GAO-01-880R IRS Management Letter

United States General Accounting Office

Washington, DC 20548

July 30, 2001

The Honorable Charles O. Rossotti

Commissioner of Internal Revenue

Subject: Management Letter: Improvements Needed in IRS’ Accounting Procedures

and Internal Controls

Dear Mr. Rossotti:

In March 2001, 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 as of, and for the fiscal year ending, September 30, 2000.1

 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. We are in the process of

preparing a separate report addressing the significant internal control and

compliance issues identified and highlighted in our March 2001 audit report.

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

year 2000 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.

Results in Brief

During fiscal year 2000, IRS had several immaterial internal control issues that

affected financial reporting. These issues concern policies and procedures over

(1) reimbursable activity, (2) property and equipment (P&E) purchased through the

Department of the Treasury’s working capital fund (WCF),2

 (3) oversight of financial

reporting-related contractor support, and (4) transfers of funds between

appropriations.

Specifically, we found the following.

 1

Financial Audit: IRS’ Fiscal Year 2000 Financial Statements (GAO-01-394, Mar. 1, 2001).

2

The 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 it,

the WCF owns the property and equipment purchased.
Page 2 GAO-01-880R IRS Management Letter

● IRS was unable to determine if its costs for reimbursable activities were accurate

and whether it was recouping the costs of the goods or services it provided. Also,

IRS’ records regarding reimbursable amounts not yet paid (reimbursable

receivables) were not reliable.

● IRS did not have procedures in place to properly record its WCF prepaid

expenses. The lack of such procedures resulted in IRS understating its assets and

overstating its expenses by $7.3 million in fiscal year 2000.

● IRS accepted information from its contractors for inclusion in its year-end

financial reporting without sufficient oversight or review. This allowed

uncorrected data related to P&E and undelivered orders to be included in the

generation of IRS’ financial statements that, without audit adjustments, could

have led to erroneous information being reported by IRS.

● IRS did not always follow standard procedures with respect to the transfer of

funds between appropriations. Specifically, IRS recorded a transfer of budgetary

authority in its general ledger 7 months before Treasury processed the transfer.

At the end of our discussion on each of these issues, we offer recommendations for

strengthening IRS’ internal controls.

In responding to a draft of this letter, IRS agreed with portions of the letter, but

disagreed with the issues regarding prepaid expenses and lack of contractor

oversight. 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.

Scope and Methodology

As part of our audit of IRS’ fiscal year 2000 financial statements, we evaluated IRS’

internal controls and its compliance with selected provisions of laws and regulations.

We designed our audit procedures to test relevant controls and included tests for

proper authorization, execution, accounting, and reporting of transactions.

We conducted our fiscal year 2000 audit in accordance with U. S. generally accepted

government auditing standards. Further details on our scope and methodology are

included in our March 2001 report on the results of our fiscal year 2000 financial

statement audit.3

 3

GAO-01-394, Mar. 1, 2001.
Page 3 GAO-01-880R IRS Management Letter

IRS Needs Procedures to

Properly Track and Report

Reimbursable Activity

During our fiscal year 2000 financial audit, we noted a number of issues related to

IRS’ tracking and reporting of reimbursable activity.4

 These issues resulted in both

IRS’ inability to provide accurate cost information and in misstatements in accounts

used to record and report reimbursable activity. We reported on inaccuracies in

reimbursable activity records last year.5

U.S. generally accepted accounting principles (GAAP) recognize that reliable

information on costs of federal programs and activities is crucial for effective

management of government operations and is especially important to assess

operating performance.6

 Specifically, the accounting standards require that when an

entity provides goods or services to another entity, regardless of whether full

reimbursement is received, the providing entity should recognize in its accounting

records the full cost of those goods or services. The full costs of the goods or

services should also be reported to the receiving entity by the providing entity.

Regarding the need to maintain accurate records, GAO’s Standards for Internal

Control in the Federal Government 7 states that internal control should generally be

designed to assure that ongoing monitoring occurs in the course of normal

operations. This includes regular management and supervisory activities,

comparisons, reconciliations, and other actions people take in performing their

duties.

IRS’ accounting systems did not track or report cost information at the level

necessary to determine the actual cost of reimbursable activities as required by

federal accounting standards. For reimbursable activity, IRS bills customers using

estimates of costs for the goods or services it provides. Although the use of estimates

is a valid accounting practice, IRS’ systems did not adequately capture the actual cost

of these goods and services they provide. Because of this, IRS was unable to

determine if its estimates were accurate and whether it was recouping the costs of

the goods or services it provided. Additionally, this prevented IRS from reporting

reliable cost information to program managers, the Congress, and other interested

parties.

 4

IRS provides goods and services to federal agencies, state and foreign governments, and private

organizations on a reimbursable cost basis. Payments due to IRS for these activities are referred to as

reimbursable receivables.

5

Management Letter: Suggested Improvements in IRS’ Accounting Procedures and Internal Controls

(GAO/AIMD-00-162R, June 14, 2000).

6

Statement of Federal Financial Accounting Standards (SFFAS) No. 4 (para.108).

7

Standards for Internal Control in the Federal Government (GAO/AIMD-00-21.3.1, Nov. 1999), contains

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

systems of internal control as required by 31 U.S.C. sec. 3512 (commonly referred to as the Federal

Managers’ Financial Integrity Act).
Page 4 GAO-01-880R IRS Management Letter

We also found that the records IRS maintains regarding reimbursable amounts not

yet paid (reimbursable receivables) were not reliable. IRS did not routinely age or

analyze its receivables to ensure their validity. We tested a nonrepresentative

selection of six reimbursable receivables at the end of fiscal year 2000 and found

errors in the records for five of the accounts. Specifically, we found that three of the

receivables (50 percent) in our nonrepresentative selection had already been paid and

were therefore no longer valid receivables. The other two receivables had been

outstanding for several years and had previously been identified by IRS as

uncollectible. Although they should have been written off in the detailed records,

these items were still recorded as valid receivables. This is consistent with our

findings reported in last year’s management letter, in which we noted that 54 percent

of the reimbursable receivables we tested were no longer valid.

Because IRS did not routinely review its reimbursable receivables, it was unable to

identify invalid or inaccurate receivables and make the needed corrections. Proper

analysis through aging and reconciliation of IRS’ records is a part of good

management practice and could have identified these inaccuracies and allowed IRS

to correct its records of reimbursable receivables. Additionally, providing accurate

general and subsidiary ledger balances reflecting only valid receivables would better

support management in its collection efforts and provide for more reliable and easily

verifiable reporting to management.

Recommendations

To allow the proper reporting of the cost of reimbursable activity, we recommend

that you ensure that IRS personnel

● develop a mechanism to track and report the actual costs associated with

reimbursable activities.

To provide for more accurate records and better management of reimbursable

activity, we recommend that you ensure that IRS personnel

● establish procedures to periodically reconcile the subsidiary records to the

control account for reimbursable receivables to ensure that the balance is

adequately supported and

● routinely age and review currently open reimbursable receivable accounts to

identify accounts that are no longer valid or collectible.

IRS’ Comments and Our Evaluation

In its comments, IRS noted that, with few exceptions, it does not bill its customers in

advance of providing goods or services. We agree, and have modified the language

accordingly. IRS did not address our recommendations that it track the actual costs

of reimbursable activity or that it establish procedures to reconcile its records of

reimbursable receivables and routinely review the status of those receivables.
Page 5 GAO-01-880R IRS Management Letter

IRS Needs Procedures to Properly

Account for Prepaid Expenses and

Treasury Working Capital Fund Assets

During our fiscal year 2000 audit, we continued to find issues with respect to IRS’

accounting procedures for certain assets paid for in one year but used for several

years. GAAP8

 define such payments as prepayments and require agencies to record

them as assets (prepaid expenses) in the year of payment because the cost of the

goods and services will benefit the entity in future years. Recording an asset in this

way and expensing the cost systematically over the asset’s 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.

However, IRS recorded the entire cost as an expense at the time of purchase. IRS

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

WCF. The WCF purchases and retains ownership of capital items (such as telephone

routers) for IRS and bills IRS for the full cost of these items in the year of purchase.

Although the equipment is located at IRS offices and IRS benefits from the purchase

for a number of years, IRS has been recognizing the full cost of these items as an

expense in the first year.

When we identified this issue in the previous year’s audit, IRS corrected the problem

for fiscal year-end financial reporting. To do so, IRS used a contractor to estimate its

prepaid expenses by statistically projecting the net book value of WCF assets at IRS

locations in order to properly reflect prepaid expenses on its balance sheet as of

September 30, 1999. The contractor physically inventoried a sample of WCF assets at

IRS locations and then projected the value of the assets. As a result of this

projection, IRS made a $21.7 million adjustment to reflect this amount as a prepaid

expense on its September 30, 1999, balance sheet. Although we suggested in last

year’s management letter that IRS develop procedures to record prepayments as

assets in future periods, IRS still did not have such procedures in place to properly

record its WCF prepaid expenses for fiscal year 2000. The lack of such procedures

resulted in IRS understating its assets and overstating its expenses by $7.3 million in

fiscal year 2000.

In last year’s audit, we identified two additional issues related to the WCF. In a

separate management letter,9

 we made several suggestions to help IRS strengthen its

procedures and controls in this area. We found during this year’s audit that IRS had

implemented corrective action based on one of these suggestions. Specifically, IRS

 8

SFFAS No. 1, Accounting for Selected Assets and Liabilities, provides accounting standards for

selected assets and liabilities. Paragraph 58 of SFFAS No. 1 defines prepayments (prepaid expenses)

and paragraph 59 states prepayments should be recorded as assets. Statement of Accounting

Standards No. 4, Managerial Cost Accounting Standards, (paras. 5 to 11) provides concepts and

standards aimed at providing reliable and timely information on the full cost of federal programs and

their activities and outputs.

9

GAO/AIMD-00-162R, June 14, 2000.
Page 6 GAO-01-880R IRS Management Letter

agreed with our suggestion to remove multiple property tags from property at IRS

locations.10 During this year’s audit we did not identify any instances of property with

multiple tags. We also found during this year’s audit that IRS has removed WCF

items from its records, thus addressing the underlying issue that gave rise to our

suggestion.

Recommendation

We recommend that IRS develop and implement procedures to require that

prepayments be recorded as assets routinely at the time the cost is incurred in

accordance with GAAP. 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 the benefit.

IRS’ Comments and Our Evaluation

In commenting on this section, IRS stated that it records Online Payment and

Collection billings from the WCF as a prepaid asset and then decides how much of

the asset to charge to expense based on reports it receives from the WCF. However,

most of the equipment purchased by the WCF, which is used by IRS, is expensed by

the WCF in the year of purchase due to its capitalization threshold. Therefore, by

using the WCF reports as a basis for determining how much of the cost should be

expensed, IRS effectively expenses this equipment in the year of purchase even

though it will benefit IRS for more than 1 year. The accounting treatment of these

items by the WCF should not affect how IRS accounts for the amounts paid for the

use of the equipment. Because procedures were not in place to properly account for

these costs, IRS understated its assets and overstated its expenses by $7.3 million in

fiscal year 2000.

IRS Needs Better Oversight of

Financial Reporting-Related

Contractor Support

In previous years, and again this year, we noted a number of errors and discrepancies

in IRS financial records that could have been avoided or corrected by greater

management oversight and review. During fiscal year 1999, we reported that IRS did

not perform sufficient supervisory review to detect and eliminate errors and thus

ensure that transactions were properly recorded and adequately supported and that

reports were properly prepared.11 We suggested 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

 10The suggestion arose because we found that many of the telecommunication equipment items we

observed at IRS facilities had both IRS and WCF tags. Having multiple tags made it difficult to

determine whether these items should have been recorded in IRS or Treasury WCF records.

11GAO/AIMD-00-162R, June 14, 2000.
Page 7 GAO-01-880R IRS Management Letter

that reports are properly prepared before information is summarized and reported

externally.

During fiscal year 2000, IRS contracted out several activities that directly supported

its year-end financial reporting process. However, it did not maintain sufficient

oversight of these contractors to ensure that their work was reliable. This hampered

IRS’ ability to ensure reasonable controls existed over the accuracy of its reported

financial information.

GAO’s Standards for Internal Control in the Federal Government requires that

supervisory personnel perform sufficient review to detect and eliminate errors, and

thus ensure that transactions are properly recorded and adequately supported and

that reports are properly prepared.12 Contracting out financial activities in support of

year-end financial reporting does not relieve IRS of its responsibility to maintain

accurate records or to adequately review financial information.

In fiscal year 2000, we found that IRS accepted information from its contractors for

inclusion in its year-end financial reporting without sufficient oversight or review.

For example, during fiscal year 2000 IRS hired a contractor to extract and analyze

from IRS’ records major system acquisitions and purchases to derive the amounts

that it should capitalize as P&E on its financial statements. IRS then recorded

adjusting entries provided by the contractor to transfer these P&E acquisitions to the

appropriate general ledger account. However, information provided by the contractor

was not always accurate and IRS did not review the data to ensure their reliability.

For example,

● 8 of 60 transactions we tested, totaling $879,000, were inappropriately identified

by the contractor as P&E for fiscal year 2000, and two of the 8 transactions were

actually purchases of P&E that should have been reported in fiscal year 1999,

while the remaining 6 transactions should have remained as expenses, and

● the contractor’s calculation of fiscal year 2000 depreciation expense totaling

$359 million contained errors of $61 million (17 percent).

IRS had similar problems with contractor-developed adjustments for undelivered

orders.13 In prior years and again in fiscal year 2000, we found that IRS did not always

reduce the balance of undelivered orders when goods and services were received.

This resulted in IRS overstating its undelivered orders and understating its accrued

expenses since IRS had already received the goods and services and should have

decreased its undelivered orders accordingly. In response to a recommendation we

made after our fiscal year 1999 audit that IRS periodically analyze outstanding

balances to determine their status and whether any adjustments are necessary, IRS

hired a contractor to review its accrued expenses as of September 30, 1999.

 12GAO/AIMD-00-21.3.1, Nov. 1999.

13Undelivered orders represent the value of goods and services that were ordered and obligated but

have not been received.
Page 8 GAO-01-880R IRS Management Letter

However, during our fiscal year 2000 audit, we noted that several of the contractordeveloped adjustments were erroneous. We also found that IRS had accepted the

adjustments without reviewing them for appropriateness.

Financial information provided by contractors was not always correct, and IRS did

not detect the errors as a result of its lack of sufficient oversight. This allowed

uncorrected data to be included in the generation of IRS’ financial statements and,

without audit adjustments, could have led to erroneous information being reported

by IRS.

Recommendation

We recommend that you ensure that IRS personnel maintain effective oversight of the

completeness and accuracy of contractor-generated information.

IRS’ Comments and Our Evaluation

In commenting on this section, IRS stated that it reviewed the deliverables and

supporting workpapers provided by the contractor relating to property and

equipment and made adjustments. IRS further stated that it did not and should not be

expected to review every transaction to determine if an exception occurred. While

we do not expect that IRS should review every transaction, we do expect that

effective review and oversight should result in material problems being identified.

Our detailed testing of 60 transactions, in which we found 8 errors, was based on a

statistical sample. Based on our work, we estimate the most likely overstatement of

the P&E balance as a result of transactions incorrectly recorded as fiscal year 2000

P&E was $61 million, with an upper error limit of $106 million. This exceeded our

test materiality.14

IRS also stated that the other issue we raised with respect to P&E was the result of a

change we made to the life expectancy of certain assets. There was no change in life

expectancy of assets from fiscal year 1999 through fiscal year 2000. However, we did

find cases in which the contractor did not correctly use the life expectancies

established in fiscal year 1999.

With respect to the discussion of accrued expenses in this section, IRS stated that it

performed a thorough review of the contractor’s work in reviewing accrued expenses

as of September 30, 1999. However, we question the adequacy of this review. We

found that in a number of instances the contractor did not go beyond summary level

information in determining accrual amounts. For example, IRS allocated $209,500 of

the total invoice cost of $260,130 related to an information services contract to fiscal

year 1999, and the remaining $50,630 to fiscal year 2000. However, based on the

terms of the service contract, we determined that only $1,724 of the invoice cost

related to services for fiscal year 1999, while the remaining $258,406 related to

services to be rendered in fiscal year 2000. It appears the contractor did not go

beyond the first page of the invoice in determining the accrual amount, while the

 14Our estimate is based on a 95 percent confidence level and the use of a test materiality of $87 million.
Page 9 GAO-01-880R IRS Management Letter

supporting pages of the invoice clearly broke out the fiscal year 1999 costs. In testing

a statistical sample of accrued expenses recorded at the end of fiscal year 1999, we

identified errors in 36 percent of the sample cases. We believe an appropriate review

would have caught much of these errors.

IRS Needs to More Closely Adhere to Treasury

Requirements Regarding Transferring

Funds Between Appropriations

During our fiscal year 2000 financial audit, we found that IRS did not always follow

standard procedures with respect to the transfer of funds between appropriations.

IRS recorded a transfer of budgetary authority15 in its general ledger before Treasury

processed the transfer in response to obtaining the congressional approval provided

for in the Treasury Department Appropriations Act, 2000. Section 2035 of the

Treasury Financial Manual (TFM) requires that agencies record such nonexpenditure

transfers16 in the same month as they are processed by the Treasury.

During our fiscal year 2000 audit, we determined that IRS transferred funds between

accounts in its general ledger about 7 months before Treasury processed the same

transaction. Specifically, in October 1999, IRS transferred appropriated amounts of

$100 million out of the Tax Law Enforcement fund balance account, of which

$60 million was transferred to the Processing, Assistance, and Management fund

balance account and $40 million was transferred to the Information Systems fund

balance account.

Section 101 of the Treasury Department Appropriations Act, 2000, provides that up to

5 percent of an IRS appropriation may be transferred to another IRS appropriation

upon advance approval of the Senate and House Committees on Appropriations. IRS,

through Treasury, did not request this approval until March 2000. The transfer was

approved in April 2000, and Treasury recorded the transfer in May 2000.

However, IRS had administratively recorded the transfer in its general ledger in

October 1999—7 months before Treasury processed the transaction.

Although we did not identify any instances of IRS’ expenditures exceeding approved

funding levels in fiscal year 2000, IRS violated section 2035 of the TFM by recording

the transfer of appropriations before the transfer was processed by Treasury.

Recommendation

We recommend that you direct IRS management to ensure that it complies with

Treasury regulations requiring that all transfers of funds between appropriations be

properly approved and documented prior to recording them in the financial records.

 15Budgetary authority is the authority the Congress grants federal agencies to incur obligations and to

make payments out of the Treasury for specified purposes. An appropriation act is the most common

form of budgetary authority.

16Nonexpenditure transfers of appropriations increase or decrease appropriation amounts between

appropriation and fund accounts as a result of legislation.
Page 10 GAO-01-880R IRS Management Letter

IRS’ Comments and Our Evaluation

IRS did not address the transfer of funds issue discussed in this section.

- - - - -

This letter 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 submit your statement to the Senate Committee on

Governmental Affairs and the House Committee on Government Reform within 60

days of the date of this letter. A written statement must also be sent to the House and

Senate Committees on Appropriations with the agency’s first request for

appropriations made more than 60 days after the date of the letter.

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

Chairmen and Ranking Minority Members of the Senate Committee on

Appropriations; Senate Committee on Finance; Senate Committee on Governmental

Affairs; Senate Committee on the Budget; Subcommittee on Treasury and General

Government, Senate Committee on Appropriations; Subcommittee on Taxation and

IRS Oversight, Senate Committee on Finance; and the Subcommittee on Oversight of

Government Management, Restructuring, and the District of Columbia, Senate

Committee on Governmental Affairs. We are also sending copies to the Chairmen and

Ranking Minority Members of the House Committee on Appropriations; House

Committee on Ways and Means; House Committee on Government Reform; House

Committee on the Budget; Subcommittee on Treasury, Postal Service, and General

Government, House Committee on Appropriations; Subcommittee on Government

Efficiency, Financial Management, and Intergovernmental Relations, House

Committee on Government Reform; and the Subcommittee on Oversight, House

Committee on Ways and Means. In addition, we are sending copies of this letter to the

Chairman and Vice-Chairman of the Joint Committee on Taxation, the Secretary of

the Treasury, the Director of the Office of Management and Budget, the Chairman of

the IRS Oversight Board, and other interested parties. Copies will be made available

to others upon request. The letter is also available on GAO’s homepage at

http://www.gao.gov.
Page 11 GAO-01-880R IRS Management Letter

We acknowledge and appreciate the cooperation and assistance provided by IRS

officials and staff during our audit of IRS’ fiscal year 2000 financial statements. If you

have any questions or need assistance in addressing these matters, please contact

Steven J. Sebastian, Acting Director, at (202) 512-9521. Additional contacts and staff

acknowledgments are provided in enclosure II.

Sincerely yours,

Jeffrey C. Steinhoff

Managing Director

Financial Management and Assurance

Enclosures
Enclosure I

Page 12 GAO-01-880R IRS Management Letter

Comments From the Internal Revenue Service
Enclosure I

Page 13 GAO-01-880R IRS Management Letter
Enclosure I

Page 14 GAO-01-880R IRS Management Letter
Enclosure II

Page 15 GAO-01-880R IRS Management Letter

GAO Contacts and Staff Acknowledgments

GAO Contacts

J. Lawrence Malenich, (202) 512-9399

William J. Cordrey, (404) 679-1873

Acknowledgments

Staff making key contributions to this letter were Paul Caban, John H. Davis, Meafelia

Gusukuma, Angel Sharma, and Leonard Zapata.

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