. These adjustments had

to be made because IRS does not receive the FTD coupons needed to record

these payments in the correct tax class until after the general ledger has

closed. The manual adjustments are made to correct for misstatements

and thus to ensure that these amounts are properly reflected by tax class

in the financial statements.

41Statement of Federal Financial Accounting Standards No. 7, Accounting for Revenue and Other

Financing Sources and Concepts for Reconciling Budgetary and Financial Accounting, May 10, 1996.

Page 33 GAO/AIMD-99-16 IRS Financial Management
B-280501 

IRS’ General Ledger Does

Not Comply With

Standards

The Federal Financial Management Improvement Act requires federal

agencies to comply with the U.S. Government Standard General Ledger

(SGL) at the transaction level. For IRS, this requires that

• data in internal and external financial reports that are produced by IRS

systems, such as the general ledger and the master files, be directly

traceable to SGL accounts established in IRS’ general ledger structure,

• general ledger transactions be recorded consistent with SGL definitions and

processing rules, which include rules specifying how and when specific

types of transactions should be recorded, and

• transaction detail supporting general ledger account balances be available

in financial management systems such as the master files and be directly

traceable to specific SGL account codes.

IRS’ general ledger system does not comply with SGL requirements. For

example, individual transactions cannot be traced from the general ledger

back to the source transactions, and IRS does not use the standard general

ledger accounts. IRS recognized these shortcomings in its fiscal year 1997

Federal Managers’ Financial Integrity Act report and identified several

planned steps to correct this problem. However, these steps are not

scheduled to be completed until fiscal year 1999.

Since we reported in our fiscal year 1997 audit report that IRS’ systems do

not substantially comply with FFMIA requirements, IRS is required to make

its own determination of compliance within 120 days of our report. If IRS

determines that its systems do not comply, it is required to establish a

remediation plan in consultation with OMB. The plan must include

resources, remedies, and intermediate target dates necessary to bring its

financial management systems into substantial compliance generally no

later than 3 years after the date the determination is made. We will

monitor IRS’ progress in developing its plan and implementing corrective

actions during our fiscal year 1998 financial statement audit of IRS.

Past Actions by IRS Not

Sufficient to Resolve

Problems

We have been reporting problems with IRS’ general ledger system since our

first audit of IRS’ financial statements. For example, we previously

recommended that IRS reconcile detailed revenue transactions for

individual taxpayers to the master file and the general ledger.42 IRS’

response produced the current approach which has allowed it to reconcile

the master files to the general ledger and helped facilitate the preparation

of reliable year-end financial statements. As of the fiscal year 1997

42See appendix II, recommendation 10.

Page 34 GAO/AIMD-99-16 IRS Financial Management
B-280501 

financial statement audit, we consider this recommendation closed. We

also recommended that IRS identify revenue reporting information needs,

develop related sources of reliable information, and establish and

implement policies and procedures for compiling this information.43 IRS is

acting to address these recommendations, such as working with a

contractor to develop and implement financial reporting policies and

procedures. However, IRS’ general ledger system still does not comply with

Federal Financial Management Systems Requirements and the SGL at the

transaction level. Consequently, IRS’ financial management systems are not

in substantial compliance with the requirements of the Federal Financial

Management Improvement Act.

Phase 0 of IRS’ systems modernization plan is expected to comply with the

Standard General Ledger requirements and most of the federal accounting

standards for reporting of revenue and receivables. Therefore,

implementation of Phase 0 is a needed first step toward improving IRS’

overall financial management systems. However, it will not accomplish full

compliance with federal revenue accounting standards, full traceability

from the general ledger back to the master files, nor reliable identification

of the categories of unpaid assessments. IRS does not plan to address these

deficiencies until a significant portion of IRS’ systems modernization is

achieved, which we believe is over a decade away.

Recommendation To address the weaknesses identified in IRS’ general ledger system, we

recommend that the Commissioner implement Phase 0 of its overall

systems modernization plan as quickly as possible. In doing so, IRS should

incorporate plans to ensure that the resulting system can routinely

generate timely and reliable financial management reports which can be

used by internal and external users and which will increase the timeliness

of preparation and audit of its annual financial statements. Until Phase 0 is

implemented, IRS should continue to utilize special computer programs

and prepare manual adjustments, as needed, to derive amounts to be

reported in the financial statements.

Agency Comments

and Our Evaluation

In commenting on this report, the Internal Revenue Service generally

agreed with our findings and recommendations and noted that IRS has

already made significant progress in addressing a number of the issues

raised in the report. However, IRS disagreed with 3 of the 11

recommendations.

43See appendix II, recommendation 5.

Page 35 GAO/AIMD-99-16 IRS Financial Management
B-280501 

First, IRS stated that our short-term recommendation to manually review

and eliminate duplicate or other assessments related to trust fund

recovery penalties that have already been paid off is not achievable as

written, citing the cost of such a manual process. IRS did state that it would

consider studying ways to address this problem prior to implementing its

longer term solutions to its financial management systems deficiencies.

We believe the problem is significant enough to warrant immediate action

because it is an issue of sensitivity to taxpayer rights. The high frequency

of cases we identified in our statistical sample of IRS’ inventory of unpaid

assessments where taxpayer accounts had not been properly credited for

amounts paid (53 of 83 cases, or about 64 percent) results in unnecessary

taxpayer burdens. Such burdens could include inappropriate liens on

taxpayers’ property, which could restrict their ability to sell this property

and obtain financing for other purchases. Additionally, these burdens

could result in cost to both the taxpayer and, ultimately, to IRS in resolving

the problems created by these system deficiencies. This is a significant

problem that should not wait to be addressed until longer term solutions

to IRS’ financial management system deficiencies—which will likely take

more than 10 years—are implemented. IRS should thus determine the best

way to deal with this problem manually until its systems changes are fully

implemented. Allowing these hardships to taxpayers to continue for such

an extended period of time is inconsistent with IRS’ new customer-oriented

philosophy. IRS needs to ensure that problems with its current financial

management systems do not result in additional burdens and costs to

taxpayers.

Second, while IRS agreed that its record retention policies need to be

revisited, it disagreed that its ability to effectively pursue collection from

taxpayers for amounts owed could be hindered because it does not

maintain sufficient supporting documentation for its unpaid assessments

and does not have documentation standards for its collection cases. IRS

noted that it believed documentation standards for well-organized,

complete collection case files already exist, that some of the

documentation issues we noted are the result of IRS personnel being

unclear about the extent to which documentation should be made

available for audit purposes, and that our conclusions are based only on

documentation problems identified in those cases sampled as part of the

audit. We disagree. Throughout the audit, we informed IRS of our

documentation needs, but we were unable to obtain certain critical

documents, such as appraisals and asset searches. These documents

would have assisted not only us but also IRS personnel in determining the

proper classification of unpaid assessments and in developing a sound

Page 36 GAO/AIMD-99-16 IRS Financial Management
B-280501 

estimate of the collectibility of certain unpaid assessments. Such

documentation was never made available, nor did IRS personnel ever state

that it existed. This is not a new problem. We have been reporting

documentation deficiencies since we began auditing IRS’ financial

statements in fiscal year 1992. IRS’ comments also imply that the

documentation problems we identified are limited to those cases we

sampled as part of our audit and that these conditions do not necessarily

reflect the conditions that exist for other cases that we did not specifically

review. We also disagree with this. Our conclusions are based on a

detailed review of a statistical sample of IRS’ complete inventory of unpaid

assessments. As such, the documentation deficiencies we found in our

sample of unpaid assessment cases are representative of IRS’ complete

inventory of unpaid assessments. This is a long-standing problem that

needs to be addressed.

Finally, IRS disagreed with our short-term recommendation to conduct a

cost-benefit study to determine whether instituting better preventive

controls over processing tax returns with refunds would be cost beneficial

in preventing erroneous refunds. In disagreeing with this recommendation,

IRS noted that instituting preventive controls—such as manually comparing

W-2s and other third party documents to return information prior to

processing the returns and issuing refunds—was not practical and would

not eliminate the need for its post processing matching program. Some of

these concerns have merit. IRS is correct in noting that not all third party

documents that could be used to verify information on tax returns, such as

form 1099, are currently available for a manual comparison when the tax

return is filed. For this reason, we agree that better preventive controls

would not necessarily eliminate the need for a post processing matching

program. Nevertheless, certain enhancements to IRS’ tax returns

processing controls could reduce the potential for IRS issuing erroneous

refunds like those we identified in our audit. IRS should study the costs and

associated benefits of augmenting its procedures to implement preventive

controls over tax return processing and implement such controls if they

are determined to be cost beneficial. While IRS has made a preliminary

estimate of the cost of manually comparing W-2s to tax returns during

processing, it has not addressed the benefits in terms of reducing both the

dollar amount of erroneous refunds issued and the cost of IRS’ efforts to

recover them. Until such a comprehensive study is complete, IRS does not

have an adequate basis for asserting that instituting preventive controls is

not cost beneficial, especially considering that over $142 billion in refunds

were disbursed in fiscal year 1997.

Page 37 GAO/AIMD-99-16 IRS Financial Management
B-280501 

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

appendix III.

This report contains recommendations to you. The head of a federal

agency is required by 31 U.S.C. 720 to submit a written statement on

actions taken on these recommendations. You should send your

statements to the Senate Committee on Governmental Affairs and the

House Committee on Government Reform and Oversight within 60 days

after the date of this letter. A written statement also must be sent to the

House and Senate Committees on Appropriations with the agency’s first

request for appropriations made over 60 days after the date of this letter.

We are sending copies of this report to the Secretary of the Treasury; the

Director of the Office of Management and Budget; the Chairmen and

Ranking Minority Members of the Senate Committee on Appropriations

and its Subcommittee on Treasury and General Government; Senate

Committee on Finance and its Subcommittee on Taxation and IRS

Oversight; Senate Committee on Governmental Affairs; Senate Committee

on the Budget; House Committee on Appropriations and its Subcommittee

on Treasury, Postal Service, and General Government; House Committee

on Ways and Means; House Committee on Government Reform and

Oversight and its Subcommittee on Government Management, Information

and Technology; House Committee on the Budget; and other interested

congressional committees. Copies will be made available to others upon

request.

Page 38 GAO/AIMD-99-16 IRS Financial Management
B-280501 

Please contact me at (202) 512-9505 or Steven J. Sebastian, Assistant

Director, at (202) 512-9521 if you have any questions concerning this

report. Major contributors to this report are listed in appendix IV.

Sincerely yours,

Gregory D. Kutz

Associate Director

Governmentwide Accounting and

 Financial Management Issues

Page 39 GAO/AIMD-99-16 IRS Financial Management
Contents

Letter 1

Appendix I 

Scope and

Methodology

42

Appendix II 

Status of GAO

Recommendations on

IRS Custodial Activity

44

Appendix III 

Comments From the

Internal Revenue

Service

49

Appendix IV 

Major Contributors to

This Report

53

Related GAO Reports 56

Figures Figure 1: Comparison of Unpaid Assessments Before and After

Audit Adjustments at September 30, 1997

7

Figure 2: Initial Handling of Service Center Mail 17

Figure 3: Sample FTD Coupon 28

Page 40 GAO/AIMD-99-16 IRS Financial Management
Contents

Abbreviations

EFTPS Electronic Federal Tax Payment System

EIC Earned Income Credit

FICA Federal Insurance Contributions Act

FFMIA Federal Financial Management Improvement Act

FMS Financial Management Service

FTD Federal Tax Deposit

IRS Internal Revenue Service

OMB Office of Management and Budget

SGL U.S. Government Standard General Ledger

Page 41 GAO/AIMD-99-16 IRS Financial Management
Appendix I 

Scope and Methodology

To assess whether management’s assertion about the effectiveness of

internal controls was fairly stated for fiscal year 1997, we identified four

transaction cycles relevant to IRS’ custodial financial statement balances:

financial reporting, revenue, refunds, and taxes receivable. To gain an

understanding of these transaction cycles, we interviewed IRS officials;

reviewed IRS policy, procedure, and accounting manuals; documented our

understanding of the transaction processes and relevant internal controls;

and performed walk-throughs to determine whether the internal controls

were placed in operation. We then designed audit procedures and tested

relevant controls such as tests for proper authorization, execution,

accounting, and reporting of transactions.

To determine whether custodial assets were safeguarded from loss, we

examined the (1) key revenue reconciliations performed by the service

centers, (2) adequacy of physical safeguards for custodial assets, and

(3) proper segregation of duties at 4 of IRS’ 10 service centers, chosen

primarily because of the high volume of revenue receipts at these

locations.

To determine whether transactions were executed in accordance with

pertinent laws and regulations, we tested IRS’ compliance with selected

provisions of laws and regulations as required by OMB circular 93-06, Audit

Requirements for Federal Financial Statements. We examined IRS’ financial

management systems to enable us to report on whether they substantially

complied with the Federal Financial Management Systems Requirements,

applicable federal accounting standards, and the U.S. Government

Standard General Ledger at the transaction level, as required by FFMIA. We

also considered the implementation guidance for FFMIA issued by OMB on

September 9, 1997.

To determine whether there were material misstatements in the financial

statements, we reviewed IRS reconciliations, performed multipurpose tests,

and conducted analytical procedures to obtain evidence about the

achievement of specific control objectives. We examined IRS’

reconciliation of the detailed master files to IRS’ general ledger system to

ensure that they reconciled in all material respects. To perform

multipurpose tests of revenue and refund transactions, we selected

statistical samples from seven populations of transactions taken from IRS’

master files for the first 9 months of the fiscal year. These resulted in 1,341

total revenue and refund transactions examined. We selected these seven

samples to meet specific audit needs. For example, we tested excise and

federal unemployment tax receipts and refunds separately to assist the

Page 42 GAO/AIMD-99-16 IRS Financial Management
Appendix I 

Scope and Methodology

Department of Labor and Department of Transportation offices of

Inspectors General in their financial statement audits of those agencies.1

We also performed a predictive test2 of total revenues by tax class for the

last 3 months of the fiscal year to gain additional assurance that revenue

and refunds reported at fiscal year-end were not materially misstated. In

addition, we reviewed IRS’ fiscal year-end reconciliations of its master files,

general ledger, and U.S. Treasury records to ensure that revenue and

refund transactions from these systems agreed in all material respects.

To perform multipurpose tests of unpaid assessments, we first examined

IRS’ reconciliation of the detailed master files to IRS’ general ledger system

to ensure that they reconciled in all material respects. We then selected

statistical samples of transactions from each of the three unpaid

assessment categories from IRS’ master files as of July 1997. This yielded a

total of 730 sample items consisting of financial receivables, compliance

assessments, and write-offs. Our detailed testing procedures included

determining whether items were correctly classified in each of the three

categories. For those items that remained correctly classified as taxes

receivable, we worked with IRS to assess collectibility for those items, and

used the results to project the estimated net collectible balance. We

performed analytical procedures to verify that the unpaid assessments

balance did not change unexpectedly between the test date and fiscal

year-end, and that the change was consistent with our expectations.

Our work was performed at IRS’ National Office in Washington D.C.; IRS’

computing center in Martinsburg, West Virginia; and at all 10 IRS service

centers located across the country.

1

See Agreed-Upon Procedures: Excise Taxes (GAO/AIMD-98-78R, February 26, 1998) and Agreed-Upon

Procedures: Federal Unemployment Taxes (GAO/AIMD-98-79R, February 26, 1998).

2

A predictive test consists of comparing recorded balances with auditor’s expectations. The auditor

develops an expectation of what the recorded amount should be based on an analysis and

understanding of relationships between the recorded amounts and other data.

Page 43 GAO/AIMD-99-16 IRS Financial Management
Appendix II 

Status of GAO Recommendations on IRS

Custodial Activity

As a result of our financial audits of IRS from fiscal years 1992 through

1996, GAO made a total of 30 recommendations for improving IRS’ custodial

accounting and internal controls. Action had been completed on eight of

these recommendations as of the end of the fiscal year 1996 custodial

financial statement audit, and thus were closed. Of the 22

recommendations that remained open, 8 are computer-related internal

controls and will be reported on separately in an upcoming report on

computer controls. Three recommendations were subsequently closed

based upon agreement between GAO and IRS.

The following chart shows the updated status of the remaining 11 prior

custodial accounting and internal control recommendations which were

still open at the completion of the fiscal year 1996 audit, numbered 1-11 in

the chart below. The chart also shows the status of IRS’ actions in response

to these prior recommendations as reported by IRS in its January 15, 1998

report to the Congress. We have also added the 11 new recommendations

we are making in this report as a result of our fiscal year 1997 audit. They

are numbered 12-22 in the following chart.

Custodial recommendations

Status of GAO

recommendations

reported by IRS on

January 15, 1998 GAO status of recommendations

Financial Audit: IRS Significantly Overstated Its Accounts

Receivable Balance (GAO/AFMD-93-42, May 6, 1993)

1. Take steps to ensure the accuracy of the balances reported in

IRS financial statements. In the long term, this will require

modifying IRS systems so that they are capable of

(a) identifying which assessments currently recorded in the Master

File System represent valid receivables and (b) designating new

assessments that should be included in the receivables balance

as they are recorded. Until these capabilities are implemented, IRS

should rely on statistical sampling to determine what portion of its

assessments represent valid receivables.

Closed. Closed. IRS has implemented a statistical

sampling method to determine those

unpaid assessments that represent taxes

receivable. However, we have made

additional recommendations 12, 13, and

15 below to address this problem.

(continued)

Page 44 GAO/AIMD-99-16 IRS Financial Management
Appendix II 

Status of GAO Recommendations on IRS

Custodial Activity

Custodial recommendations

Status of GAO

recommendations

reported by IRS on

January 15, 1998 GAO status of recommendations

2. Modify the IRS methodology for assessing the collectibility of its

receivables by

—including only valid accounts receivable in the analysis;

—eliminating, from the gross receivables balance, assessments

determined to have no chance of being collected;

—including an analysis of individual taxpayer accounts to assess

their ability to pay;

—basing group analyses on categories of assessments with

similar collection risk characteristics; and

—considering current and forecast economic conditions, as well

as historical collection data, in analyses of groups of assessments.

Once the appropriate data are accumulated, IRS may use

modeling to analyze collectibility of accounts on a group basis, in

addition to separately analyzing individual accounts. Such

modeling should consider factors that are essential for estimating

the level of losses, such as historical loss experience, recent

economic events, and current and forecast economic conditions.

In the meantime, statistical sampling should be used as the basis

for both individual and group analyses.

Closed. Closed. IRS has implemented a statistical

sampling method for assessing the

collectibility of its receivables. However,

we have made additional

recommendations 12, 13, and 15 below to

address this problem.

Financial Management: Important IRS Revenue Information Is

Unavailable or Unreliable (GAO/AIMD-94-22, December 21, 1993)

3. Develop a method to determine specific taxes collected by trust

fund so that the difference between amounts assessed and

amounts collected is readily determinable and excise tax receipts

can be distributed as required by law. This could be done by

obtaining specific payment detail from the taxpayer, consistent

with our April 1993 FTD report. Alternatively, IRS might consider

whether allocating payments to specific taxes based on the related

taxpayer returns is a preferable method.

Closed. Closed. As recommended, IRS developed

a method to allocate payments to specific

excise taxes based on the related taxpayer

returns. We will review their methodology

and its implementation during our fiscal

year 1998 audit.

4. Determine the trust fund revenue information needs of other

agencies and provide such information, as appropriate. If IRS is

precluded by law from providing needed information, IRS should

consider proposing legislative changes.

Closed. Closed.

5. Identify reporting information needs, develop related sources of

reliable information, and establish and implement policies and

procedures for compiling this information. These procedures

should describe any (1) adjustments that may be needed to

available information and (2) analyses that must be performed to

determine the ultimate disposition and classification of amounts

associated with in-process transactions and amounts pending

investigation and resolution.

Open. Action in progress. During our fiscal year

1998 audit, we will monitor actions

implemented to determine if the issue is

being adequately addressed.

6. Monitor implementation of actions to reduce the errors in

calculating and reporting manual interest on taxpayer accounts,

and test the effectiveness of these actions.

Closed. Open. We will follow up on IRS’

implementation of this recommendation as

part of our fiscal year 1998 audit.

7. Give a priority to the IRS efforts that will allow for earlier

matching of income and withholding information submitted by

individuals and third parties.

Closed. We are closing this recommendation and

making two more specific

recommendations, see 20 and 21 below.

(continued)

Page 45 GAO/AIMD-99-16 IRS Financial Management
Appendix II 

Status of GAO Recommendations on IRS

Custodial Activity

Custodial recommendations

Status of GAO

recommendations

reported by IRS on

January 15, 1998 GAO status of recommendations

Financial Audit: Examination of IRS’ Fiscal Year 1993 Financial

Statements (GAO/AIMD-94-120, June 15, 1994)

8. Ensure that system development efforts provide reliable,

complete, timely, and comprehensive information with which to

evaluate the effectiveness of its enforcement and collection

programs.

Closed. Open. We will follow up on IRS’

implementation of this recommendation as

part of our fiscal year 1998 audit.

9. Establish and implement procedures to analyze the impact of

abatements on the effectiveness of assessments from IRS’ various

collection programs.

Closed. Open. We will follow up on IRS’

implementation of this recommendation as

part of our fiscal year 1998 audit.

10. Reconcile detailed revenue transactions for individual

taxpayers to the master file and general ledger.

Open. Closed. IRS was able to materially

reconcile the master files to the general

ledger in all material respects for fiscal

year 1997.

11. Establish and implement procedures to proactively identify

errors that occur during processing of data, and design and

implement improved systems and controls to prevent or detect

such errors in the future.

Closed. Closed. We are closing this

recommendation and making several new

and more specific recommendations, see

12, 15, 20, and 21 below.

Internal Revenue Service: Immediate and Long-Term Actions

Needed to Improve Financial Management (GAO/AIMD-99-16,

October 30, 1998)

12. Manually review and eliminate duplicate or other assessments

that have already been paid off to assure all accounts related to a

single assessment are appropriately credited for payments

received.

N/A - new

recommendation.

New recommendation.

13. Improve the accuracy of its master file extraction programs

used to classify unpaid assessments such that, once the

extractions are made, any subsequent adjustments needed would

not be material. At a minimum, IRS should consider the nature of

the adjustments made to the fiscal year 1997 amounts extracted

and adjust the extraction programs in future years accordingly.

N/A - new

recommendation.

New recommendation.

14. Establish minimum documentation standards or checklists for

collection files. These standards or checklists should include

minimum documentation and file organization requirements for all

taxes receivable and compliance assessment cases, specifying

the types of documentation required, standard file organization,

and the retention period that will assure such documents are

maintained until the statute of limitations has expired.

N/A - new

recommendation.

New recommendation.

(continued)

Page 46 GAO/AIMD-99-16 IRS Financial Management
Appendix II 

Status of GAO Recommendations on IRS

Custodial Activity

Custodial recommendations

Status of GAO

recommendations

reported by IRS on

January 15, 1998 GAO status of recommendations

15. Ensure that IRS’ modernization blueprint includes developing a

subsidiary ledger to accurately and promptly identify, classify,

track, and report all IRS unpaid assessments by amount and

taxpayer. This subsidiary ledger must also have the capability to

distinguish unpaid assessments by category in order to identify

those assessments that represent taxes receivable versus

compliance assessments and write-offs. In cases involving trust

fund recovery penalties, the subsidiary ledger should ensure that

(1) the trust fund recovery penalty assessment is appropriately

tracked for all taxpayers liable, but counted only once for reporting

purposes, and (2) all payments made are properly credited to the

accounts of all individuals assessed for the liability.

N/A - new

recommendation.

New recommendation.

16. Examine and consider options to increase deterrent controls at

service centers. Some options IRS should examine and consider

include:

—installing surveillance cameras to monitor staff when they are

opening, extracting, and sorting the mail, and when they are

processing receipts;

—restricting personal items that can be brought into the receipt

processing areas, such as handbags, briefcases, and bulky

outerwear; and

—providing lockers and require their use for storing personal

belongings outside of the receipt processing areas.

N/A - new

recommendation.

New recommendation.

17. Provide adequate training and monitoring of extraction unit

staff to ensure that staff are informed and properly trained on the

proper procedures, and that the procedures are being followed.

N/A - new

recommendation.

New recommendation.

18. Limit the units that may receive unopened mail directly to only

those units which require confidentiality due to the nature of their

work. At a minimum, mail addressed to off-site locations should be

routed through the service center first to identify mail that may

contain taxpayer receipts.

N/A - new

recommendation.

New recommendation.

19. Insure that security guards and other unauthorized service

center personnel do not receive walk-in payments from taxpayers.

N/A - new

recommendation.

New recommendation.

20. Conduct a cost-benefit study to evaluate whether preventive

controls, such as manually comparing W-2 information to tax

returns at the time returns are received rather than many months

later, would be cost beneficial. This study should include a

complete analysis of the projected costs and associated benefits

of increases to preventive controls. If such controls are determined

to be beneficial, IRS should implement them to the extent practical

to reduce the amount of inappropriate refund payments.

N/A - new

recommendation.

New recommendation.

21. Ensure that IRS’ modernization blueprint includes the ability to

compare W-2 and other third-party information to tax returns as

they are processed to further prevent improper refunds from being

issued.

N/A - new

recommendation.

New recommendation.

(continued)

Page 47 GAO/AIMD-99-16 IRS Financial Management
Appendix II 

Status of GAO Recommendations on IRS

Custodial Activity

Custodial recommendations

Status of GAO

recommendations

reported by IRS on

January 15, 1998 GAO status of recommendations

22. Implement Phase 0 of IRS’ systems modernization plan as

quickly as possible. In doing so, IRS should incorporate plans to

ensure that the resulting system can routinely generate prompt

and reliable financial management reports which can be used by

internal and external users and which will increase the timeliness

of preparation and audit of its annual financial statements. Until

Phase 0 is implemented, IRS should continue to utilize special

computer programs and prepare manual adjustments, as needed,

to derive amounts to be reported in the financial statements.

N/A - new

recommendation.

New recommendation.

Page 48 GAO/AIMD-99-16 IRS Financial Management
Appendix III 

Comments From the Internal Revenue

Service

Note: GAO comments

supplementing those in

the report text appear at

the end of this appendix.

See comment 1.

Page 49 GAO/AIMD-99-16 IRS Financial Management
Appendix III 

Comments From the Internal Revenue

Service

See comment 1.

See comment 1.

Page 50 GAO/AIMD-99-16 IRS Financial Management
Appendix III 

Comments From the Internal Revenue

Service

Page 51 GAO/AIMD-99-16 IRS Financial Management
Appendix III 

Comments From the Internal Revenue

Service

The following is GAO’s comment on the Internal Revenue Service’s letter

dated September 14, 1998.

GAO Comment 1. Discussed in “Agency Comments and Our Evaluation” section.

Page 52 GAO/AIMD-99-16 IRS Financial Management
Appendix IV 

Major Contributors to This Report

Accounting and

Information

Management Division,

Washington, D.C.

Steven J. Sebastian, Assistant Director

San Francisco Field

Office

Ellen Rominger, Senior Evaluator

Laurie King, Auditor

Seattle Field Office Doreen Eng, Assistant Director

Catherine Arnold, Evaluator

Susan Chin, Auditor-in-Charge

Richard Harada, Senior Auditor

Julianne Hartman Cutts, Auditor-in-Charge

Stan Stenersen, Reports Analyst

Page 53 GAO/AIMD-99-16 IRS Financial Management
Appendix IV 

Major Contributors to This Report

Page 54 GAO/AIMD-99-16 IRS Financial Management
Appendix IV 

Major Contributors to This Report

Page 55 GAO/AIMD-99-16 IRS Financial Management
Related GAO Reports

Federal Tax Deposit System: IRS Can Improve the Federal Tax Deposit

System (GAO/AFMD-93-40, April 28, 1993)

Financial Audit: IRS Significantly Overstated its Accounts Receivable

Balance (GAO/AFMD-93-42, May 6, 1993)

Financial Audit: Examination of IRS’ Fiscal Year 1992 Financial Statements

(GAO/AFMD-93-2, June 30, 1993)

Financial Management: Important IRS Revenue Information is Unavailable

or Unreliable, (GAO/AIMD-94-22, December 21, 1993).

Financial Audit: Examination of IRS’ Fiscal Year 1993 Financial Statements

(GAO/AIMD-94-120, June 15, 1994)

Financial Audit: Examination of IRS’ Fiscal Year 1994 Financial Statements

(GAO/AIMD-95-141, August 4, 1995)

Financial Audit: Examination of IRS’ Fiscal Year 1995 Financial Statements

(GAO/AIMD-96-101, July 11, 1996)

Financial Audit: Examination of IRS’ Fiscal Year 1996 Custodial Financial

Statements (GAO/AIMD-98-18, December 24, 1997)

Tax Systems Modernization: Blueprint Is a Good Start But Not Yet

Sufficiently Complete to Build or Acquire Systems (GAO/AIMD/GGD-98-54,

February 24, 1998)

Financial Audit: Examination of IRS’ Fiscal Year 1997 Custodial Financial

Statements (GAO/AIMD-98-77, February 26, 1998)

Internal Revenue Service: Remaining Challenges to Achieve Lasting

Financial Management Improvements (GAO/T-AIMD/GGD-98-139, April 15, 1998)

(919180) Page 56 GAO/AIMD-99-16 IRS Financial Management
Ordering Information

The first copy of each GAO report and testimony is free.

Additional copies are $2 each. Orders should be sent to the

following address, accompanied by a check or money order

made out to the Superintendent of Documents, when

necessary. VISA and MasterCard credit cards are accepted, also.

Orders for 100 or more copies to be mailed to a single address

are discounted 25 percent.

Orders by mail:

U.S. General Accounting Office

P.O. Box 37050

Washington, DC 20013

or visit:

Room 1100

700 4th St. NW (corner of 4th and G Sts. NW)

U.S. General Accounting Office

Washington, DC

Orders may also be placed by calling (202) 512-6000 

or by using fax number (202) 512-6061, or TDD (202) 512-2537.

Each day, GAO issues a list of newly available reports and

testimony. To receive facsimile copies of the daily list or any

list from the past 30 days, please call (202) 512-6000 using a

touchtone phone. A recorded menu will provide information on

how to obtain these lists.

For information on how to access GAO reports on the INTERNET,

send an e-mail message with "info" in the body to:

info@www.gao.gov

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

http://www.gao.gov

PRINTED ON RECYCLED PAPER
United States

General Accounting Office

Washington, D.C. 20548-0001

Official Business

Penalty for Private Use $300

Address Correction Requested

Bulk Rate

Postage & Fees Paid

GAO

Permit No. G100