Fiscal Year 2005 U.S. Government Financial Statements: Sustained Improvement in Federal Financial Management Is Crucial to Addressing Our Nation's Financial Condition and Long-term Fiscal Imbalance
Published: 2006-03-01T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: GAO is required by law to annually audit the consolidated financial statements of the U.S. government. The Congress and the President need to have timely, reliable, and useful financial and performance information. Sound decisions on the current results and future direction of vital federal government programs and policies are made more difficult without such information. Until the problems discussed in GAO's audit report on the U.S. government's consolidated financial statements are adequately addressed, they will continue to (1) hamper the federal government's ability to reliably report a significant portion of its assets, liabilities, costs, and other information; (2) affect the federal government's ability to reliably measure the full cost as well as the financial and nonfinancial performance of certain programs and activities; (3) impair the federal government's ability to adequately safeguard significant assets and properly record various transactions; and (4) hinder the federal government from having reliable financial information to operate in an economical, efficient, and effective manner.
section_title: What GAO Found
paragraphs: For the ninth consecutive year, certain material weaknesses in internal control and in selected accounting and financial reporting practices resulted in conditions that continued to prevent GAO from being able to provide the Congress and American people an opinion as to whether the consolidated financial statements of the U.S. government are fairly stated in conformity with U.S. generally accepted accounting principles. Three major impediments to an opinion on the consolidated financial statements continued to be (1) serious financial management problems at the Department of Defense, (2) the federal government's inability to adequately account for and reconcile intragovernmental activity and balances between federal agencies, and (3) the federal government's ineffective process for preparing the consolidated financial statements. Further, in our opinion, as of September 30, 2005, the federal government did not maintain effective internal control over financial reporting and compliance with significant laws and regulations due to numerous material weaknesses. More troubling still is the federal government's overall financial condition and long-term fiscal imbalance. While the fiscal year 2005 budget deficit was lower than 2004, it was still very high, especially given the impending retirement of the "baby boom" generation and rising health care costs. Importantly, as reported in the fiscal year 2005 Financial Report of the United States Government, the federal government's accrual-based net operating cost--the cost to operate the federal government--increased to $760 billion in fiscal year 2005 from $616 billion in fiscal year 2004. This represents an increase of about $144 billion or 23 percent. The federal government's gross debt was about $8 trillion as of September 30, 2005. This number excludes such items as the gap between the present value of future promised and funded Social Security and Medicare benefits, veterans' health care, and a range of other liabilities, commitments, and contingencies that the federal government has pledged to support. Including these items, the federal government's fiscal exposures now total more than $46 trillion, representing close to four times gross domestic product (GDP) in fiscal year 2005 and up from about $20 trillion or two times GDP in 2000. Given these and other factors, a fundamental reexamination of major spending programs, tax policies, and government priorities will be important and necessary to put us on a prudent and sustainable fiscal path. This will likely require a national discussion about what Americans want from their government and how much they are willing to pay for those things. We continue to have concerns about the identification of misstatements in federal agencies' prior year financial statements. Frequent restatements to correct errors can undermine public trust and confidence in both the entity and all responsible parties. The material internal control weaknesses discussed in this testimony serve to increase the risk that additional errors may occur and not be identified on a timely basis by agency management or their auditors, resulting in further restatements.

section_title: Letter
paragraphs: I am most pleased to be here today and commend your subcommittee’s  tradition of oversight hearings on this and other financial management  issues throughout the year. Such hearings continue to play a vital role in  ensuring that the federal government is held accountable to the American  people. Today I will discuss our report on the U.S. government’s  consolidated financial statements for fiscal years 2005 and 2004. Our work  was conducted in accordance with U.S. generally accepted government  auditing standards.
Both the consolidated financial statements and our report on them are  included in the fiscal year 2005 Financial Report of the United States  Government. This most recent report was issued by the Department of the  Treasury (Treasury) on December 15, 2005, and is available through GAO’s  Internet site, at www.gao.gov/financial/fy2005financialreport.html, and  Treasury’s Internet site, at www.fms.treas.gov/fr/index.html. I also would  like to highlight a guide we issued in September 2005 titled Understanding  the Primary Components of the Annual Financial Report of the United  States Government, which was prepared to help those who seek to obtain  a better understanding of the Financial Report. This guide can also be  found on GAO’s Internet site at  www.gao.gov/financial/fy2005/guidetofrofusg.pdf.
For the ninth consecutive year, certain material weaknesses in internal  control and in selected accounting and financial reporting practices  resulted in conditions that continued to prevent us from being able to  provide the Congress and American people an opinion as to whether the  consolidated financial statements of the U.S. government were fairly  stated in conformity with U.S. generally accepted accounting principles  (GAAP). Further, we also reported that the federal government did not  maintain effective internal control over financial reporting (including  safeguarding assets) and compliance with significant laws and regulations  as of September 30, 2005. Until the problems that I will discuss today and  that are discussed in our audit report are adequately addressed, they will  continue to have adverse implications for the federal government and the  taxpayers.
More troubling still is the federal government’s overall financial condition  and long-term fiscal imbalance. While the fiscal year 2005 budget deficit  was lower than 2004, it was still very high, especially given the impending  retirement of the “baby boom” generation and rising health care costs.  Importantly, as reported in the fiscal year 2005 Financial Report of the  United States Government, the federal government’s accrual-based net  operating cost—that is, the cost to operate the federal government— increased to $760 billion in fiscal year 2005 from $616 billion in fiscal year  2004. This represents an increase of about $144 billion or 23 percent. To  make matters worse, the federal government’s liabilities and unfunded  commitments, which include military and civilian retirement benefits and  promised Social Security and Medicare payments, are growing rapidly.  Simply put, our nation’s financial condition and long-term fiscal imbalance  is on an imprudent and unsustainable course.
In this testimony, I will discuss (1) the federal government’s long-term  fiscal imbalance, (2) our continued concerns about the identification of  misstatements in federal agencies’ prior year financial statements, and (3)  the major issues relating to the consolidated financial statements for fiscal  years 2005 and 2004. I will also discuss systems problems that continue to  hinder federal agency accountability, and describe progress that has been  made toward addressing major impediments to an opinion on the  consolidated financial statements.
subsections: section_title: The Nation’s Fiscal Imbalance
paragraphs: The Financial Report of the United States Government provides useful  information on the government’s financial position at the end of the fiscal  year and changes that have occurred over the course of the year. However,  in evaluating the nation’s fiscal condition, it is critical to look beyond the  short-term results and consider the overall long-term financial condition  and long-term fiscal imbalance of the government—that is, the  sustainability of the federal government’s programs, commitments, and  responsibilities in relation to the resources expected to be available. More  important than the large increase in the government’s net operating cost in  fiscal year 2005 and persistent short-term budget deficits, fiscal  simulations by GAO and others show that over the long term, we face large  and growing structural deficits due primarily to known demographic  trends, rising health care costs, and lower federal revenues relative to the  economy.
As I have testified before, the current financial reporting model does not  clearly, comprehensively, and transparently show the wide range of  responsibilities, programs, and activities that may either obligate the  federal government to future spending or create an expectation for such  spending. Thus, it provides a potentially unrealistic and misleading picture  of the federal government’s overall performance, financial condition, and  future fiscal outlook. The federal government’s gross debt in the U.S.  government’s consolidated financial statements was about $8 trillion as of  September 30, 2005. This number excludes such items as the current gap  between the present value of future promised and funded Social Security  and Medicare benefits, veterans’ health care, and a range of other  liabilities (e.g., federal employee and veteran benefits payable),  commitments, and contingencies that the federal government has pledged  to support. Including these items, the federal government’s fiscal  exposures now total more than $46 trillion, representing close to four  times gross domestic product (GDP) in fiscal year 2005 and up from about  $20 trillion or two times GDP in 2000. About one third of the  approximately $26 trillion increase resulted from enactment of the  Medicare prescription drug benefit in fiscal year 2004. (See table 1.) The  federal government’s current fiscal exposures translate into a burden of  about $156,000 per American or approximately $375,000 per full-time  worker, up from $72,000 and $165,000 respectively, in 2000. Furthermore,  these amounts do not include future costs resulting from Hurricane  Katrina or the conflicts in Iraq and Afghanistan.
In addition to the approximately $46 trillion of estimated fiscal exposures  discussed above, there are exposures that are not included in those figures  because the amounts of the exposures are not currently estimable. For  example, the Department of Energy, in the footnotes to its fiscal year 2005  financial statements, disclosed that its environmental liability estimates do  not include cleanup costs at sites for which there is no current feasible  remediation approach, such as the nuclear explosion test area at the  Nevada Test Site. It is important to understand the nature and extent of  these types of additional exposures in the long-term fiscal planning for the  federal government.
Additionally, tax expenditure amounts are not required to be disclosed,  nor are they disclosed, in agency or the U.S. government’s consolidated  financial statements. Tax expenditures are reductions in tax revenues that  result from preferential provisions, such as tax exclusions, credits, and  deductions. These revenue losses reduce the resources available to fund  other programs or they require higher tax rates to raise a given amount of  revenue. As we reported in September 2005, the number of tax  expenditures more than doubled since 1974, and the sum of tax  expenditure revenue loss estimates tripled in real terms to nearly $730  billion in 2004. Under the most recent estimates, this has risen to more  than $775 billion in 2005. Enhanced reporting on tax expenditures would  ensure greater transparency and accountability for revenue forgone by the  federal government and provide a more comprehensive picture of the  federal government’s policies and fiscal position.
Further, additional changes are needed to communicate important  information to users about current operating results and the long-term  financial condition of the U.S. government and annual changes therein. In  particular, the government’s financial statements should clearly  communicate to the user:  the on-budget or operating results versus unified budget results for the  year;  the long-term sustainability of federal government programs—areas to  consider include  the relationship of the federal government’s existing  commitments/responsibilities, including social insurance, to  appropriate measures, such as GDP and per capita amounts,  the government's long-term fiscal imbalance in relation to appropriate  measures, such as GDP, and  the magnitude of the potential alternatives for resolving the long term  deficits, such as the rate of tax increases or spending reductions  necessary to balance the government's long-term finances;  inter-generational equity issues, e.g., assessing the extent to which  different age groups may be required to assume financial burdens for  commitments already made; and   a liability at the governmentwide level for funds held by Social Insurance  trust funds.
Another tool that would serve to more effectively communicate the federal  government’s finances to the public would be a Summary Annual Report.  Such a report would summarize, in a clear, concise, and transparent  manner, key financial and performance information included in the  Financial Report of the United States Government.
The federal government’s financial condition and long-term fiscal  imbalance present enormous challenges to the nation’s ability to respond  to emerging forces reshaping American society, the United States’ place in  the world, and the future role of the federal government. GAO’s long-term  simulations illustrate the magnitude of the fiscal challenges associated  with an aging society and the significance of the related challenges the  government will be called upon to address. Figures 1 and 2 present these  simulations under two different sets of assumptions. In figure 1, we start  with the Congressional Budget Office’s (CBO) 10-year baseline— constructed according to the statutory requirements for that baseline.  Consistent with these requirements, discretionary spending is assumed to  grow with inflation for the first 10 years and all tax cuts currently  scheduled to expire are assumed to expire. After 2016, discretionary  spending is assumed to grow at the same rate as the economy, and  revenue is held constant as a share of GDP at the 2016 level. In figure 2,  two assumptions are changed: (1) discretionary spending is assumed to  grow at the same rate as the economy after 2006 rather than merely with  inflation, and (2) all expiring tax provisions are extended. For both  simulations, Social Security and Medicare spending is based on the 2005  Trustees’ intermediate cost projections, and we assume that benefits  continue to be paid in full after the trust funds are exhausted. Medicaid  spending is based on CBO’s December 2005 long-term projections under  midrange assumptions.
As these simulations illustrate, absent policy changes on the spending or  revenue side of the budget, the growth in spending on federal retirement  and health entitlements will encumber an escalating share of the  government’s resources. Indeed, when we assume that all the temporary  tax reductions are made permanent and discretionary spending keeps  pace with the economy, our long-term simulations suggest that by 2040  federal revenues would be adequate to pay only some Social Security  benefits and interest on the federal debt. Neither slowing the growth in  discretionary spending nor allowing the tax provisions to expire—nor both  together—would eliminate the imbalance.
Although revenues will be part of the debate about our fiscal future,  assuming no changes to Social Security, Medicare, Medicaid, and other  drivers of the long-term fiscal gap would require at least a doubling of  taxes—and that seems to be highly implausible. Accordingly, substantive  reform of Social Security and our major health programs is critical to  recapturing our future fiscal flexibility. Ultimately, the nation will have to  decide what level of federal benefits and spending it wants and how it will  pay for these benefits. Our current path also will increasingly constrain  our ability to address emerging and unexpected budgetary needs and  increase the burdens that will be faced by future generations. Continuing  on this fiscal path will mean escalating and ultimately unsustainable  federal deficits and debt that will serve to threaten the standard of living  for the American people and ultimately our national security.
As these simulations illustrate, regardless of the assumptions used, the  problem is too big to be solved by economic growth alone or by making  modest changes to existing spending and tax policies. Rather, a  fundamental reexamination, reprioritization, and reengineering of major  spending programs, tax policies, and government priorities will be  important to recapture our fiscal flexibility and update our programs and  priorities to respond to emerging social, economic, and security changes.  Ultimately, this will likely require a national discussion about what  Americans want from their government and how much they are willing to  pay for those things.
section_title: Restatements of Agencies’ Financial Statements
paragraphs: According to Statement of Federal Financial Accounting Standards  (SFFAS) No. 21, Reporting Corrections of Errors and Changes in  Accounting Principles, prior period financial statements presented should  only be restated for corrections of errors, when such errors caused the  financial statements to be materially misstated. Errors in financial  statements can result from mathematical mistakes, mistakes in the  application of accounting principles, or oversight or misuse of facts that  existed at the time the financial statements were prepared.
We continue to have concerns about the identification of misstatements in  federal agencies’ prior year financial statements. At least 7 of the 24 CFO  Act agencies restated certain of their fiscal year 2004 financial statements  to correct errors. During fiscal year 2005, we reviewed the causes and  nature of the restatements made by several Chief Financial Officers (CFO)  Act agencies in fiscal year 2004 to their fiscal year 2003 financial  statements and recommended improvements in internal controls and audit  procedures to prevent or detect future similar errors. Generally, the  reasons for the restatements we reviewed were agencies’ lack of effective  internal controls over the processing and reporting of certain transactions  and the failure of the auditors to design and/or perform adequate audit  procedures to detect such errors. During our review, we noted that the  extent of the restatements to the agencies’ fiscal year 2003 financial  statements varied from agency to agency, ranging from correcting two line  items on an agency’s balance sheet to correcting numerous line items on  several of another agency’s financial statements. In some cases, the net  operating results of the agency were affected by the restatement. The  amounts of the agencies’ restatements ranged from several million dollars  to more than $91 billion.
Frequent restatements to correct errors can undermine public trust and  confidence in both the entity and all responsible parties. Material internal  control weaknesses discussed in our fiscal year 2005 audit report serve to  increase the risk that additional errors may occur and not be identified on  a timely basis by agency management or their auditors, resulting in further  restatements.
section_title: Highlights of Major Issues Related to the U.S. Government’s Consolidated Financial Statements for Fiscal Years 2005 and 2004
paragraphs: As has been the case for the previous eight fiscal years, the federal  government did not maintain adequate systems or have sufficient reliable  evidence to support certain material information reported in the U.S.  government’s consolidated financial statements. These material  deficiencies, which generally have existed for years, contributed to our  disclaimer of opinion on the U.S. government’s consolidated financial  statements for the fiscal years ended September 30, 2005, and 2004 and  also constitute material weaknesses in internal control. Appendix I  describes the material deficiencies in more detail and highlights the  primary effects of these material weaknesses on the consolidated financial  statements and on the management of federal government operations.  These material deficiencies were the federal government’s inability to    satisfactorily determine that property, plant, and equipment and  inventories and related property, primarily held by the Department of  Defense (DOD), were properly reported in the consolidated financial  statements; reasonably estimate or adequately support amounts reported for certain  liabilities, such as environmental and disposal liabilities, or determine  whether commitments and contingencies were complete and properly  reported;   support significant portions of the total net cost of operations, most  notably related to DOD, and adequately reconcile disbursement activity at  certain federal agencies;   adequately account for and reconcile intragovernmental activity and  balances between federal agencies;    ensure that the federal government’s consolidated financial statements  were consistent with the underlying audited agency financial statements,  balanced, and in conformity with GAAP; and  resolve material differences that exist between the total net outlays  reported in federal agencies’ Statements of Budgetary Resources and the  records used by Treasury to prepare the Statements of Changes in Cash  Balance from Unified Budget and Other Activities.
Due to the material deficiencies and additional limitations on the scope of  our work, as discussed in our audit report, there may also be additional  issues that could affect the consolidated financial statements that have not  been identified.
In addition to the material weaknesses that represented material  deficiencies, which were discussed above, we found the following four  other material weaknesses in internal control as of September 30, 2005.  These weaknesses are discussed in more detail in appendix II, including  the primary effects of the material weaknesses on the consolidated  financial statements and on the management of federal government  operations. These material weaknesses were the federal government’s  inability to  implement effective processes and procedures for properly estimating the  cost of certain lending programs, related loan guarantee liabilities, and  value of direct loans;   determine the extent to which improper payments exist;  identify and resolve information security control weaknesses and manage  information security risks on an ongoing basis; and   effectively manage its tax collection activities.
section_title: Systems Problems at Agencies Continue to Hinder Accountability
paragraphs: For fiscal year 2005, 18 of 24 CFO Act agencies were able to attain  unqualified opinions on their financial statements by the November 15,  2005, reporting deadline established by the Office of Management and  Budget (OMB) (see app. III). The independent auditor of the Department  of State subsequently withdrew its qualified opinion on the department’s  fiscal year 2005 financial statements and reissued an unqualified opinion  on such financial statements dated December 14, 2005. As a result, 19 CFO  Act agencies received unqualified opinions on their fiscal year 2005  financial statements. However, irrespective of these unqualified opinions,  many agencies do not have timely, reliable, and useful financial  information and effective controls with which to make informed decisions  and ensure accountability on an ongoing basis. The ability to produce the  data needed for efficient and effective management of day-to-day  operations in the federal government and provide the necessary  accountability to taxpayers and the Congress has been a long-standing  challenge at most federal agencies.
The results of the fiscal year 2005 Federal Financial Managers Integrity Act  of 1996 (FFMIA) assessments performed by agency inspectors general or  their contract auditors show that certain problems continue to affect  financial management systems at most CFO Act agencies. These problems  include nonintegrated financial systems, lack of accurate and timely  recording of data, inadequate reconciliation procedures, and  noncompliance with accounting standards and the U.S. Government  Standard General Ledger (SGL). While the problems are much more  severe at some agencies than at others, the nature and severity of the  problems indicate that overall, management at most CFO Act agencies  lack the complete range of information needed for accountability,  performance reporting, and decision making.
FFMIA requires auditors, as part of the CFO Act agencies’ financial  statement audits, to report whether agencies’ financial management  systems substantially comply with (1) federal financial management  systems requirements, (2) applicable federal accounting standards, and (3)  the SGL at the transaction level. The major barrier to achieving  compliance with FFMIA continues to be the inability of agencies to meet  federal financial management systems requirements, which involve not  only core financial systems, but also administrative and programmatic  systems.
For fiscal year 2005, auditors for 18 of the 24 CFO Act agencies reported  that the agencies’ financial management systems did not substantially  comply with one or more of the FFMIA requirements noted above. For 5 of  the remaining 6 CFO Act agencies, auditors provided negative assurance,  meaning that nothing came to their attention indicating that the agencies’  financial management systems did not substantially meet FFMIA  requirements. The auditors for these 5 agencies did not definitively state  whether the agencies’ systems substantially complied with FFMIA  requirements, as is required under the statute. In contrast, auditors for the  Department of Labor provided positive assurance by stating that, in their  opinion, the department’s financial management systems substantially  complied with the requirements of FFMIA. Further, auditors for the  Department of Energy and the General Services Administration reported  that those agencies’ financial management systems did not substantially  comply with FFMIA requirements in fiscal year 2005 due to recently  identified internal control weaknesses over financial reporting. The  auditors had not reported any FFMIA compliance issues at those 2 federal  agencies in fiscal year 2004.
As individual agencies move forward with various initiatives to address  FFMIA-related problems, it is important that consideration be given to the  numerous governmentwide initiatives under way to address long-standing  financial management weaknesses. OMB continues to move forward on  new initiatives to enhance financial management and provide results- oriented information in the federal government. Two ongoing  developments in this area in fiscal year 2005 were the realignment of  responsibilities formerly performed by the Joint Financial Management  Improvement Program and its Program Management Office and the  development of financial management lines of business. The overall vision  of these initiatives is to eliminate duplicative roles, streamline financial  management improvement efforts, and improve the cost, quality, and  performance of financial management systems by leveraging shared  services solutions.
section_title: Addressing Major Impediments to an Opinion on Consolidated Financial Statements
paragraphs: Three major impediments to our ability to render an opinion on the U.S.  government’s consolidated financial statements continued to be: (1)  serious financial management problems at DOD, (2) the federal  government’s inability to adequately account for and reconcile  intragovernmental activity and balances between federal agencies, and (3)  the federal government’s ineffective process for preparing the  consolidated financial statements. Extensive cooperative efforts between  agency chief financial officers, inspectors general, Treasury officials, and  OMB officials will be needed to resolve these serious obstacles to  achieving an opinion on the U.S. government’s consolidated financial  statements.
subsections: section_title: Financial Management at DOD
paragraphs: Essential to improving financial management governmentwide and  ultimately to achieving an opinion on the U.S. government’s consolidated  financial statements is the resolution of serious weaknesses in DOD’s  business operations. DOD’s financial management weaknesses are  pervasive, complex, long standing, and deeply rooted in virtually all  business operations throughout the department. To date, none of the  military services or major DOD components has passed the test of an  independent financial audit because of pervasive weaknesses in business  management systems, processes, and internal control. Of the 25 areas on  GAO’s governmentwide high-risk list, 8 are DOD programs or operations,  and the department shares responsibility for 6 other high-risk areas that  are governmentwide in scope. These weaknesses adversely affect the  department’s (and the federal government’s) ability to control costs;  ensure basic accountability; anticipate future costs and claims on the  budget; measure performance; maintain funds control; prevent fraud,  waste, and abuse; and address pressing management issues.
Effective management, reporting, and decision making depend upon  information that is timely, reliable, and useful. Recent actions taken by the  department to develop an integrated strategy to better understand and  initiate efforts to systematically transform and address weaknesses in its  business operations are encouraging. On September 28, 2005, DOD  approved two key components of its transformation strategy: the Business  Enterprise Architecture and the Business Transition Plan. An enterprise  architecture should provide a clear and comprehensive picture of an  entity, whether it is an organization (e.g., a federal department) or a  functional or mission area that cuts across more than one organization  (e.g., financial management). This picture consists of snapshots of both  the enterprise’s current “As Is” operational and technological environment  and its target or “To Be” environment. A transition plan should provide the  capital investment roadmap for transitioning from the current to the target  environment by describing how and when new business systems will be  developed and implemented. In November 2005, we reported that while  DOD had made important progress toward building a foundation upon  which to improve its business operations, it did not fully satisfy the  requirements of the Ronald W. Reagan National Defense Authorization Act  for 2005. For example, we reported that the architecture did not address  how DOD would comply with federal accounting, financial, and reporting  requirements, such as the United States Government Standard General  Ledger.
In late December 2005, DOD issued its Financial Improvement and Audit  Readiness (FIAR) Plan, a third major component of its business  transformation strategy. According to DOD briefings, the “purpose of the  FIAR Plan is to provide a roadmap to guide the department in improving  financial management and achieving a clean audit opinion.” Similar to an  earlier DOD improvement effort, the Financial Improvement Initiative, the  FIAR Plan utilizes an incremental approach to structure its process for  examining its operations, diagnosing problems, planning corrective  actions, and preparing for audit. However, unlike the previous plan, the  FIAR Plan does not establish an overall goal of achieving a clean audit  opinion on its departmentwide financial statements by a specific date.  Rather, the FIAR Plan appears to recognize that it will take several years  before DOD is able to implement the systems, processes, and other  changes necessary to fully address its financial management weaknesses.  In the interim, DOD plans to focus its initial efforts on four areas:   (1) military equipment, (2) real property, (3) military retiree eligible health  care fund liabilities, and (4) environmental liabilities. The FIAR Plan also  focuses on the U.S. Marine Corps and the U.S. Army Corps of Engineers,  Civil Works because these organizations intend to be ready for audit in  fiscal years 2007 and 2008, respectively. As the FIAR Plan evolves, DOD  intends to refine or include additional goals to improve processes and  systems related to other balance sheet line items and financial statements.
There will need to be ongoing and sustained top management attention to  business transformation at DOD to address what are some of the most  difficult financial management challenges in the federal government. As  we noted in our November 2005 testimony, we continue to believe that  the implementation of a new Chief Management Officer position at DOD  will be needed in order for the department to succeed in its overall  business transformation strategy. We will continue to monitor DOD’s  efforts to transform its business operations and address its financial  management deficiencies as part of our continuing DOD business  enterprise architecture work and our oversight of DOD’s financial  statement audit.
section_title: Intragovernmental Activity and Balances
paragraphs: Federal agencies are unable to adequately account for and reconcile  intragovernmental activity and balances. OMB and Treasury require the  CFOs of 35 executive departments and agencies to reconcile, on a  quarterly basis, selected intragovernmental activity and balances with  their trading partners. In addition, these agencies are required to report  to Treasury, the agency’s inspector general, and GAO on the extent and  results of intragovernmental activity and balances reconciliation efforts as  of the end of the fiscal year.
A substantial number of the agencies did not fully perform the required  reconciliations for fiscal years 2005 and 2004. For fiscal year 2005, based  on trading partner information provided in the Governmentwide Financial  Reporting System discussed below, Treasury produced a “Material  Difference Report” for each agency showing amounts for certain  intragovernmental activity and balances that significantly differed from  those of its corresponding trading partners. After analysis of the fiscal year  2005 “Material Difference Reports”, we noted a significant number of  CFOs were still unable to explain their material differences with their  trading partners. For both fiscal years 2005 and 2004, amounts reported by  federal agency trading partners for certain intragovernmental accounts  were significantly out of balance. As a result, the federal government’s  ability to determine the impact of these differences on the amounts  reported in the consolidated financial statements is impaired. Resolving  the intragovernmental transactions problem remains a difficult challenge  and will require a commitment by federal agencies and strong leadership  and oversight by OMB.
section_title: Preparing the Consolidated Financial Statements
paragraphs: The federal government continued to have inadequate systems, controls,  and procedures to ensure that the consolidated financial statements are  consistent with the underlying audited agency financial statements,  balanced, and in conformity with GAAP. During fiscal year 2005, Treasury  continued the ongoing development of a new system, the Governmentwide  Financial Reporting System (GFRS), to collect agency financial statement  information directly from federal agencies’ audited financial statements.  The goal of GFRS is to be able to directly link information from federal  agencies’ audited financial statements to amounts reported in the  consolidated financial statements, a concept that we strongly support, and  to resolve many of the weaknesses we have identified in the process for  preparing the consolidated financial statements. For the fiscal year 2005  reporting process, Treasury’s GFRS was able to capture certain agency  financial information from agencies’ audited financial statements, but  GFRS was still not at the stage that it could be used to fully compile the  consolidated financial statements from the information captured. Treasury  did, however, make progress in demonstrating that amounts in the  consolidated Balance Sheet and Statement of Net Cost were consistent  with federal agencies’ audited financial statements prior to eliminating  intragovernmental activity and balances.
section_title: Closing Comments
paragraphs: In closing, given the federal government’s overall financial condition and  long-term fiscal imbalance, the need for the Congress and the President to  have timely, reliable, and useful financial and performance information is  greater than ever. Sound decisions on the current results and future  direction of vital federal government programs and policies are made  more difficult without such information. Until the problems discussed in  our audit report are adequately addressed, they will continue to have  adverse implications for the federal government and the taxpayers. It will  also be key that the appropriations, budget, authorizing, and oversight  committees hold agency top leadership accountable for resolving these  problems and that they support improvement efforts.
Addressing the nation’s long-term fiscal imbalance constitutes a major  transformational challenge that may take a generation or more to resolve.
Given the size of the projected deficit, the U.S. government will not be able  to grow its way out of this problem—tough choices will be required.
Traditional incremental approaches to budgeting will need to give way to  more fundamental and periodic reexaminations of the base of government.  Our report, 21st Century Challenges: Reexamining the Base of the  Federal Government, is intended to support the Congress in identifying  issues and options that could help address these fiscal pressures.
Further, the Congress needs to have access to the long-term cost of  selected spending and tax proposals before they enact related laws. The  fiscal risks previously mentioned can be managed only if they are properly  accounted for and publicly disclosed, including the many existing  commitments facing the federal government. New reporting approaches,  as well as enhanced budget processes and control mechanisms, are  needed to better understand, monitor, and manage the impact of spending  and tax policies over the long term. In addition, a set of key national,  outcome-based performance metrics would inform strategic planning,  enhance performance and accountability reporting, and help to assess the  impact of various spending programs and tax policies.
Mr. Chairman, this concludes my prepared statement. I would be pleased  to respond to any questions that you or other members of the  subcommittee may have at this time.
section_title: GAO Contacts
paragraphs: For further information regarding this testimony, please contact Jeffrey C.  Steinhoff, Managing Director, and Gary T. Engel, Director, Financial  Management and Assurance, at (202) 512-2600.
section_title: Appendix I: Material Deficiencies
subsections: section_title: Material Deficiencies
paragraphs: The continuing material deficiencies discussed below contributed to our  disclaimer of opinion on the federal government’s consolidated financial  statements for fiscal years 2005 and 2004. The federal government did not  maintain adequate systems or have sufficient, reliable evidence to support  information reported in the consolidated financial statements, as  described below.
section_title: Property, Plant, and Equipment and Inventories and Related Property
paragraphs: The federal government could not satisfactorily determine that property,  plant, and equipment (PP&E) and inventories and related property were  properly reported in the consolidated financial statements. Most of the  PP&E and inventories and related property are the responsibility of the  Department of Defense (DOD). As in past years, DOD did not maintain  adequate systems or have sufficient records to provide reliable  information on these assets. Other agencies, most notably the National  Aeronautics and Space Administration, reported continued weaknesses in  internal control procedures and processes related to PP&E.
Without reliable asset information, the federal government does not fully  know the assets it owns and their location and condition and cannot  effectively (1) safeguard assets from physical deterioration, theft, or loss;  (2) account for acquisitions and disposals of such assets; (3) ensure that  the assets are available for use when needed; (4) prevent unnecessary  storage and maintenance costs or purchase of assets already on hand; and  (5) determine the full costs of programs that use these assets.
section_title: Liabilities and Commitments and Contingencies
paragraphs: The federal government could not reasonably estimate or adequately  support amounts reported for certain liabilities. For example, DOD was  not able to estimate with assurance key components of its environmental  and disposal liabilities. In addition, DOD could not support a significant  amount of its estimated military postretirement health benefits liabilities  included in federal employee and veteran benefits payable. These  unsupported amounts related to the cost of direct health care provided by  DOD-managed military treatment facilities. Further, the federal  government could not determine whether commitments and  contingencies, including those related to treaties and other international  agreements entered into to further the U.S. government’s interests, were  complete and properly reported.
Problems in accounting for liabilities affect the determination of the full  cost of the federal government’s current operations and the extent of its  liabilities. Also, improperly stated environmental and disposal liabilities  and weak internal control supporting the process for their estimation  affect the federal government’s ability to determine priorities for cleanup  and disposal activities and to appropriately consider future budgetary  resources needed to carry out these activities. In addition, when  disclosures of commitments and contingencies are incomplete or  incorrect, reliable information is not available about the extent of the  federal government’s obligations.
section_title: Cost of Government Operations and Disbursement Activity
paragraphs: The previously discussed material deficiencies in reporting assets and  liabilities, material deficiencies in financial statement preparation, as  discussed below, and the lack of adequate disbursement reconciliations at  certain federal agencies affect reported net costs. As a result, the federal  government was unable to support significant portions of the total net cost  of operations, most notably related to DOD.
With respect to disbursements, DOD and certain other federal agencies  reported continued weaknesses in reconciling disbursement activity. For  fiscal years 2005 and 2004, there was unreconciled disbursement activity,  including unreconciled differences between federal agencies’ and the  Department of the Treasury’s records of disbursements and unsupported  federal agency adjustments, totaling billions of dollars, which could also  affect the balance sheet.
Unreliable cost information affects the federal government’s ability to  control and reduce costs, assess performance, evaluate programs, and set  fees to recover costs where required. Improperly recorded disbursements  could result in misstatements in the financial statements and in certain  data provided by federal agencies for inclusion in the President’s budget  concerning obligations and outlays.
section_title: Accounting for and Reconciliation of Intragovernmental Activity and Balances
paragraphs: Federal agencies are unable to adequately account for and reconcile  intragovernmental activity and balances. The Office of Management and  Budget (OMB) and Treasury require the Chief Financial Officers (CFO) of  35 executive departments and agencies to reconcile, on a quarterly basis,  selected intragovernmental activity and balances with their trading  partners. In addition, these agencies are required to report to Treasury,  the agency’s inspector general, and GAO on the extent and results of  intragovernmental activity and balances reconciliation efforts as of the  end of the fiscal year.
A substantial number of the agencies did not fully perform the required  reconciliations for fiscal years 2005 and 2004. For these fiscal years, based  on trading partner information provided in the Governmentwide Financial  Reporting System (GFRS), Treasury produced a “Material Difference  Report” for each agency showing amounts for certain intragovernmental  activity and balances that significantly differed from those of its  corresponding trading partners. After analysis of the “Material Difference  Reports” for fiscal year 2005, we noted a significant number of CFOs were  still unable to explain the differences with their trading partners. For both  fiscal years 2005 and 2004, amounts reported by federal agency trading  partners for certain intragovernmental accounts were significantly out of  balance. In addition, about 25 percent of the significant federal agencies  reported internal control weaknesses regarding reconciliations of  intragovernmental activity and balances. As a result, the federal  government’s ability to determine the impact of these differences on the  amounts reported in the consolidated financial statements is impaired.
section_title: Preparation of Consolidated Financial Statements
paragraphs: Fiscal year 2005 was the second year that Treasury used its GFRS to  collect agency financial statement information taken directly from federal  agencies’ audited financial statements. The goal of GFRS is to be able to  directly link information from federal agencies’ audited financial  statements to amounts reported in the U.S. government’s consolidated  financial statements and resolve many of the weaknesses we previously  identified in the process for preparing the consolidated financial  statements. For both the fiscal year 2005 and 2004 reporting processes,  GFRS was able to capture agency financial information, but GFRS was still  not at the stage that it could be used to fully compile the consolidated  financial statements from the information captured. Therefore, for fiscal  year 2005 Treasury continued to primarily use manual procedures to  prepare the consolidated financial statements. As discussed in the scope  limitations section of our audit report, Treasury could not produce the  fiscal year 2005 consolidated financial statements and supporting  documentation in time for us to complete all of our planned auditing  procedures. In addition, the federal government continued to have  inadequate systems, controls, and procedures to ensure that the  consolidated financial statements are consistent with the underlying  audited agency financial statements, balanced, and in conformity with U.S.  generally accepted accounting principles (GAAP). Specifically, during our  fiscal year 2005 audit, we found the following  Treasury’s process for compiling the consolidated financial statements did  not ensure that the information in all of the five principal financial  statements and notes was fully consistent with the underlying information  in federal agencies’ audited financial statements and other financial data.  Treasury made progress in demonstrating amounts in the Balance Sheet  and the Statement of Net Cost were consistent with federal agencies’  audited financial statements prior to eliminating intragovernmental  activity and balances. However, about 25 percent of the significant federal  agencies’ auditors reported internal control weaknesses related to the  processes the agencies perform to provide financial statement information  to Treasury for preparing the consolidated financial statements.
To make the fiscal years 2005 and 2004 consolidated financial statements  balance, Treasury recorded a net $4.3 billion decrease and a net $3.4  billion increase, respectively, to net operating cost on the Statements of  Operations and Changes in Net Position, which it labeled “Unreconciled  Transactions Affecting the Change in Net Position.” An additional net $3.2  billion and $1.2 billion of unreconciled transactions were recorded in the  Statement of Net Cost for fiscal years 2005 and 2004, respectively.  Treasury is unable to fully identify and quantify all components of these  unreconciled activities.
The federal government did not have an adequate process to identify and  report items needed to reconcile the operating results, which for fiscal  year 2005 showed a net operating cost of $760 billion, to the budget  results, which for the same period showed a unified budget deficit of  $318.5 billion. In addition, a net $13.2 billion “net amount of all other  differences” was needed to force this statement into balance.
Treasury’s ability to eliminate certain intragovernmental activity and  balances continues to be impaired by the federal agencies’ problems in  handling their intragovernmental transactions. As discussed above,  amounts reported for federal agency trading partners for certain  intragovernmental accounts were significantly out of balance, resulting in  the need for unsupported intragovernmental elimination entries in order to  force the Statement of Operations and Changes in Net Position into  balance. In addition, significant differences in other intragovernmental  accounts, primarily related to transactions with the General Fund, have  not been reconciled and still remain unresolved. Therefore, the federal  government continues to be unable to determine the impact of  unreconciled intragovernmental activity and balances on the consolidated  financial statements.
Treasury lacked a process to ensure that fiscal years 2005 and 2004  consolidated financial statements and notes were comparable. Certain  information reported for fiscal 2004 may require reclassification to be  comparable to the fiscal year 2005 amounts. However, Treasury did not  analyze this information or reclassify amounts within various financial  statement line items and notes to enhance comparability. For example, the  Reconciliations of Net Operating Cost and Unified Budget Deficit showed  $47.8 billion and $.2 billion for property, plant, and equipment disposals  and revaluations for fiscal years 2005 and 2004, respectively. However,  based on the financial information provided by agencies to Treasury in  GFRS, the fiscal year 2004 amount would be $25.4 billion. The difference  would be reclassified from the net amount of all other differences line item  on the Reconciliations of Net Operating Cost and Unified Budget Deficit.
Treasury did not have an adequate process to ensure that the financial  statements, related notes, Stewardship Information, and Supplemental  Information are presented in conformity with GAAP. For example, we  found that certain financial information required by GAAP was not  disclosed in the consolidated financial statements. Treasury submitted a  proposal to the Federal Accounting Standards Advisory Board (FASAB)  seeking to amend previously issued standards and eliminate or lessen the  disclosure requirements for the consolidated financial statements so that  GAAP would no longer require certain of the information that Treasury  has not been reporting. Comments are due to the FASAB today, on an  exposure draft of a proposed FASAB standard, based on the Treasury  proposal. Treasury stated that it is waiting for FASAB approval and  issuance of this proposed standard to determine the disclosures that will  be required in future consolidated financial statements. As a result of  Treasury not providing us with adequate documentation of its rationale for  excluding the currently required information and certain of the material  deficiencies noted above, we were unable again to determine if the  missing information was material to the consolidated financial statements.
Information system weaknesses existed within the segments of GFRS that  were used during the fiscal years 2005 and 2004 reporting processes. We  found that the GFRS database (1) was not configured to prevent the  alteration of data submitted by federal agencies and (2) was used for both  production and testing during the reporting processes. Therefore,  information submitted by federal agencies within GFRS is not adequately  protected against unauthorized modification or loss. In addition, Treasury  was unable to explain why numerous GFRS users appeared to have  inappropriate access to GFRS agency information or demonstrate the  appropriate segregation of duties exist.
Although Treasury made progress in addressing them, certain other  internal control weaknesses in its process for preparing the consolidated  financial statements continued to exist and involved a lack of (1)  appropriate documentation of certain policies and procedures for  preparing the consolidated financial statements, (2) adequate supporting  documentation for certain adjustments made to the consolidated financial  statements, and (3) necessary management reviews.
The consolidated financial statements include financial information for the  executive, legislative, and judicial branches, to the extent that federal  agencies within those branches have provided Treasury such information.  However, there are undetermined amounts of assets, liabilities, costs, and  revenues that are not included, and the federal government did not  provide evidence or disclose in the consolidated financial statements that  the excluded financial information was immaterial.
Treasury did not have the infrastructure to address the magnitude of the  fiscal year 2005 financial reporting challenges it was faced with, such as an  incomplete financial reporting system, compressed time frames for  compiling the financial information, and lack of adequate internal control  over the financial statement preparation process. We found that personnel  at Treasury’s Financial Management Service had excessive workloads that  required an extraordinary amount of effort and dedication to compile the  consolidated financial statements; however, there were not enough  personnel with specialized financial reporting experience to ensure  reliable financial reporting by the reporting date.
Treasury, in coordination with OMB, had not provided us with adequate  documentation evidencing an executable plan of action and milestones for  short-term and long-range solutions for certain internal control  weaknesses we have previously reported regarding the process for  preparing the consolidated financial statements.
section_title: Net Outlays-A Component of the Budget Deficit
paragraphs: OMB Circular A-136, Financial Reporting Requirements, which  incorporated and updated OMB Bulletin No. 01-09, Form and Content of  Agency Financial Statements, states that outlays in federal agencies’  Statement of Budgetary Resources (SBR) should agree with the net  outlays reported in the Budget of the United States Government. In  addition, Statement of Federal Financial Accounting Standards No. 7,  Accounting for Revenue and Other Financing Sources and Concepts for  Reconciling Budgetary and Financial Accounting, requires explanation  of any material differences between the information required to be  disclosed (including net outlays) in the financial statements and the  amounts described as “actual” in the Budget of the United States  Government.
The federal government reported in the Statement of Changes in Cash  Balance from Unified Budget and Other Activities (Statement of Changes  in Cash Balance) and the Reconciliations of Net Operating Cost and  Unified Budget Deficit (Reconciliation Statement) budget deficits for fiscal  years 2005 and 2004 of $318.5 billion and $412.3 billion, respectively. The  budget deficit is calculated by subtracting actual budget outlays from  actual budget receipts. As we have reported since fiscal year 2003, we  found material unreconciled differences between the total net outlays  reported in selected federal agencies’ SBRs and Treasury’s central  accounting records, which it uses to prepare the Statement of Changes in  Cash Balance. Treasury’s processes for preparing the Statement of  Changes in Cash Balance do not include procedures for identifying and  resolving differences between its central accounting records and net  outlay amounts reported in agencies’ SBRs.
In fiscal year 2004, we noted reported internal control weaknesses  regarding certain agencies’ SBRs. In fiscal year 2005, several agencies’  auditors reported internal control weaknesses (1) affecting the agencies’  SBRs, and (2) relating to monitoring, accounting, and reporting of  budgetary transactions. These weaknesses could affect the reporting and  calculation of the net outlay amounts in the agencies’ SBRs. In addition,  such weaknesses transcend to agencies’ ability to also report reliable  budgetary information to Treasury and OMB and may affect the unified  budget outlays reported by Treasury in its Combined Statement of  Receipts, Outlays, and Balances, and certain amounts reported in the  Budget of the United States Government.
OMB has been working with agencies to reduce the differences between  the total net outlays reported in the federal agencies’ SBRs and the  Statement of Changes in Cash Balance. In June 2005, OMB issued its  Differences Between FY 2004 Budget Execution Reports and Financial  Statements for CFO Act Agencies report which discusses various types of  differences in federal agency financial statements and budget execution  reports, including net outlays, and makes recommendations for OMB and  federal agencies to consider in improving both sets of reports in the future.
Until the material differences between the total net outlays reported in the  federal agencies’ SBRs and the records used to prepare the Statement of  Changes in Cash Balance are timely reconciled, the effect of these  differences on the U.S. government’s consolidated financial statements  will be unknown.
section_title: Appendix II: Other Material Weaknesses
subsections: section_title: Other Material Weaknesses
paragraphs: The federal government did not maintain effective internal control over  financial reporting (including safeguarding assets) and compliance with  significant laws and regulations as of September 30, 2005. In addition to  the material deficiencies discussed in appendix I, we found the following  four other material weaknesses in internal control.
section_title: Loans Receivable and Loan Guarantee Liabilities
paragraphs: Federal agencies continue to have material weaknesses and reportable  conditions related to their lending activities. The Department of Housing  and Urban Development lacked adequate management reviews of  underlying data and cost estimation methodologies that resulted in  material errors being undetected, and significant adjustments were  needed. In addition, the Department of Education’s processes do not  provide for a robust budget-to-actual cost comparison or facilitate  assessments of the validity of its lending program cost estimates. While the  Small Business Administration made substantial progress to improve its  cost-estimation processes, additional improvements are still needed to  ensure that year-end reporting is accurate. These deficiencies plus others  at the Department of Agriculture relating to the processes and procedures  for estimating program costs continue to adversely affect the federal  government’s ability to support annual budget requests for these  programs, make future budgetary decisions, manage program costs, and  measure the performance of lending activities. Further, these weaknesses  and the complexities associated with estimating the costs of lending  activities greatly increase the risk that significant errors in agency and  governmentwide financial statements could occur and go undetected.
section_title: Improper Payments
paragraphs: While agencies have made progress in implementing processes and  controls to identify, estimate, and reduce improper payments, such  improper payments are a long-standing, widespread, and significant  problem in the federal government. The Congress acknowledged this  problem by passing the Improper Payment Information Act of 2002 (IPIA).  The IPIA requires agencies to review all programs and activities, identify  those that may be susceptible to significant improper payments, estimate  and report the annual amount of improper payments for those programs,  and implement actions to cost-effectively reduce improper payments.  Further, in fiscal year 2005, the Office of Management and Budget (OMB)  began to separately track the elimination of improper payments under the  President’s Management Agenda.
Significant challenges remain to effectively achieve the goals of the IPIA.  From our review of agencies’ fiscal year 2005 Performance and  Accountability Reports (PARs), we noted that some agencies still have not  instituted a systematic method of reviewing all programs and activities,  have not identified all programs susceptible to significant improper  payments, and/or have not annually estimated improper payments for their  high-risk programs. For example, seven major agency programs with  outlays totaling about $280 billion, including Medicaid and the Temporary  Assistance For Needy Families programs, still cannot annually estimate  improper payments, even though they were required by OMB to report  such information beginning with their fiscal year 2003 budget submissions.  In addition, two agency auditors that tested compliance with IPIA cited  agency noncompliance with the act in their annual audit reports.
Federal agencies’ estimates of improper payments, based on available  information, for fiscal year 2005 exceeded $38 billion, a net decrease of  about $7 billion, or 16 percent, from the prior year improper payment  estimate of $45 billion. This decrease was attributable to the following  factors. In fiscal year 2005, the Department of Health and Human Services  reported a $9.6 billion decrease in its Medicare program improper payment  estimate, principally due to improvements in its due diligence with  providers to ensure the necessary documentation is in place to support  payment claims. However, in fiscal year 2005, this decrease was partially  offset as a result of more programs reporting estimates of improper  payments.
section_title: Information Security
paragraphs: Although progress has been made, serious and widespread information  security control weaknesses continue to place federal assets at risk of  inadvertent or deliberate misuse, financial information at risk of  unauthorized modification or destruction, sensitive information at risk of  inappropriate disclosure, and critical operations at risk of disruption. GAO  has reported information security as a high-risk area across government  since February 1997. Such information security control weaknesses could  result in compromising the reliability and availability of data that are  recorded in or transmitted by federal financial management systems. A  primary reason for these weaknesses is that federal agencies have not yet  fully institutionalized comprehensive security management programs,  which are critical to identifying information security control weaknesses,  resolving information security problems, and managing information  security risks on an ongoing basis. The Congress has shown continuing  interest in addressing these risks, as evidenced with hearings on Federal  Information Security Management Act of 2002 implementation and  information security. In addition, the administration has taken important  actions to improve information security, such as revising agency internal  control requirements in OMB Circular A-123 and issuing extensive  guidance on information security.
section_title: Tax Collection Activities
paragraphs: Material internal control weaknesses and systems deficiencies continue to  affect the federal government’s ability to effectively manage its tax  collection activities, an issue that has been reported in our financial  statement audit reports for the past 8 years. Due to errors and delays in  recording taxpayer information, payments, and other activities, taxpayers  were not always credited for payments made on their taxes owed, which  could result in undue taxpayer burden. In addition, the federal government  did not always follow up on potential unreported or underreported taxes  and did not always pursue collection efforts against taxpayers owing taxes  to the federal government.
Weaknesses in controls over tax collection activities continue to affect the  federal government’s ability to efficiently and effectively account for and  collect revenue. Additionally, weaknesses in financial reporting of  revenues affect the federal government’s ability to make informed  decisions about collection efforts. As a result, the federal government is  vulnerable to loss of tax revenue and exposed to potentially billions of  dollars in losses due to inappropriate refund disbursements.