GAO

United States General Accounting Office

A

Testimony

Before the Subcommittee on Government Efficiency and 

Financial Management, Government Reform Committee, 

House of Representatives

For Release on Delivery 

Expected at 2 p.m. EDT

April 29, 2003

SMALL BUSINESS 

ADMINISTRATION 

Loan Accounting and Other 

Financial Management 

Issues Impair 

Accountability 

Statement of Linda M. Calbom, Director

Financial Management and Assurance

GAO-03-676T
Since August 1999, SBA held seven loan asset sales, disposing of a total of 

$5.8 billion in disaster assistance and business loans. Our review of the 

budgeting and accounting for the first five loan sales found errors that could 

significantly affect the reported results in SBA’s budget and financial 

statements. We found that SBA (1) incorrectly calculated losses on loan 

sales reported in the footnotes to its financial statements, (2) did not 

appropriately consider the effect of loan sales on its estimates of the cost of 

the remaining portfolio, which could significantly affect its budget and 

financial statement reporting, and (3) had significant unexplained declines in 

its subsidy allowance for the disaster loan program. As shown in the figure, 

the subsidy allowance eventually declined to a negative balance, which 

indicated that SBA expected profits on its subsidized disaster loans. 

Despite these errors and uncertainties, SBA’s auditor gave unqualified audit 

opinions on SBA’s fiscal year 2000 and 2001 financial statements. We 

discussed these issues with SBA’s auditors, who have since reassessed the 

unusual balance in the subsidy allowance account and withdrawn their 

unqualified audit opinions on the fiscal year 2000 and 2001 financial 

statements. The agency’s inability to properly account for its loans sold and 

not sold, combined with several other financial management issues, led the 

auditors to issue a disclaimer of opinion on SBA’s fiscal year 2002 financial 

statements. Until SBA corrects its financial management deficiencies, the 

agency’s financial accounting and budgetary reporting will be unreliable. 

Based on recent discussions with SBA officials, we understand that they are 

making progress in identifying the sources of the loan accounting problems 

and in determining corrective actions. 

SBA Disaster Loans Subsidy Allowance 

 Note: Analysis based on SBA data.

Recently, the Small Business 

Administration’s (SBA) auditors 

withdrew their unqualified audit 

opinions on SBA's fiscal year 2000 

and 2001 financial statements and 

issued disclaimers of opinion. The 

auditors also issued a disclaimer of 

opinion on SBA's fiscal year 2002 

financial statements. This turn of 

events was primarily due to flaws 

in the way SBA accounted for its 

loan sales and for the remaining 

portfolio. There were also several 

other issues affecting SBA's fiscal 

year 2002 audit, including key 

internal control weaknesses and 

systems that did not substantially 

comply with the Federal Financial 

Management Improvement Act. 

The information GAO presents in 

this testimony, which is discussed 

in greater detail in our January 

2003 report, Small Business 

Administration: Accounting 

Anomalies and Limited 

Operational Data Make Results of 

Loan Sales Uncertain (GAO-03-87), 

is intended to assist Congress in 

assessing the current status of 

financial accountability at SBA. 

GAO is not making new 

recommendations in this 

testimony, but in a past report has 

made specific recommendations 

aimed at addressing the 

deficiencies in the accounting for 

loan asset sales and the remaining 

portfolio. 

www.gao.gov/cgi-bin/getrpt?GAO-03-676T.

To view the full testimony, click on the link 

above. 

For more information, contact Linda Calbom 

at (202) 512-9508 or calboml@gao.gov. 

Highlights of GAO-03-676T, a testimony 

before the Subcommittee on Government 

Efficiency and Financial Management, 

Government Reform Committee, House of 

Representatives 

April 29, 2003

SMALL BUSINESS ADMINISTRATION

Loan Accounting and Other Financial 

Management Issues Impair Accountability 
Page 1 GAO-03-676T 

Mr. Chairman and Members of the Subcommittee:

I am pleased to be here today to discuss the status of financial management 

at the Small Business Administration (SBA). Recently SBA's auditor 

withdrew its unqualified audit opinions on SBA's fiscal year 2000 and 2001 

financial statements and issued disclaimers of opinion. The auditor also 

issued a disclaimer of opinion on SBA's fiscal year 2002 financial 

statements. This turn of events was primarily due to flaws we identified in 

the way SBA accounted for its loan sales and for the remaining portfolio. 

There were also several other issues affecting SBA's fiscal year 2002 

financial statement audit, including key internal control weaknesses and 

systems that did not substantially comply with the Federal Financial 

Management Improvement Act (FFMIA). I will discuss all of these issues 

today which, when combined, point to an overall lack of financial 

accountability at SBA.

SBA’s Accounting for 

Loan Sales and the 

Remaining Portfolio 

was Flawed

This January, we reported1 that SBA had sold almost 110,000 loans with an 

unpaid principal balance of about $4.4 billion in five loan sales from August 

1999 through January 2002.2

 Our review of the budgeting and accounting 

for these loan sales found errors that could significantly affect the reported 

results in SBA’s budget and financial statements. 

1

 U.S. General Accounting Office, Small Business Administration: Accounting Anomalies 

and Limited Operational Data Make Results of Loan Sales Uncertain, GAO-03-87

(Washington, D.C.: Jan. 3, 2003).

2

 SBA has held two additional loan sales that were not included in our review. In August 

2002, SBA held its sixth sale, which included about 30,000 loans with an outstanding balance 

of $657 million. The seventh sale took place in December 2002 and consisted of about 

29,000 loans with an outstanding balance of $682 million. In all seven sales SBA has sold 

about 169,000 loans with an outstanding balance of $5.8 billion.
Page 2 GAO-03-676T 

We found that SBA (1) incorrectly calculated losses on loan sales reported 

in the footnotes to its financial statements, (2) did not appropriately 

consider the effect of loan sales on its estimates of the cost of the 

remaining portfolio, which could significantly affect its budget and 

financial statement reporting, and (3) had significant unexplained declines 

in its subsidy allowance3

 for the disaster loan program. Until SBA makes 

the necessary corrections to its procedures to estimate the cost of its credit 

programs, including the effect of its loan sales, the reliability of the current 

and future subsidy rates will remain unknown. We understand that SBA is 

taking steps to address the issues we identified, including working with a 

consulting firm to perform a detailed analysis of its loan sale accounting 

and cost estimation procedures.

SBA Improperly Calculated 

Losses on Loan Sales

Accounting records related to SBA’s first five loan sales indicated that 

losses exceeded $1.5 billion. However, this amount is overstated because 

of errors in the way SBA calculated the losses. Because of the lack of 

reliable financial data, we were unable to determine the financial effect of 

loan sales on SBA’s budget and financial statements. These errors raise 

serious concerns about the information related to the results of loan sales 

included in the footnotes to the annual financial statements that SBA 

provided to the Office of Management and Budget (OMB) and the Congress 

for decision-making purposes.

3

 For a subsidized loan program, the subsidy allowance account generally represents the 

subsidized portion – the amount of expected losses related to estimated defaults and 

financing costs from making below-market rate loans – assumed by the federal government. 

The subsidy allowance account is subtracted from the loans receivable balance on the 

balance sheet to arrive at the net loan amount expected to be repaid. 
Page 3 GAO-03-676T 

For accounting purposes, the gain or loss on a loan sale represents the 

difference between the net book value (the outstanding loans receivable 

balance minus the subsidy allowance) of the loans sold and the net sale 

proceeds.4

 The footnotes to SBA’s fiscal year 1999 and 2000 financial 

statements reported accounting losses of $75 million and $600 million, 

respectively, on its loan sales. SBA did not separately disclose the losses 

calculated on the two loan sales that took place during fiscal year 2001.5

 

According to SBA’s accounting records, the first five sales resulted in total 

losses of more than $1.5 billion. 

Prior to a loan sale, an estimate of the loans’ current value to the 

government or “hold value” is calculated to determine what the loans are 

worth to the government in the event that the loans are held to maturity or 

some other resolution, such as prepayment or default.6

 This hold value is 

compared to an estimate of the expected net sale proceeds to determine if 

it is advantageous for the loans to be sold.7

 After a sale, the hold value is 

compared to the actual net sale proceeds to determine whether or not and 

by how much the government benefited from the sale. SBA determined 

that the first five loan sales resulted in a $606 million benefit to the 

government.8

 This benefit calculation differs from the accounting gain or 

loss because the benefit calculation is not designed to take into 

consideration changes in interest rates from the time the loans were 

disbursed to the date of the sale, while the accounting gain or loss, if 

properly computed, does take these changes into account. 

4

 OMB Circular A-11 defines net sale proceeds in the context of loan sales as the amounts 

paid by purchasers less all seller transaction costs (such as underwriting, rating agency, 

legal, financial advisory, and due diligence fees) that are paid out of the gross sales proceeds 

rather than paid as direct obligations by the agency.

5

 SBA also did not disclose any gain or loss on the two loan sales, number 5 and 6, which 

took place during fiscal year 2002 in its financial statements for that year.

6

 The hold value is calculated on a present value basis, meaning the worth of a future stream 

of returns or costs in terms of money paid immediately. In calculating the hold value, 

interest rates from the most recent President’s budget at the time the estimate is prepared 

provide the basis for converting future amounts into their “money now,” or present value, 

equivalents. 

7

 OMB reviews these calculations as part of its approval process for SBA to conduct a loan 

sale.

8

 We did not audit the data used to calculate the hold values for each sale, and therefore did 

not conclude on the reasonableness of the hold values for any of the sales.
Page 4 GAO-03-676T 

We reviewed the methodology SBA used to calculate the results of its loan 

sales for accounting purposes and found significant errors. When 

calculating whether loans are sold at a gain or a loss, agencies must 

estimate the portion of the subsidy allowance to allocate to each loan sold 

in order to calculate the net book value for those loans. Since SBA’s 

calculation of the net book value of the loans sold exceeded the net 

proceeds from the sales, losses were calculated. Our review of these 

calculations found that SBA’s estimates did not consider all the appropriate 

cash flows when allocating the subsidy allowance to the sold loans. For 

example, when calculating the gains or losses for the disaster loan 

program, SBA failed to allocate a portion of the subsidy allowance for 

financing costs associated with lending to borrowers at below market 

interest rates. Doing so would have reduced the amount of loss that SBA 

reported on the loan sales.

In addition, SBA incorrectly allocated the subsidy allowance for the 

previously defaulted 7(a) and 504 guaranteed loans, which could materially 

distort the gain or loss. SBA used its estimated net default cost, which 

considers first the probability of default and then the estimated recovery 

rate after default. For example, if a $10,000 guaranteed loan has an 

estimated default rate of 10 percent and an estimated recovery rate of 50 

percent, the subsidy allowance allocated by SBA would be $500 ([$10,000 x 

.10] x .50). Therefore, the net book value calculated for the loan would be 

$9,500. However, since guaranteed loans sold have already defaulted, it is 

not appropriate to apply the estimated default rate of 10 percent. SBA 

should have applied only the estimated recovery rate of 50 percent for 

these loans, and the subsidy allowance allocated would be $5,000 ($10,000 

x .50) and the net book value calculated for the loan would be $5,000. 

Figure 1 illustrates the difference in the calculated gain or loss resulting 

from this error if the previously defaulted loan were sold for $6,500. The 

left column, based on SBA’s incorrect methodology, shows that the loan 

was sold for a $3,000 loss, while the right column appropriately allocates 

the allowance based on expected recoveries and results in a $1,500 gain, a 

difference of $4,500 for this example of a $10,000 guaranteed loan sold. 
Page 5 GAO-03-676T 

Figure 1: Gain / Loss Calculation on Previously Defaulted Guaranteed Loans Sold

SBA’s errors in calculating the losses on disaster loans and previously 

defaulted guaranteed loans sold both resulted in overestimates of the net 

book value of the loans sold and the losses that SBA reported in the 

footnotes to its fiscal year 1999 and 2000 financial statements. Because of 

the way the results of loan sales are incorporated in the budget and the 

financial statements, the reestimates, if done properly, should have 

corrected the impact of these errors. However, as I discuss next, the 

reestimates were not reliable.

Subsidy Cost Reestimates 

are Unreliable 

SBA did not conduct key analyses of the loans sold and those remaining in 

its portfolio so it could determine how the sales affected its reestimates of 

program costs for its remaining loans. OMB’s budget guidance directs 

agencies to make reestimates for all changes in cash flow assumptions in 

order to adjust the subsidy estimate for differences between the original 

estimated cash flows and the actual cash flows. SBA officials 

acknowledged that analyses of the impact of loan sales on its historical 

averages should be done. However, they told us they lacked the 

appropriate historical data and resources to perform these analyses. 

Because SBA did not assess the effect loan sales would have on its 

historical averages of loan performance, such as when loans default or 

prepay, the agency did not know whether these averages, which can 

significantly affect the estimated cost of a loan program, reasonably predict 

future loan performance. As a result, information in both the budget and 

financial statements related to the reestimated cost of SBA’s loan programs 

cannot be relied upon. 

SBA is generally required to update or “reestimate” loan program costs 

annually. OMB Circular A-11 directs agencies to do reestimates for all 

changes in cash flow assumptions. Thus, reestimates should include all 
Page 6 GAO-03-676T 

aspects of the original cost estimate, including prepayments, defaults, 

delinquencies, and recoveries. These reestimates are done to adjust the 

subsidy cost estimate for differences between the original cash flow 

projections and the amount and timing of cash flows that are expected 

based on actual experience, new forecasts about future economic 

conditions, and other events that affect the cash flows. 

Even after selling about $4.4 billion of loans, nearly half of its loan 

portfolio, SBA had not analyzed the effect of loan sales on the estimated 

cost of the remaining loans in its portfolio. SBA officials told us loans are 

selected for sale based on certain criteria, such as where the loan is located 

or serviced, the type of collateral, or whether the loan is performing. Since 

the loan selection process is not random—that is, all loans do not have an 

equal chance of being selected—it is likely that the loans sold had different 

characteristics than the portfolio’s historical averages prior to sales. 

Consequently, the characteristics of the remaining loans may also differ 

substantially from the portfolio historical averages prior to the sales. For 

example, during our analysis of the loans that were sold, we determined 

that 84 percent of the $3.8 billion of disaster loans sold were performing–

meaning that payments were not more than 30 days delinquent. Selling 

mostly performing loans could leave a disproportionate level of 

nonperforming loans in SBA’s portfolio. Because SBA had not analyzed the 

effect of loan sales on the characteristics of its remaining portfolio, it does 

not know if the percentages of remaining performing and nonperforming 

loans are different from the historical averages prior to the sales. A change 

in these percentages could indicate that expected defaults in the remaining 

portfolio could be higher or lower than current assumptions, based on 

historical data, suggest. 

Another important loan characteristic is the stated loan term. This term is 

the contractual amount of time borrowers have to repay their loans. SBA’s 

estimated costs of the disaster loan program are based on historical 

average loan term assumptions of 16 years for business disaster loans and 

17 years for home disaster loans. Based on our review of the disaster loans 

sold in the first five sales, the average loan term was about 25 years. 

However, SBA continued to use average loan term assumptions of 16 and 

17 years in its reestimates without doing the appropriate analysis to 

determine whether these assumptions were still valid. Based on our recent 

discussion with SBA officials, their detailed analysis of the cost estimation 

procedures for the disaster loan program found that, among other things, 

the average loan term assumption should have been greater. Relatively 

minor changes in some cash flow assumptions, such as higher or lower 
Page 7 GAO-03-676T 

default and recovery rates and changes in loan terms, can significantly 

affect the estimated cost of the loan program and therefore the program’s 

budget. 

The Subsidy Allowance 

Account Was Misstated

During our review of the accounting for loan sales, we noted that the 

subsidy allowance account for the disaster loan program had an unusually 

low balance. For a subsidized loan program, the subsidy allowance 

account is generally the amount of expected losses on a group of loans 

related to estimated defaults and financing costs from making belowmarket rate loans. In effect, the subsidy allowance is the cost associated 

with the loans that SBA does not expect to recover from borrowers. For 

financial reporting purposes, the subsidy allowance reduces the 

outstanding loans receivable balance to the amount that SBA expects to 

collect from borrowers, known as the net loans receivable balance (or net 

book value), which is shown on the balance sheet. 

Table 1 summarizes the disaster loan program’s reported outstanding loans 

receivable balance, the subsidy allowance balance, the net book value, and 

the subsidy allowance as a percentage of the loans receivable balance for 

fiscal years 1998 through 2002. The reported subsidy allowance compared 

to the loans receivable balance decreased significantly in fiscal years 2000 

and 2001, to the point of showing that the remaining portfolio of the 

disaster program was expected to generate a profit. This declining trend 

continued into fiscal year 2002. SBA could not provide support for the 

balance or explain the reason for this anomaly. 

Table 1: Reported Loans Receivable Balances of SBA’s Disaster Loan Program 

Source: SBA.

Dollars in millions

Disaster loan program

Fiscal 

year 1998

Fiscal 

year 1999

Fiscal 

year 2000

Fiscal 

year 2001

Fiscal 

year 2002

Loans receivable 

Outstanding $5,614 $5,659 $5,305 $3,293 $3,110

Less / (plus): subsidy 

allowance balance $1,502 $929 $505 ($77) ($522)

Net book value $4,112 $4,730 $4,800 $3,370 $3,632

Subsidy allowance as a 

percentage of loans 

receivable balance 26.8% 16.4% 9.5% (2.3%) (16.8%)
Page 8 GAO-03-676T 

Table 1 shows a rapid decrease in the reported subsidy allowance between 

fiscal year 2000 and 2001. Most of this decrease actually occurred in fiscal 

year 2000, but was masked by an adjustment made during the fiscal year 

2000 financial statement audit. Before SBA made the audit adjustment, the 

subsidy allowance for the disaster program was about $91 million for fiscal 

year 2000. This balance was $838 million, or about 90 percent, less than the 

$929 million balance for fiscal year 1999, while loans receivable 

outstanding decreased by only $354 million, or about 6 percent. 

In order to restore the subsidy allowance to a more reasonable balance at 

the end of fiscal year 2000, in agreement with its auditor, SBA increased the 

subsidy allowance balance by recording an audit adjustment that was 

essentially meant to reflect the expected impact of loan sales on the 

reestimates prepared in fiscal year 2000, which did not factor in the effects 

of loan sales.9

 This increased the reported cost of the disaster loan 

program by $414 million in fiscal year 2000. Since the amount of the 

adjustment was based on SBA’s erroneous calculations of loan sale losses, 

as previously discussed, the amount of the adjustment was incorrect. 

During fiscal year 2001, SBA reversed the audit adjustment and revised its 

reestimates to include cash flows related to loan sales. Our review of the 

fiscal year 2001 disaster loan program reestimates indicated that loan sales 

increased the reported cost of the program by about $292 million. 

However, this amount is also likely misstated because, as I previously 

mentioned, the reestimates did not consider the specific characteristics of 

the loans sold or the loans remaining in the portfolio. 

9

 Theoretically, had the reestimates factored in the loan sales, the subsidy allowance 

account would have been appropriately adjusted, regardless of any errors made in recording 

the calculated accounting losses.
Page 9 GAO-03-676T 

The unexplained decline in the subsidy allowance continued in the fiscal 

year 2001 financial statements where SBA reported a negative balance in 

the subsidy allowance for the disaster loan program. As shown in table 1, 

this allowance account no longer reduced the amount SBA expected 

borrowers to repay – it actually increased the expected repayments from 

borrowers and indicated that the loan program was profitable. However, 

because the program is subsidized, with estimated default and financing 

costs exceeding the amount of interest borrowers are expected to pay, it 

should not show an expected profit, and thus the balance for the subsidy 

allowance account appears to be significantly misstated.10 As in the prior 

year, SBA could not explain the unusual balance. Based on our review of 

SBA’s fiscal year 2002 financial statements, the unexplained trend 

continued and the negative balance of the subsidy allowance (expected 

profit) increased to $522 million. 

While the objective of our work was not to determine the specific cause of 

the unusual balance, several possibilities exist. As previously mentioned, 

not considering the characteristics of the loans sold or of those remaining 

in SBA’s portfolio could contribute to the unusual balance. Another 

possibility is that SBA may have underestimated the cost of its disaster loan 

program because the cash flow assumptions used to estimate the subsidy 

cost did not reflect the true characteristics or performance of its loan 

portfolio. For example, as I previously discussed, SBA used average loan 

term assumptions of 16 and 17 years to estimate the cost of the disaster 

loan program. However, based on recent discussions with SBA officials, 

they have found that the average loan term should have been greater. 

Underestimating the loan term would mean that SBA did not put enough 

into the subsidy allowance account to cover interest costs associated with 

these loans and the subsidy allowance would be depleted as these costs 

were written off against it until there was a negative balance. From a 

budgetary perspective, this could mean that SBA did not request an 

appropriation large enough to cover the cost of the loan program. 

Despite the significant, unexplained decline in the subsidy allowance and 

the errors in calculating the losses on loan sales, SBA received unqualified 

or “clean” audit opinions on its fiscal year 2000 and 2001 financial 

statements. An unqualified audit opinion indicates that the balances in the 

10 Based on SBA’s reestimates for its fiscal year 2001 financial statements, the subsidy cost of 

this program ranged from $17 to $33 for every $100 the federal government lends, depending 

on the interest rates in effect when the loans were made.
Page 10 GAO-03-676T 

financial statements are free of significant errors, known as material 

misstatements. As previously mentioned, SBA’s auditor attempted to adjust 

the anomalies in the subsidy allowance during the fiscal year 2000 financial 

statement audit. However, the adjustment was based on the previously 

described erroneous loss calculation. For the fiscal year 2001 audit, SBA’s 

auditor performed a number of audit procedures related to the disaster 

loan program subsidy allowance account. For example, the auditor 

evaluated the methodology and formulas used to calculate reestimates, 

assessed data used to calculate key cash flow assumptions, and reviewed 

various internal controls over the subsidy estimation process. However, 

this work did not appear to focus on determining the cause of the unusual 

negative balance of the account, which, contrary to the fact that this is a 

subsidized loan program, would indicate that these loans were expected to 

generate a profit. The auditor’s workpapers indicated that the auditor had 

agreed, in discussions with SBA management, that if the “methodology and 

data were materially correct, we [the auditor] would conclude that the 

resulting subsidy reserve [allowance] would be materially correct for 

financial statement reporting purposes.” The workpapers also indicated 

that, “whatever the results of the reestimates are, as long as the 

methodology is sound and supportable, we [the auditor] would not 

consider the balance [of the subsidy allowance] anything other than 

‘natural.’”

Although SBA’s auditor may have recognized some of the errors we 

identified, they did not determine the cause of the unusual balance and 

propose the necessary audit adjustments or modify their audit report as 

appropriate. In such situations, when auditors cannot determine whether a 

balance is fairly stated because sufficient reliable supporting 

documentation is not available, audit standards11 call for auditors to either 

qualify their opinion with the noted exception or issue a disclaimer of 

opinion, meaning that the auditor was unable to obtain satisfaction that the 

financial statements are fairly stated and therefore does not express an 

opinion. We discussed these issues with SBA’s auditor and they have since 

reevaluated and withdrawn their unqualified audit opinions on SBA’s fiscal 

year 2000 and 2001 financial statements and issued disclaimers of opinion. 

In response to our findings, SBA contracted with an independent 

consulting firm to complete a more detailed analysis of its loan sale 

accounting and cost estimation procedures to determine the cause of the 

11 Statements on Auditing Standards, AU §508 paragraphs 22 and 23.
Page 11 GAO-03-676T 

unusual balance in the subsidy allowance account. We recently met with 

SBA officials to discuss the steps taken to date to address the issues we 

identified. We understand that SBA, working with the consultants, has 

identified a number of issues related to the methods and assumptions used 

to estimate the cost for the disaster loan program. While we have not had 

an opportunity to analyze their findings in detail, based on our previous 

work, several of the issues they identified, including the understated 

average loan term, appear to be plausible causes of the decline in the 

subsidy allowance for the disaster loan program. 

Results of Fiscal Year 

2002 Financial 

Statement Audit

SBA’s inability to account for its loan sales or adequately reestimate the 

cost of loans not sold, combined with other financial management issues, 

led to the auditors issuing a disclaimer of opinion on SBA’s fiscal year 2002 

financial statements. I will now briefly discuss the disclaimer of opinion, 

the internal control weaknesses they reflect, and the consequences of these 

weaknesses regarding compliance with FFMIA.

Disclaimer of Opinion The disclaimer of opinion for fiscal year 2002 was primarily due to three 

issues: (1) SBA's disaster loan modeling contained deficiencies and was no 

longer adequate for determining the costs of disaster loans sold or 

reestimating the cost of loans not sold, (2) SBA did not present future 

expected default costs on pre-1992 loan guarantees12 or determine the 

correct valuation of related balances, and (3) SBA could not ensure that the 

balance in the Master Reserve Fund13 residual asset or liability was reliable.

As I’ve previously discussed, SBA’s inability to determine the cost of loans 

sold or adequately reestimate the cost of loans not sold could materially 

affect amounts reported in the budget and the financial statements. SBA 

and its consultants had not completed their analysis of SBA’s loan sale 

accounting and cost estimation procedures prior to the completion of the 

fiscal year 2002 audit. Therefore, SBA was not able to provide sufficient 

12 Pre-1992 loan guarantees are loan guarantees committed prior to October 1, 1991. The 

accounting standard requires that the liabilities of pre-1992 loan guarantees be recognized 

when it is more likely than not that the loan guarantees will require a future cash outlaw to 

pay default claims.

13 The 7(a) secondary market program, one of SBA’s business loan programs, is administered 

by an agent of SBA. Payments for this program flow through the Master Reserve Fund.
Page 12 GAO-03-676T 

evidence to its auditors to support certain amounts reported and 

disclosures made in its fiscal year 2001 and 2002 financial statements, 

thereby limiting the scope of the audit and leading to the disclaimer of 

opinion. 

Additionally, SBA did not present future expected default costs on pre-1992 

loan guarantees. SBA made several adjusting entries to both the fiscal year 

2002 and fiscal year 2001 financial statements in an effort to correct this. 

However, SBA did not have a calculation methodology to determine its 

expected future default costs and related liability or to support the 

adjustments made. Therefore, SBA could not provide sufficient 

documentation that the liability balance of $116 million as of September 30, 

2002, was fairly stated. 

The final issue contributing to SBA’s disclaimer related to the Master 

Reserve Fund. SBA's fiscal and transfer agent maintains the Master 

Reserve Fund to facilitate operation of the secondary market program14 for 

7(a) Business Loans, a loan guarantee program for small businesses that 

would otherwise be unable to obtain financing at reasonable rates. The 

Master Reserve Fund receives payments from lenders who have SBAguaranteed loans and makes payments to the investors in the secondary 

market program. In fiscal year 2002, SBA estimated that there was a 

potential future deficit (shortfall resulting from payments to investors 

exceeding payments from lenders) in the range of zero to $18.3 million 

required to liquidate the obligations in the 7(a) secondary market. This 

potential deficit contrasted with fiscal year 2001 where an estimated excess 

of $68 million was reported.

According to SBA’s auditor, SBA used samples of Master Reserve Fund 

activity for fiscal years 2002 and fiscal year 2001 to estimate the year-end 

balances. The samples were small and differed in important respects from 

the total population of loans. Thus, the sampling was not entirely 

representative of the loan population and did not provide sufficient 

evidence that the estimate of the Master Reserve Fund balance was fairly 

stated. 

14 The secondary market program was created to increase the attractiveness of small 

business lending to the lending community. Through this market, lenders are able to sell the 

guaranteed portion of SBA guaranteed loans to investors, thereby improving the lenders’ 

liquidity and increasing the yield on the nonguaranteed portion of the SBA loan.
Page 13 GAO-03-676T 

Internal Control 

Weaknesses 

The study and evaluation of the system of internal control over financial 

reporting are included as part of the financial statement audit under 

generally accepted auditing standards. Internal control is an integral 

component of an agency’s management that provides reasonable assurance 

that the following objectives are being achieved: (1) effectiveness and 

efficiency of operations, (2) reliability of financial reporting, and 

(3) compliance with applicable laws and regulations.15 Internal control 

serves as the first line of defense in safeguarding assets and in preventing 

and detecting errors and fraud. As federal policymakers and program 

managers continually seek to better achieve agencies’ missions and 

program results, they seek ways to improve accountability. A key factor in 

achieving these outcomes and minimizing operational problems is the 

implementation of appropriate internal control.

Internal control over financial information is evaluated during the audit, 

and the auditor is required to communicate to the agency any condition 

that represents a significant deficiency in internal controls—referred to as 

a reportable condition.16 A material internal control weakness is a 

reportable condition that does not reduce to a relatively low level the risk 

that errors, fraud, or noncompliance involving significant amounts may 

occur and not be detected in a timely manner by employees in the normal 

course of performing their assigned functions. SBA’s auditor identified five 

material weaknesses and one reportable condition. 

As I previously stated, SBA received a disclaimer of opinion from its 

auditor in fiscal year 2002 primarily due to three issues, and each of these 

issues resulted from a material weakness in their internal controls. SBA’s 

auditor reported material weaknesses relating to (1) disaster loan 

modeling, (2) the liability for loan guarantees and related accounts for pre1992 loan commitments, and (3) the Master Reserve Fund, all of which I 

have discussed. The fourth material weakness related to SBA’s financial 

reporting process. According to SBA’s auditor, SBA continued to 

experience widespread difficulties in producing complete, accurate, timely, 

and adequately supported draft and final financial statements, including 

15 Standards for Internal Control in the Federal Government, (GAO/AIMD-00-21.3.1) 

Washington, D.C.: November 1999)

16 A reportable condition is a significant deficiency in the design or operation of internal 

controls that could adversely affect the organization’s ability to provide reasonable 

assurance on the reliability of its financial reporting, performance reporting, and 

compliance with laws and regulations.
Page 14 GAO-03-676T 

footnotes. The auditor stated that additional attention is needed to ensure 

that a fully effective quality assurance process is documented and in place. 

The auditor further stated that SBA's difficulties with financial reporting 

may be attributable to devoting insufficient resources to the process, 

particularly the quality control process. 

The fifth material weakness was due to funds control weaknesses. For 

example, the auditor reported that SBA established invalid undelivered 

orders in its liquidating funds and did not return all unobligated balances in 

its liquidating funds to the general fund at the end of the fiscal year. Also, 

SBA did not have sufficient funds controls in place to ensure that payments 

for defaulted 7(a) loan guarantees did not exceed authorized amounts or to 

ensure that obligations were not incurred against anticipated budgetary 

resources. These shortcomings increase the risk that SBA may violate the 

Antideficiency Act.17

Finally, while SBA has continued to improve internal controls over its 

information system environment in certain areas, the auditor reported that 

further improvement is needed to ensure a sound information system 

control environment. This internal control deficiency was included as a 

reportable condition in the auditor’s 2002 report on internal controls. 

Weaknesses were reported in all six categories of general computer 

controls.18 General computer controls create the environment in which 

application systems and controls operate. During a financial statement 

audit, the auditor focuses on general controls for the agency’s major 

computer facilities and systems supporting a number of different computer 

applications, such as major data processing installations or local area 

networks. If general computer controls are weak, as is the case at SBA, 

they severely diminish the reliability of controls associated with individual 

applications.

17 The Antideficiency Act, among other things, prohibits the making of expenditures or the 

incurring of obligations prior to or in excess of appropriations. 

18 The six general control categories are: (1) entity-wide security program control, (2) access 

control, (3) application software development and program change control, (4) system 

software control, (5) segregation-of-duty control, and (6) service continuity control.
Page 15 GAO-03-676T 

Federal Financial 

Management Improvement 

Act of 1996

SBA’s auditor also concluded that SBA’s systems did not substantially 

comply with the Federal Financial Management Improvement Act of 1996 

(FFMIA). FFMIA is a measure of an agency’s ability to incorporate into its 

financial management system accounting standards and reporting 

objectives established for the federal government, so that all assets, 

liabilities, revenues, expenses, and the full costs of programs and activities 

can be consistently and accurately recorded, monitored, and uniformly 

reported. Substantial noncompliance with FFMIA indicates that SBA’s 

financial management systems do not routinely provide reliable, useful, 

timely, and consistent information to fulfill its responsibility of being 

accountable to the public and of providing timely financial information to 

manage on a day-to-day basis.

SBA’s financial management systems in fiscal year 2002 did not 

substantially comply with all three aspects of FFMIA: (1) federal financial 

management systems requirements, (2) federal accounting standards, or 

(3) the U.S. government standard general ledger (SGL) at the transaction 

level. 

SBA’s auditor noted that SBA was not in substantial compliance with 

federal financial management systems requirements because its core 

financial system is not able to provide complete, reliable, timely and 

consistent financial information on programs to enable management to 

fulfill its responsibility to the public and to provide timely information for 

managing current operations. Also, access control, segregation-of-duties, 

and other general control weaknesses exist in SBA’s information systems 

controls. Additionally, funds control deficiencies exist as is evidenced in 

SBA’s material weakness in that area.

The auditor concluded that SBA did not substantially comply with federal 

accounting standards because it cannot support the reported cost of loans 

sold, the reestimates of the subsidy for loans not sold, or the liability for 

pre-1992 loan guarantees. SBA also cannot support the balance in the 

Master Reserve Fund.

Finally SBA’s auditor concluded that SBA’s financial systems did not 

substantially comply with the SGL at the transaction level. During fiscal 

year 2002, SBA modified its Financial Reporting Information System but 

did not detect in a timely manner an error created by the modification. 

SBA also experienced problems that resulted in the posting of invalid 

information to the system when it converted to its current Oracle-based 

administrative accounting system.
Page 16 GAO-03-676T 

In closing, Mr. Chairman, SBA’s financial management deficiencies are 

quite severe and point to an inability to provide full accountability for 

taxpayer funds provided to the agency for carrying out its programs. Until 

these deficiencies are corrected, SBA’s financial accounting and budgetary 

reporting will be unreliable. In our January 2003 report, we made a number 

of recommendations to SBA covering these matters related to accounting 

for loan sales. SBA agreed with our recommendations, and we understand 

that they are making progress identifying potential causes of these 

deficiencies and actions to address them. We look forward to assessing the 

results of these activities.

Mr. Chairman, this concludes my statement. I would be happy to answer 

any questions you or other members of the subcommittee may have.

Contact and 

Acknowledgments

For information about this statement, please contact Linda Calbom, 

Director, Financial Management and Assurance, at (202) 512-9508, or Julia 

Duquette, Assistant Director, at (202) 512-5131. You may also reach them 

by e-mail at calboml@gao.gov or duquettej@gao.gov. Other individuals who 

made key contributions to this testimony include Marcia Carlsen and Lisa 

Crye. Numerous other individuals made contributions to the work 

supporting this testimony.

(190092)
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