GAO/AIMD-00-162R IRS Management Letter

United States General Accounting Office

Washington, DC 20548

Accounting and Information

Management Division

B-285297

June 14, 2000

The Honorable Charles O. Rossotti

Commissioner of Internal Revenue

Subject: Management Letter: Suggested Improvements in IRS' Accounting

Procedures and Internal Controls

Dear Mr. Rossotti:

In February 2000, we issued our report on the results of our audit of the Internal Revenue

Service's (IRS) financial statements and on the effectiveness of its internal controls for the

fiscal year ending September 30, 1999.1 We also reported our conclusions on IRS'

compliance with significant provisions of selected laws and regulations and on whether IRS'

systems substantially comply with requirements of the Federal Financial Management

Improvement Act of 1996.

The purpose of this letter is to report additional matters identified during our fiscal year 1999

audit regarding accounting procedures and internal controls that could be improved. These

matters are not considered material in relation to the financial statements; however, they

warrant management's consideration. These additional internal control matters concern

policies and procedures over (1) property and equipment purchased through Treasury’s

working capital fund (WCF), (2) reimbursable receivable transactions, (3) supervisory

reviews at IRS’ National Office, and (4) IRS’ Federal Managers’ Financial Integrity Act of

1982 (FMFIA) process. At the end of our discussion on each of these matters, we offer

suggestions for improving IRS’ internal controls. We conducted our audit in accordance with

generally accepted government auditing standards and Office of Management and Budget

(OMB) Bulletin 98-08.

In its response to a draft of this letter, IRS agreed with the issues regarding recording

reimbursable transactions and review procedures at the IRS national office. However, IRS

disagreed in whole or in part with our conclusions regarding Treasury’s WCF and IRS’

FMFIA process. At the end of our discussion of each of the issues in this letter, we have

summarized IRS’ related comments and provided our evaluation. The complete text of IRS’

response is included in enclosure I to this letter.

 1

See Financial Audit: IRS’ Fiscal Year 1999 Financial Statements (GAO/AIMD-00-76, February 29, 2000).
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Page 2 GAO/AIMD-00-162R IRS Management Letter

Procedures Needed to Properly

Account for Prepaid Expenses and

Treasury Working Capital Fund Assets

We found weaknesses in IRS’ accounting procedures for certain assets purchased in one year

but used for a multiyear period. Federal accounting standards2 require that prepayments be

recorded as assets. These include cash outlays for the cost of goods and services that will

benefit an entity in future years. Recording assets in this way and expensing the cost

systematically over their useful life is necessary in order to match the expense with the

period in which the benefit is received. Doing so gives management reliable information on

the cost of federal programs—an important part of assessing operating performance.

During fiscal year 1999, we found that in some instances, IRS is billed for goods and services

that benefit the agency for more than 1 year and thus should be recorded as prepaid expenses.

However, IRS records the entire amount as an expense at the time of purchase. For example,

IRS purchases a significant portion of its telecommunications services through Treasury’s

WCF.3 WCF purchases capital items such as routers, and bills IRS for the full cost of these

items in the year of purchase. Although IRS benefits from these purchases for a number of

years, it had been recognizing the full expense of these items in the year of purchase.

IRS corrected this problem for its fiscal year 1999 balance sheet. After we brought this

problem to IRS’ attention, IRS used a contractor to estimate its prepaid expenses by

statistically projecting the net book value of WCF assets in order to properly reflect prepaid

expenses on its balance sheet at September 30, 1999. As a result of this projection, IRS

subsequently made a $21.7 million adjustment to reflect this amount as a prepaid expense on

its September 30, 1999, balance sheet. However, IRS still does not have processes or controls

in place to properly record its WCF prepaid expenses for fiscal year 2000 and beyond.

While observing the IRS contractor’s development of the estimated prepaid expense, we also

identified two control issues relating to the accountability over IRS and WCF property and

equipment. First, many telecommunication equipment items located at IRS facilities have

both IRS and WCF inventory tags. This is problematic because the same types of

telecommunications assets that are owned by WCF but benefit IRS are also purchased

directly by IRS. Thus, IRS has difficulty determining whether property and equipment should

be recorded on IRS or WCF records.

Second, the property records themselves do not reconcile. IRS keeps records of WCF assets

in its own detailed property and equipment records. Items are tracked for control purposes

but are recorded at no cost. During fiscal year 1999, we attempted to reconcile IRS’ physical

 

2Statement of Federal Financial Accounting Standards No. 1, Accounting for Selected Assets and

Liabilities, provides accounting standards for selected assets and liabilities. Statement of Accounting

Standards No. 4, Managerial Cost Accounting Standards, provides concepts and standards aimed at

providing reliable and timely information on the full cost of federal programs and their activities and

outputs.

3The WCF is a revolving fund established to provide centralized administrative services to be used by

more than one bureau or agency. Although the bureaus and agencies provide the funds that finance

WCF, WCF owns the property and equipment purchased.
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records of WCF assets to WCF’s records. However, we found that WCF’s records of

purchases for IRS contained over 43,000 items while IRS’ records contained only 24,000

items. IRS and Treasury’s WCF had not reconciled the two databases.

Suggestions

We suggest that IRS develop procedures to require that prepayments be recorded as assets in

accordance with federal accounting standards. Services that are provided to IRS that will

benefit IRS for more than 1 year should be established as prepaid expenses and amortized

over the period of benefit.

We suggest that IRS establish clear policies and procedures to ensure that

telecommunications equipment is appropriately tagged based on whether it was purchased by

IRS or WCF. No property and equipment should have multiple inventory tags.

We suggest that IRS develop a policy to require reconciliation of IRS and WCF property

records on a routine basis.

IRS’ Comments and Our Evaluation

Concerning the prepaid expense amount related to WCF equipment, IRS indicated that

although it agrees that payments made to WCF for services that span more than 1 year should

be recorded as prepaid expenses, IRS depends on the Treasury Department to inform it when

this occurs. As we noted, IRS did record a prepaid expense for the amount prepaid through

fiscal year 1999, based on a consultant’s estimate of WCF equipment at IRS. According to

IRS, it will amortize this prepaid amount over a 5-year period. For future charges, IRS

indicated that it will rely on Treasury, which has informed IRS that it will be providing only

services to IRS, hence, prepayments should not be much of an issue. We found that in the

past, as supported by the prepaid expense recorded for WCF equipment by IRS in fiscal year

1999, WCF has charged IRS for equipment it purchases before the benefit had been fully

received. To determine whether this will cease to be an issue in the future, as IRS states, we

will evaluate this issue as part of our fiscal year 2000 audit.

IRS disagreed with our suggestion that it develop a policy requiring reconciliation of IRS and

WCF property records on a routine basis, and indicated that it believes this suggestion would

be more appropriately directed to Treasury/WCF since it owns the assets concerned.

However, IRS also stated that all WCF assets were removed from its inventory system in

April 2000. This would eliminate the need for the reconciliation we suggested. We will

verify this during our fiscal year 2000 audit.

IRS also agreed to properly tag telecommunications equipment and to remove multiple tags.

We also will verify this during our fiscal year 2000 audit.
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Reimbursable Receivable Transactions

Were Not Properly Recorded

IRS does not consistently follow procedures for accounting for reimbursements that it

expects to receive when it provides goods and services to other federal agencies, state and

foreign governments, and private organizations. According to IRS procedures, once the

goods have been delivered or the services performed, IRS is to record revenue and post an

unbilled receivable to the accounting system. When the customer is billed for the goods or

services, IRS’ procedure is to liquidate the unbilled account receivable and establish a billed

account receivable. The billing document must reference the initial entry that recorded the

revenue in order to liquidate the unbilled receivable. Once the receivable is paid, a receipt

entry should be posted to liquidate the billed receivable balance.

Based on a statistical sample of September 30, 1999, reimbursable receivables, we

determined that the gross amount of reimbursable receivables was not fairly stated, although

due to the allowance for bad debts accounts, we did not take exception to the net amount. Of

13 reimbursable receivable cases tested, we found 7 cases (54 percent) where the receivable

was no longer valid. In some cases, these receivables were on the books from as far back as

fiscal year 1995. For example, a fiscal year 1995 receivable of $363,000 remained on the

books as unbilled even though the receivable had been billed and subsequently collected.

This occurred because at the point the billed receivable was recorded, it did not properly

reference the unbilled receivable. Thus, the unbilled receivable was not liquidated and

remained on the books. In other cases, the funds received were simply not recorded against

the receivables in a timely manner. For example, a $2.4 million receivable recorded in fiscal

year 1999 remained on the books at fiscal year-end even though it had been fully collected.

According to IRS officials, this error resulted from inadequate staffing resources for posting

the collections as of fiscal year-end.

Some problems were also noted with respect to IRS’ use of its allowance for bad debts

account. Many of the exceptions in our sample were receivables from several years prior and

an offsetting amount was included in the allowance for bad debts. However, in one case, IRS

inappropriately included a $3.6 million receivable from Treasury’s WCF as a component of

the allowance account. This receivable related to telecommunications services provided by

IRS to WCF in fiscal year 1996.4 According to IRS officials, discrepancies exist between IRS

and Treasury Department records on the amount owed for the services. These IRS officials

stated that IRS is working with Treasury to resolve this issue, and believe that the receivable

is collectible and thus should not have been included in the allowance account. Setting up

bad debt allowances for valid receivables distorts both the allowance account and the net

accounts receivable balance.

 

4Fiscal year 1996 was the last year for this reimbursable contract.
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Suggestions

We suggest that IRS analyze its listing of reimbursable receivables to determine which

outstanding receivables are still valid. If no longer valid, the receivables and corresponding

allowance amounts should be written off.

We suggest that IRS ensure compliance with its procedure manual’s requirements for

recording reimbursable receivables and subsequent collections. For example, when entered

into the accounting system, documents should reference the unbilled receivable, and cash

receipt documents should reference the billing document that created the account receivable.

Also, supervisors should review entries to ensure that procedures are being followed.

We also suggest that IRS reconcile its reimbursable receivable records to Treasury’s in order

to substantiate the amount owed by WCF. After this is done, IRS should promptly collect the

appropriate amount due from Treasury.

IRS’ Comments and Our Evaluation

IRS agreed that the validity of the receivables is important, and indicated that it is currently

reviewing them to assess their collectibility. IRS also agreed with the need for a link

between billed and unbilled receivables and indicated it has already added such a link. In

addition, IRS indicated that it is contact with Treasury concerning the amounts owed by

WCF, believes that these amounts are at least partially collectible, and is aggressively

pursuing collection of these amounts. We will follow-up during our fiscal year 2000 audit to

assess the effectiveness of IRS’ actions.

Review Procedures at IRS’ National Office

Were Insufficient to Identify Errors

Errors in various IRS financial reports can be reduced by stronger review procedures. Our

Standards for Internal Controls in the Federal Government require that supervisory

personnel perform sufficient review to detect and eliminate errors, and thus to ensure that

transactions are properly recorded and adequately supported and that reports are properly

prepared.5

We found that existing review procedures at IRS’ national office were inadequate to prevent

errors in transactions posted to the general ledger and in financial information reported to

Treasury. Specifically, we found the following.

• A disbursement for $95 million was improperly recorded as a receipt and a receipt for

$94.9 million was improperly recorded as a disbursement in the general ledger. We also

determined that a $125,000 receipt was incorrectly reported. These errors were not

 

5Our Standards for Internal Control in the Federal Government (GAO/AIMD-00-21.3.1, November 1999)

contains the internal control standards to be followed by executive agencies in establishing and

maintaining systems of internal control as required by FMFIA.
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discovered and corrected until we reviewed the underlying documents supporting the

transactions and apprised IRS of the errors.

• The IRS national office’s Statement of Transactions for September 1999 reported a

$1.5 million receipt in an appropriation suspense account. However, we found the

transaction’s supporting documentation inadequate for determining whether the

transaction was actually a receipt or a disbursement.

• An IRS-prepared analysis of refunds disbursed during the first 9 months of fiscal year

1999 contained an earned income tax credit refund adjustment that was understated by

$11.8 million. We determined that IRS’ national office had incorrectly recorded the May

1999 debtor master file offset in its general ledger, and this error had not previously been

detected due to ineffective supervisory reviews.6

These problems might have been identified earlier by IRS had adequate supervisory reviews

been performed. While IRS’ Internal Revenue Manual specifies that management should be

accountable for reported amounts, it does not specifically require detailed supervisory

review.

Suggestion

We suggest that IRS revise its policies and procedures to require documented and sufficiently

detailed supervisory reviews of transactions to ensure that transactions are correct and

adequately supported and that reports are properly prepared before information is

summarized and reported externally.

IRS’ Comments and Our Evaluation

IRS agreed that stronger review procedures were needed for custodial reporting, and has

implemented additional review procedures to address this issue. In addition, IRS indicated

that its Interim Revenue Accounting and Control System, which accounts for its custodial

activities, has been reprogrammed to distinguish between Online Payment and Collections

Processing receipt and disbursement transactions. We will follow up during our fiscal year

2000 audit to assess the effectiveness of IRS’ actions.

IRS’ FMFIA Process Ends Prematurely

The self-assessments IRS performs under FMFIA (31 U.S.C. 3512) can be a better tool for

disclosing and correcting its internal control weaknesses. FMFIA requires executive

agencies, including the Department of the Treasury, to report annually to the President and

the Congress whether their internal accounting controls comply with the objectives specified

in the act. As a major component of Treasury, IRS annually provides Treasury an FMFIA

assurance statement attesting to the conformance of IRS’ internal controls with the objectives

specified in the act, which forms the basis for a major segment of Treasury’s required annual

 

6Some earned income tax credit refund amounts are used to offset nontax debts of taxpayers recorded

in the debtor master file.
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FMFIA report. IRS’ annual FMFIA assurance statement should include all known control

weaknesses that existed during the fiscal year ended September 30, 1999, (the reporting year)

that could materially affect IRS’, and therefore Treasury’s, operations. It should also

disclose sufficient information about the reported weaknesses to clearly describe the

problems and specify planned corrective actions.

However, we found that IRS' fiscal year 1999 FMFIA process ended too early to provide

reasonable assurance that all material weaknesses that existed during the reporting year were

adequately disclosed. Specifically, although IRS did not submit its fiscal year 1999 FMFIA

assurance statement to Treasury until February 2000, IRS concluded its internal selfassessment process for fiscal year 1999 on September 30, 1999.7

 IRS officials informed us

that any material weaknesses that came to their attention during this intervening period

would be considered in the succeeding reporting period (fiscal year 2000), rather than fiscal

year 1999. As a result, to the extent material weaknesses that existed in fiscal year 1999 were

identified during this period, IRS’ fiscal year 1999 FMFIA assurance statement would

ordinarily exclude them and potentially present an incomplete list of material weaknesses and

a misleading assessment of the effectiveness of IRS’ internal controls in meeting the

objectives of FMFIA.8

Suggestion

In order to ensure that IRS’ FMFIA assurance statement to Treasury appropriately

discloses all material weaknesses IRS is aware of that existed during the reporting period

covered by the statement, we suggest that IRS extend its self-assessment process for

each reporting year until such time as the related FMFIA assurance statement is

submitted to Treasury.

IRS’ Comments and Our Evaluation

IRS did not specifically address the closing date of its annual FMFIA process but

indicated that it does not believe that it ends prematurely. IRS indicated that in preparing

its assurance statement, it includes all issues known up to the date the Commissioner

signs IRS’ FMFIA statement. However, as we noted, IRS concludes its FMFIA process

for the year on September 30 although its FMFIA assurance statement to Treasury is not

finalized until several months later. IRS does not determine if its managers or TIGTA

subsequently became aware of any additional weaknesses in the interim period that

existed as of September 30. Consequently, IRS’ practice of concluding its FMFIA

process several months before the results are provided to Treasury increases the risk that

 

7

IRS’ FMFIA internal self-assessment process encompasses input concerning potential internal control

weaknesses from IRS managers and review of the results of audits performed by the Treasury

Inspector General for Tax Administration (TIGTA) and GAO.

8There was an exception made with respect to the findings of our audit of IRS’ fiscal year 1999

financial statements. Although IRS’ self-assessment period for fiscal year 1999 had concluded, we met

with IRS officials to apprise them of the findings of our fiscal year 1999 audit prior to the finalization of

IRS’ fiscal year 1999 FMFIA assurance statement. Based on these discussions, the findings of our audit

were subsequently disclosed in IRS’ final FMFIA fiscal year 1999 assurance statement.
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IRS’ FMFIA assurance statement to Treasury may not include all material internal

control weaknesses that existed during the reporting period.

IRS also urged us to provide our findings earlier in the process so management can fully

consider them as part of the annual assessment process. We believe we already do so, to

the extent practicable. We note that under the current audit process, IRS receives

notification of our detailed findings on an ongoing basis throughout the audit in the form

of matters for further consideration and periodic briefings with senior IRS management.

- - - - -

This letter is intended for use by the management of IRS. We are sending copies to Senator

Robert C. Byrd, Senator Joseph I. Lieberman, Senator Daniel Patrick Moynihan, Senator

William V. Roth, Senator Ted Stevens, and Senator Fred Thompson, and to Representative

Bill Archer, Representative Dan Burton, Representative Stephen Horn, Representative

David R. Obey, Representative Charles Rangel, Representative Jim Turner, Representative

Henry A. Waxman, and Representative C.W. Bill Young, in their capacities as Chairmen or

Ranking Minority Members of Senate and House Committees and Subcommittees. We are

also sending copies to the Honorable Lawrence H. Summers, Secretary of the Treasury; the

Honorable Jacob J. Lew, Director, Office of Management and Budget; and other interested

parties. This letter is a matter of public record and its distribution is not limited.

Consequently, copies are available to others on request.

We acknowledge and appreciate the cooperation and assistance provided by IRS officials and

staff during our audit of IRS’ fiscal year 1999 financial statements. If you have any questions

or need assistance in addressing these matters, please contact me at (202) 512-3406 or

Charles R. Fox, Assistant Director, at (202) 512-5261.

Sincerely yours,

Gregory D. Kutz

Associate Director, Governmentwide Accounting and

 Financial Management Issues

Enclosures
Enclosure I

Page 9 GAO/AIMD-00-162R IRS Management Letter

Comments From the Internal Revenue Service
Enclosure I

Page 10 GAO/AIMD-00-162R IRS Management Letter
Enclosure I

Page 11 GAO/AIMD-00-162R IRS Management Letter
Enclosure II

Page 12 GAO/AIMD-00-162R IRS Management Letter

GAO Staff Acknowledgments

The following individuals made key contributions to this letter: Doreen Eng, Joan Hawkins,

Steven Sebastian, George Jones, John Davis, Paul Foderaro, Leonard Zapata, Sophia

Harrison, Stanley Stenerson, Craig Feight, Cindy Brown Barnes, Mai Nguyen, and Edward

Jeye.

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