Fiscal Year 2002 U.S. Government Financial Statements: Sustained Leadership and Oversight Needed for Effective Implementation of Financial Management Reform
Published: 2003-04-08T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: GAO is required by law to audit the consolidated financial statements of the U.S. government. Timely, accurate, and useful financial information is essential for making informed operating decisions day to day, managing the federal government's operations more efficiently and effectively, meeting the goals of federal financial management reform legislation, supporting results-oriented management approaches, and ensuring accountability on an ongoing basis. The importance of such information is heightened by the unprecedented demographic challenge of an aging population. Federal spending on the elderly, health care, and new homeland security and defense commitments increases the need to look at competing claims on the budget and at new priorities. Over the past year, the Principals of the Joint Financial Management Improvement Program continued efforts to accelerate progress in financial management reform. Also, President Bush has implemented the President's Management Agenda to provide direction to, and closely monitor, management reform across government, which encompasses improved financial management performance. To effectively implement federal financial management reform, sustained leadership and oversight are essential.
section_title: What GAO Found
paragraphs: As in the 5 previous fiscal years, the federal government continues to have a significant number of material weaknesses related to financial systems, fundamental recordkeeping and financial reporting, and incomplete documentation. Several of these material weaknesses resulted in conditions that continued to prevent us from expressing an opinion on the U.S. government's consolidated financial statements for the fiscal years ended September 30, 2002 and 2001. Three major impediments to an opinion on the consolidated financial statements are (1) serious financial management problems at DOD, (2) the federal government's inability to fully account for and reconcile billions of dollars of transactions between federal entities, and (3) the federal government's inability to properly prepare the consolidated financial statements. Federal agencies have continued to make progress in obtaining unqualified audit opinions--21 of 24 Chief Financial Officers (CFO) Act agencies for fiscal year 2002, up from 6 for fiscal year 1996. Irrespective of the unqualified opinions, many federal agencies do not have timely, accurate, and useful financial information and sound controls with which to make informed decisions and to ensure accountability on an ongoing basis. Building on the success achieved in obtaining unqualified audit opinions, federal agency management must continue to work toward fully resolving the pervasive and generally long-standing material weaknesses that have been reported for the past 6 fiscal years. The President's Management Agenda stated that without sound internal control and accurate and timely financial information, it is not possible to accomplish the President's agenda to secure the best performance and highest measure of accountability for the American people.

section_title: Letter
paragraphs: I am pleased to be here today to discuss our report on the U.S.  government’s consolidated financial statements for fiscal years 2002 and  2001.  Both the consolidated financial statements and our report are  included in the fiscal year 2002 Financial Report of the United States  Government, which was issued by the Department of the Treasury  (Treasury) on March 31, 2003, and is available through GAO’s Internet site,  at www.gao.gov, and Treasury’s Internet site, at  www.fms.treas.gov/fr/index.html.  At the outset, I would like to thank the  subcommittee for continuing an annual tradition of oversight hearings on  this important subject.  The work of the former Subcommittee on  Government Efficiency, Financial Management, and Intergovernmental  Relations, along with its leader, former Congressman Stephen Horn, has  been a catalyst to facilitate government management reform over the past 6  years.  The continued involvement of this subcommittee will be critical to  ultimately restoring public confidence in the federal government as a  financial steward that is accountable for its finances.
As in the 5 previous fiscal years, certain material weaknesses in internal  control and in accounting and reporting prevented us from being able to  provide the Congress and American citizens an opinion as to whether the  consolidated financial statements are fairly stated in conformity with U.S.  generally accepted accounting principles.  Until the problems discussed in  our report are adequately addressed, they will continue to (1) hamper the  federal government’s ability to accurately report a significant portion of its  assets, liabilities, and costs, (2) affect the federal government’s ability to  accurately measure the full cost and financial performance of certain  programs and effectively manage related operations, and (3) significantly  impair the federal government’s ability to adequately safeguard certain  significant assets and properly record various transactions.
Across government, financial management improvement initiatives are  under way that, if effectively implemented, have the potential to  appreciably improve the quality of the federal government’s financial  management and reporting. A number of federal agencies have started to  make progress in their efforts to modernize their financial management  systems and improve financial management performance as called for in  the President’s Management Agenda. For example, the Department of the  Treasury’s Internal Revenue Service (IRS) has made significant progress in  addressing its financial management weaknesses, including addressing  controls over budgetary activity and its accountability over property and  equipment. Resolving many of IRS’s most serious financial management  weaknesses—identified by GAO as a high-risk area since 1995—will require  a sustained, long-term commitment of resources, continued strong  involvement of senior IRS management, and sustained progress in systems  modernization.
This year marks the earliest that federal agencies’ audited financial  statements have ever been available.  For the first time, Chief Financial  Officers Act (CFO) Act agencies were required to combine their audited  financial statements with performance reports and deliver both to the  Office of Management and Budget (OMB) by February 1, a month earlier  than last year.  Furthermore, the Principals of the Joint Financial  Management Improvement Program (JFMIP)—the Secretary of the  Treasury, the Directors of OMB and the Office of Personnel Management  (OPM), and I, as Comptroller General of the United States—have agreed to  accelerate the agency financial statement reporting date to November 15  for fiscal year 2004.  The Social Security Administration (SSA), which has a  long-standing record of delivering its audited financial statements well  before the mandated deadline, issued its fiscal year 2002 audited financial  statements on November 19, 2002. Treasury also accelerated its time frame  and issued its fiscal year 2002 audited financial statements on November  15, 2002, which was more than 3 months earlier than for fiscal year 2001.
For fiscal year 2002, 21 of the 24 CFO Act agencies were able to attain  unqualified audit opinions on their financial statements (the appendix lists  the 24 CFO Act agencies, their audit results, and auditors), up from 6  agencies for fiscal year 1996. Also, 4 CFO Act agencies showed  improvement by receiving unqualified opinions from their auditors this  year—the Department of Education, the National Aeronautics and Space  Administration (NASA), the Federal Emergency Management Agency, and  the Department of Agriculture (USDA), which received an unqualified audit  opinion for the first time.  On the other hand, after receiving unqualified  opinions on its financial statements since fiscal year 1996, the Small  Business Administration’s (SBA) independent auditor withdrew its  unqualified audit opinions on the agency’s fiscal years 2001 and 2000  financial statements and issued disclaimers of opinion on the agency’s  fiscal years 2002 and 2001 financial statements.
Although obtaining unqualified audit opinions is important, according to  the President’s Management Agenda, “most federal agencies that obtain  clean audits only do so after making extraordinary, labor-intensive assaults  on financial records.”  Further, the President’s Management Agenda stated  that without sound internal control and accurate and timely financial  information, it is not possible to accomplish the President’s agenda to  secure the best performance and highest measure of accountability for the  American people.  It will be increasingly difficult for federal agencies to  continue to rely on significant costly and time-intensive manual efforts to  achieve or maintain unqualified opinions until automated, integrated  processes and systems are implemented that readily produce the necessary  information.  As a result, many federal agencies must accelerate their  efforts to improve underlying financial management systems and controls,  which is consistent with reaching the financial management success  measures envisioned by the JFMIP Principals and called for by the  President’s Management Agenda.
Before discussing the results of the audit of the U.S. government’s  consolidated financial statements in more detail, I would like to discuss  why sound financial management is especially necessary for the future, as  well as for today, to meet tomorrow’s fiscal needs.  I then will highlight the  major issues relating to the consolidated financial statements for fiscal  years 2002 and 2001.  I will then discuss the urgency of providing sustained  leadership and oversight for effective implementation of financial  management reform, provide my perspectives on the importance of federal  agencies’ building on the success of their unqualified audit opinions by  significantly improving underlying financial management systems, and  underscore the need to address major impediments to an opinion on the  consolidated financial statements.  Also, I will present my observations on  selected audit matters that are key to protecting the public interest.
subsections: section_title: Meeting Tomorrow’s Fiscal Needs
paragraphs: The requirement for timely, accurate, and useful financial and performance  management information is greater than ever.  The long-term fiscal  pressures created by the retirement of the baby boom generation and new  homeland security and defense commitments, including the ongoing  Operation Iraqi Freedom, sharpen the need to look at competing claims on  federal budgetary resources and new priorities.  In previous testimony, I  noted that it should be the norm to reconsider the relevance or “fit ” of any  federal program or activity in today’s world and for the future.  Such a  fundamental review is necessary both to increase fiscal flexibility and to  make government fit the modern world.  Stated differently, there is a need  to consider what the proper role of the federal government will be in the  21st century and how the government should do business in the future.   The budget and performance integration initiative undertaken as part of the  President’s Management Agenda should help provide information for use in  conducting such reviews.  OMB’s Program Assessment Rating Tool (PART)  represents a step toward more structured involvement of program and  performance analysis in the budget.  PART includes general questions on  (1) program purpose and design, (2) strategic planning, (3) program  management, and (4) program results.  It also includes a set of more  specific questions that vary according to the type of delivery mechanism or  approach the program uses.
As we look ahead, the federal government faces an unprecedented  demographic challenge.  A nation that has prided itself on its youth will  become older.  Between now and 2035, the number of people who are 65  years old or over will double.  As the share of the population over 65  climbs, federal spending on the elderly will absorb larger and ultimately  unsustainable shares of the federal budget.  Federal spending on health and  entitlement programs for the elderly is expected to surge as people live  longer and spend more time in retirement.  In addition, advances in medical  technology are likely to keep pushing up the cost of providing health care.   Moreover, the baby boomers will have left behind fewer workers to support  them in retirement, prompting a slower rate of economic growth from  which to finance these higher costs.  Absent substantive reform of related  entitlement programs and/or dramatic changes in tax or discretionary  spending policies, we will face large, escalating, and persistent deficits.
These trends have widespread implications for our society, our economy,  and the federal budget.
On March 17, 2003, the Trustees of the Social Security and Medicare trust  funds reported on the current and projected status of these programs over  the next 75 years.  The Trustees report that the fundamentals of the  financial status of both Social Security and Medicare remain highly  problematic.  However, they stated that Medicare faces financial difficulties  that are more severe than those confronting Social Security because costs  of the Medicare program are projected to rise faster than costs of the Social  Security program.  The projections show a 20 percent increase to about  $6.2 trillion over the prior year in the Present Value of Resources Needed  Over the 75-Year Projection Period for Federal Hospital Insurance  (Medicare Part A), while the Social Security projection showed an 8  percent increase to about $4.9 trillion.  Once again, the Trustees state that  action to address the financial difficulties facing Social Security and  Medicare must be taken in a timely manner and that the sooner these  financial challenges are addressed, the more varied and less disruptive the  solutions can be.
Early action to change these programs would yield the highest fiscal  dividends for the federal budget and would provide a longer period for  prospective beneficiaries to make adjustments in their own planning.   Waiting to take action entails risks.  First, we lose an important window  where today’s relatively large workforce can increase saving and enhance  productivity, two elements critical to growing the future economy.  Second,  we lose the opportunity to reduce the burden of interest in the federal  budget, thereby creating a legacy of higher debt as well as elderly  entitlement spending for the relatively smaller workforce of the future.   Third, and most critically, we risk losing the opportunity to phase in  changes gradually so that all can make the adjustments needed in private  and public plans to accommodate this historic shift.
We prepare long-term budget simulations that seek to illustrate the likely  fiscal consequences of the coming demographic tidal wave and rising  health care costs.  Our latest long-term budget simulations reinforce the  need for change in the major cost drivers—Social Security and health care  programs.  As shown in figure 1, by midcentury, absent reform of these  entitlement programs, projected federal revenues may be adequate to pay  little beyond interest on the debt and Social Security benefits.  Further, the  shift from surplus to deficit means that the nation will move into the future  in a weaker fiscal position than was previously the case.
Although the need for structural change in Social Security is widely  recognized, this change would not be sufficient to overcome the long-term  fiscal challenges confronting the nation.  For example, the long-term fiscal  imbalance would not come close to being eliminated even if Social Security  benefits were to be limited to currently projected trust fund revenues,  because Medicare and Medicaid—spending for which is driven by both  demographics and rising health care costs—present an even greater  problem.
While addressing the challenges of Social Security and Medicare is key to  ensuring future fiscal flexibility, a fundamental review of major programs,  policies, and operations can create much-needed fiscal flexibility to  address emerging needs.  As I have stated previously, it is healthy for the  nation periodically to review and update its programs, activities, and  priorities.  Many federal programs and policies were designed years ago to  respond to earlier challenges.  Ultimately, the federal government should  strive to hand to the next generation the legacy of a government that is  effective and relevant to a changing society—a government that is as free  as possible of outmoded commitments and operations that can  inappropriately encumber the future.
A reexamination of existing programs and policies could help weed out  items that have proven to be outdated or persistently ineffective or  alternatively could prompt us to update and modernize activities through  such actions as improving program targeting and efficiency, consolidation,  or reengineering of processes and operations.  Such a review should not be  limited to only spending programs but should include the full range of tools  of governance that the federal government uses to address national  objectives.  These tools include loans and loan guarantees, tax  expenditures, and regulations.
In the last decade the Congress put in place a series of laws designed to  improve information about cost and performance.  This framework and the  information it provides can help structure and inform the debate about  what the federal government should do.  In addition, GAO has identified a  number of areas warranting reconsideration based on program  performance, targeting, and costs.
The events of the past few years have served to highlight the benefits of  fiscal flexibility.  Addressing the long-term drivers in the budget is essential  to preserving any flexibility in the long term.  In the nearer term, a  fundamental review of existing programs and policies can also create  much-needed fiscal flexibility.  In this regard, the federal government must  determine how best to address the necessary structural challenges in a  reasonably timely manner in order to identify specific actions that need to  be taken.  As steward of the nation’s future, the federal government must  begin to prepare for tomorrow.
subsections: section_title: Need for New Metrics and Mechanisms
paragraphs: Today’s budget decisions shape, in part, the choices and resources  available to future decision makers and taxpayers.  Accordingly, today’s  budget decisions involve tradeoffs between meeting current needs and  fulfilling stewardship responsibilities.  The government undertakes a wide  range of responsibilities, programs, and activities that may call for future  spending or create an expectation for such spending.  Figure 2 illustrates  some of these claims on future federal resources.
A better understanding and more transparency about these “fiscal  exposures” is needed.  The budget needs to employ new metrics and  measures and processes—relying more on long-term estimates and present  value concepts in making resource allocation decisions.  Neither current  budget reporting nor financial statements are designed to promote the  recognition and explicit consideration of all of these exposures. Our  nation’s fiscal exposures cover a wide range:  from explicit liabilities to  implicit promises embedded in current policy or public expectations.   Some, like accounts payable and loan guarantees, are included in both the  budget and financial statements and some are not.  Others, such as liability  for environmental cleanup, are reported in the financial statements, but  only a single year’s figures are in the budget.  Some implicit exposures,  such as future Social Security and Medicare benefits, are not included in  the budget or reported as liabilities in the financial statements but are  captured in long-range budget projections.  Other implicit exposures, such  as the risk assumed by insurance programs, may not be captured in either  budget or financial reporting.
The failure to understand and address these fiscal exposures can have  significant consequences, encumbering future budgets and reducing fiscal  flexibility.  Further, the failure to capture the long-term costs of a proposal  or decision limits the Congress’s ability to control fiscal exposures at the  time it is being asked to make the decision.
As the figure makes clear, there is wide diversity in the nature of these  fiscal exposures.  This diversity suggests that it would be most useful to  look at different types of fiscal exposures and tailor metrics and changes to  address each type.   We recently recommended that OMB report annually  on fiscal exposures, including a concise list and description and cost  estimates where possible.   We also recommended that, where possible,  OMB report the estimated costs associated with certain exposures as a new  budget concept—“exposure level”—as a notational item in the President’s  budget.   These two steps would help alert both the public and policy  makers about the long-term implications of programs, policies and  activities.
It is important to recognize that for trust funds, greater transparency and  fuller disclosure means going beyond trust fund balances or solvency  measures. For federal trust funds the balances do not provide meaningful  information about program sustainability.  These balances do not increase  the government’s ability to meet long-term commitments.  Nor do they  necessarily represent the full future cost of existing promises. For example,  the projected exhaustion date of the Hospital Insurance (HI) Trust Fund is  a commonly used indicator of HI’s financial condition.  Under the Trustees’  2003 intermediate estimates, the HI Trust Fund is projected to exhaust its  assets in 2026.  Long before that, however, HI’s program outlays will exceed  program tax revenues.  Under the Trustees’ 2003 intermediate estimates,  this will begin in 2013.  To finance program cash deficits, HI will need to  draw on the special-issue Treasury securities acquired during the years of  cash surpluses.  For HI to “redeem” its securities, the government will need  to obtain cash through some combination of increased taxes, spending  cuts, and/or increased borrowing from the public (or, if the unified budget  is in surplus, less debt reduction than would otherwise have been the case).    HI’s negative cash flow will place increased pressure on the federal budget  to raise the resources necessary to meet the program’s ongoing costs.
Ultimately, the critical question is not how much a trust fund has in assets,  but whether the government as a whole and the economy can afford the  promised benefits now and in the future and at what cost to other claims on  available resources.  Extending a trust fund’s solvency without reforms to  make the underlying program more sustainable can create a false sense of  security and delay needed reform.  Because the balances can be  misleading, we need to reconsider how trust funds, and the nonmarketable  federal government securities contained therein, are treated in both the  budget and the federal government’s financial statements.
Today the Congress and President Bush face the challenge of sorting out  these many claims on the federal budget without the budget enforcement  mechanisms or fiscal benchmarks that guided the federal government  through the years of deficit reduction.  However, it is still the case that the  federal government needs a decision-making framework that permits it to  evaluate choices against both today’s needs and the longer-term fiscal  future that will be handed to future generations.  More complete, visible,  and transparent reporting of fiscal exposures can better position decision  makers to do this.
section_title: Highlights of Major Issues Relating to the U.S. Government’s Consolidated Financial Statements for Fiscal Years 2002 and 2001
paragraphs: As I mentioned earlier, as has been the case for the past 5 fiscal years, the  federal government continues to have a significant number of material  weaknesses related to financial systems, fundamental recordkeeping and  financial reporting, and incomplete documentation.  Several of these  material weaknesses (referred to hereafter as material deficiencies)  resulted in conditions that continued to prevent us from expressing an  opinion on the U.S. government’s consolidated financial statements for the  fiscal years ended September 30, 2002 and 2001.  There may also be  additional issues that could affect the consolidated financial statements  that have not been identified.
Major challenges include the federal government’s inability to  properly account for and report property, plant, and equipment and  inventories and related property, primarily at the Department of Defense  (DOD);  reasonably estimate or adequately support amounts reported for certain  liabilities, such as environmental and disposal liabilities and related  costs at DOD, and ensure complete and proper reporting for  commitments and contingencies;  support major portions of the total net cost of government operations,  most notably related to DOD, and ensure that all disbursements are  properly recorded;  fully account for and reconcile intragovernmental activity and balances;   properly prepare the federal government’s financial statements,  including fully ensuring that the information in the consolidated  financial statements is consistent with the underlying agency financial  statements, balancing the statements, adequately reconciling the results  of operations to budget results, and eliminating transactions between  governmental entities.
In addition, we identified material weaknesses in internal control related to  loans receivable and loan guarantee liabilities, improper payments, tax  collection activities, and information security.
I would now like to discuss in more detail the material deficiencies  identified by our work.
subsections: section_title: Property, Plant, and Equipment and Inventories and Related Property
paragraphs: The federal government could not satisfactorily determine that all such  assets were included in the consolidated financial statements, verify that  certain reported assets actually exist, or substantiate the amounts at which  they were valued.  A significant portion of the property, plant, and  equipment and the vast majority of inventories and related property are the  responsibility of DOD.  DOD did not maintain adequate systems or have  sufficient records to provide reliable information on these assets.  Other  agencies, most notably NASA, reported continued weaknesses in internal  control procedures and processes related to property, plant, and  equipment.
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, the federal  government was not able to reliably estimate key components of DOD’s  environmental and disposal liabilities and could not support its estimate of  military postretirement health benefits liabilities included in federal  employee and veteran benefits payable.  Further, the federal government  could not determine whether commitments and contingencies, including  those related to treaties and other agreements entered into to further the  U.S. government’s interest, were complete and properly reported.
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 government operations, most notably related to DOD.  As it relates to  disbursement reconciliations, some federal agencies did not adequately  reconcile disbursements to Treasury’s records of disbursements, which is  intended to be a key control to detect and correct errors and other  misstatements in financial records in a timely manner. We have seen  progress in this area over the past 6 years.  However, for fiscal years 2002  and 2001 there were unsupported adjustments and unreconciled  differences between federal agencies’ and Treasury’s records of  disbursements totaling billions of dollars.
section_title: Accounting for and Reconciliation of Intragovernmental Activity and Balances
paragraphs: OMB and Treasury require CFO Act agencies to reconcile selected  intragovernmental activity and balances with their “trading partners” and  to report on the extent and results of intragovernmental activity and  balances reconciliation efforts.  However, a substantial number of the CFO  Act agencies did not fully perform such reconciliations for fiscal years 2002  and 2001.  For both of these years, amounts reported for federal agency  trading partners for certain intragovernmental accounts were significantly  out of balance.  I will discuss these issues further later in this testimony, as  well as certain related corrective actions being taken.
section_title: Preparation of Consolidated Financial Statements
paragraphs: The federal government did not have adequate systems, controls, and  procedures to properly prepare its consolidated financial statements.   Specifically, we identified problems with compiling the consolidated  financial statements, such as adequately ensuring that the information for  each federal agency that was included in the consolidated financial  statements was consistent with the underlying agency financial statements.   In addition, we identified problems with the elimination of  intragovernmental activity and balances.  Later in this testimony, these  matters are discussed further, along with certain corrective actions being  taken.  Also, disclosure of certain financial information was not presented  in the consolidated financial statements in conformity with U.S. generally  accepted accounting principles.
section_title: Ineffective Internal Control
paragraphs: In addition to the material deficiencies noted above, we found four other  material weaknesses in internal control as of September 30, 2002:  (1)  several federal agencies continue to have significant deficiencies in the  processes and procedures used to estimate the costs of their lending  programs and value their loan receivables; (2) most federal agencies have  not estimated or reported the magnitude of improper payments in their  programs; (3) material internal control weaknesses and systems  deficiencies continue to affect the federal government’s ability to  effectively manage its tax collection activities; and (4) federal agencies  have not yet institutionalized comprehensive information security  management programs.
subsections: section_title: Loans Receivable and Loan Guarantee Liabilities
paragraphs: Prior to fiscal year 2001, we cited accounting for loans receivable and loan  guarantee liabilities as a material deficiency contributing to our disclaimer  of opinion because certain key federal credit agencies could not reliably  estimate the costs of their lending programs or determine the net loan  amounts expected to be collected.  In fiscal year 2001, due to significant  improvements at USDA, we removed this area from the list of issues  contributing to our disclaimer.  Nevertheless, several federal agencies  continue to have significant deficiencies in the processes and procedures  used to estimate the costs of their lending programs and value their loan  receivables.
In a recent report on SBA's loan asset sale program, we reviewed SBA’s  budgeting and accounting for loan sales and found that SBA incorrectly  calculated the accounting losses on the loan sales and lacked reliable  financial data to determine the overall financial impact of the sales.   Further, because SBA did not analyze the effect of loan sales on its  remaining portfolio, its reestimates of loan program costs for the budget  and financial statements may contain significant errors. In addition, SBA  could not explain significant declines in its loss allowance account for  disaster loans. SBA’s inspector general and its independent auditor agreed  with our findings, and the independent auditor withdrew its unqualified  audit opinions on SBA’s fiscal years 2001 and 2000 financial statements.   Until SBA corrects these errors and determines the cause of the precipitous  decline in the loss allowance account for disaster loans, SBA’s financial  statements cannot be relied upon. Further, the reliability of current and  future subsidy cost estimates will remain unknown. These errors and the  lack of key analyses also mean that congressional decision makers are not  receiving accurate financial data to make informed decisions about SBA’s  budget and the level of appropriations the agency should receive.
In addition, we again noted that certain other federal credit agencies  continue to require significant adjustments to the estimates of program  costs, net loan amounts to be collected, and related notes.  Auditors for  these agencies reported related material internal control weaknesses.
section_title: Improper Payments
paragraphs: Across the federal government, improper payments occur in a variety of  programs and activities, including those related to health care, contract  management, federal financial assistance, and tax refunds. Many  improper payments occur in federal programs that are administered by  entities other than the federal government.  In general, improper payments  often result from a lack of or an inadequate system of internal controls.   While estimates of improper payments disclosed in federal agency financial  statements totaled approximately $20 billion for both fiscal years 2002 and  2001, the federal government did not estimate the full extent of improper  payments.  The President’s Management Agenda includes addressing  erroneous payments (a term we consider synonymous with improper  payments) as one of the key elements for improving financial performance.
The Department of Health and Human Services (HHS) has been reporting a  national estimate of improper Medicare fee-for-service payments as part of  its annual financial statements since fiscal year 1996.  In fiscal year 2002,  HHS reported estimated improper Medicare fee-for-service payments of  approximately $13.3 billion, or about 6.3 percent of such benefits.  HHS’s  Centers for Medicare and Medicaid Services (CMS) has initiated projects to  improve the precision of Medicare fee-for-service improper payment  estimates and aid in the development of corrective actions to reduce  improper payment losses.  For example, CMS developed a comprehensive  error-testing program that will produce contractor-, provider-, and benefit- specific error rates.  These error rates can be aggregated to add greater  precision to the national Medicare fee-for-service error rate estimates.
However, most federal agencies have not estimated or reported the  magnitude of improper payments in their programs and comprehensively  addressed this issue in their annual performance plans under the  Government Performance and Results Act (GPRA) of 1993.  For example,  IRS follows up on only a portion of the suspicious Earned Income Tax  Credit (EITC) claims it identifies, although the EITC has historically been  vulnerable to high rates of invalid claims.  In February 2002, IRS estimated  that taxpayers filed returns for tax year 1999 claiming at least $8.5 billion in  invalid EITCs, of which only $1.2 billion (14 percent) either was recovered  or was expected to be recovered through compliance efforts.  Although the  full extent of refunds resulting from invalid EITCs is unknown, IRS has not  routinely estimated the potential magnitude of invalid refunds and has not  disclosed an annual estimate of improper payments in its financial reports.   As a result, the amount of improper payments included in the almost $28  billion IRS disbursed for EITCs for fiscal year 2002 is unknown.
Without systematically measuring the extent of improper payments, federal  agency management cannot determine (1) whether problems exist that  merit agency action, (2) what mitigation strategies are appropriate and the  amount to invest in them, and (3) whether efforts implemented to reduce  improper payments are successful.  OMB, which has shown leadership in  this area, now requires annual submissions on improper payments from 15  federal agencies.  Specifically, OMB requires actual and projected  information on erroneous payment rates and the status of actions taken to  reduce improper payments.  Further, the Improper Payments Information  Act of 2002 requires federal agencies to (1) annually review programs and  activities that they administer to identify those that may be susceptible to  significant improper payments, (2) estimate improper payments in  susceptible programs and activities, and (3) provide reports to the  Congress that include such information as the status of actions to reduce  improper payments for programs and activities with estimated improper  payments of $10 million or more.
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.  This situation continues to result in the need for  extensive, costly, and time-consuming ad hoc programming and analyses,  as well as material audit adjustments, to prepare basic financial  information.  As further discussed later in this testimony, this approach  cannot be used to prepare such information on a timely, routine basis to  assist in ongoing decision making.  Additionally, the severity of the system  deficiencies that give rise to the need to resort to such procedures for  financial reporting purposes, as well as deficient physical safeguards, result  in burden on taxpayers and lost revenue.
The lack of appropriate subsidiary systems to track the status of taxpayer  accounts and material weaknesses in financial reporting affect the  government’s ability to make informed decisions about collection efforts.   Due to errors and delays in recording activity in taxpayer accounts,  taxpayers were not always being credited for payments made on their tax  liabilities.  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.   This could result in billions of dollars not being collected and adversely  affect future compliance.
The federal government continues to be vulnerable to lost tax revenue due  to weaknesses in controls intended to maximize the government’s ability to  collect what is owed and to minimize the risk of payment of improper  refunds. The federal government identifies billions of dollars of potentially  underreported taxes and improper refunds each year.  However, due in  large part to perceived resource constraints, the federal government  selects only a portion of the questionable cases it identifies for follow-up  investigation and action.  In addition, the federal government often does  not initiate follow-up on the cases it selects until months after the related  tax returns have been filed and any related refunds disbursed, affecting its  chances of collecting amounts due on these cases.  Consequently, the  federal government is exposed to potentially significant losses from  reduced revenue and disbursements of improper refunds.  Finally,  continued weaknesses in physical controls over cash, checks, and sensitive  data received from taxpayers increase both the federal government’s and  the taxpayers’ exposure to losses and increases the risk of taxpayers  becoming victims of crimes committed through identity fraud.
IRS senior management continues to be committed to addressing many of  these operational and financial management issues and has made a number  of improvements to address some of these weaknesses.  Successful  implementation of long-term efforts to resolve these serious problems will  require the continued commitment of IRS management as well as  substantial resources and expertise.
section_title: Information Security Weaknesses
paragraphs: GAO has reported information security over computerized operations as a  governmentwide high-risk area since February 1997.  Information security  weaknesses are placing enormous amounts of federal government 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.  The  federal government is not in a position to estimate the full magnitude of  actual damage and loss resulting from federal information security  weaknesses because it is likely that many such incidents are either not  detected or not reported.  Although progress has been made, federal  agencies have not yet institutionalized comprehensive security  management programs, which are critical to resolving information security  problems and managing information security risk on an ongoing basis.
The information security weaknesses continue to cover the full range of  information security controls.  For example, access controls were not  effective in limiting or detecting inappropriate access to information  resources, such as ensuring that only authorized individuals can read, alter,  or delete data.  In addition, software change controls were ineffective in  ensuring that only properly authorized and tested software programs were  implemented.  Further, duties were not appropriately segregated to reduce  the risk that one individual could conduct unauthorized transactions  without being detected.  Finally, sensitive operating system software was  not adequately controlled, and adequate steps had not been taken to ensure  continuity of operations.
Through the recently enacted Federal Information Security Management  Act of 2002 (FISMA), the Congress has continued its efforts to improve  federal information security by permanently authorizing and strengthening  the information security program, evaluation, and reporting requirements  established by federal government information security reform  legislation.  This information security reform legislation has been a  significant step in improving federal agencies’ information security  programs and addressing their serious, pervasive information security  weaknesses, and, among other benefits, has increased management  attention to and accountability for information security.  FISMA will further  strengthen federal information security by requiring the National Institute  of Standards and Technology to develop mandatory minimum information  security requirements.
The administration has also taken actions to improve information security.   For example, OMB created an annual reporting process that includes  federal agency preparation of corrective action plans to track progress in  correcting identified weaknesses.  Further, in February 2003, the President  issued the National Strategy to Secure Cyberspace, which sets national  priorities for reducing threats from and vulnerabilities to cyberattacks and  improving the nation’s response to cyberincidents.
section_title: Providing Sustained Leadership and Oversight for Effective Implementation of Financial Management Reform
paragraphs: Over the past year, the JFMIP Principals continued our efforts, begun in  August 2001, to accelerate progress in financial management reform.  This  involved our personal commitment to provide the leadership necessary to  address pressing governmentwide financial management issues.  Also,  President Bush has implemented the President’s Management Agenda to  provide direction to, and to closely monitor, management reform across  government, which encompasses improved financial performance.  Actions  such as these are important elements of ensuring the government’s full and  effective implementation of the federal financial management reforms  enacted by the Congress.
subsections: section_title: The JFMIP Principals’ Initiative
paragraphs: Since August 2001, the JFMIP Principals have established an excellent  working relationship, a basis for action, and a sense of urgency through  which significant and meaningful progress can be achieved.  In fiscal year  2002, JFMIP Principals continued the series of regular, deliberative  meetings that focused on key financial management reform issues such as  defining success measures for financial management performance that  go far beyond an unqualified audit opinion on financial statements and  include measures such as financial management systems that routinely  provide timely, reliable, and useful financial information and no material  internal control weaknesses or material noncompliance with laws and  regulations and Federal Financial Management Improvement Act of  1996 (FFMIA) requirements; restructuring the Federal Accounting Standards Advisory Board’s  (FASAB) composition to enhance the independence of the Board and  increase public involvement in setting standards for federal financial  accounting and reporting;  significantly accelerating financial statement reporting to improve  timeliness for decision making and to discourage costly efforts designed  to obtain unqualified opinions on financial statements without  addressing underlying systems challenges;  establishing audit advisory committees for selected major federal   addressing difficult accounting and reporting issues, including  impediments to an audit opinion on the U.S. government's consolidated  financial statements and reporting updated social insurance financial  information in the U.S. government’s consolidated financial statements.
Continued personal involvement of the JFMIP Principals is critical to the  full and successful implementation of federal financial management reform  and to providing greater transparency and accountability in managing  federal programs and financial resources.  At the end of fiscal year 2002, I  ended my 2-year term as Chair of the JFMIP Principals, and the Chair  rotated to Office of Management and Budget Director Daniels.  I look  forward to working with the new Chair, Treasury Secretary Snow, and  Office of Personnel Management Director James in the upcoming months  to continue this important dialogue and build on the strong working  relationships that we have established.
section_title: The President’s Management Agenda
paragraphs: President Bush has established an agenda for improving the management  and performance of the federal government that targets the most apparent  deficiencies where the opportunity to improve performance is the greatest.   It is no accident that the President’s Management Agenda has a strong  correlation to GAO’s high-risk list.  This is just one example of how GAO  and OMB have worked constructively to identify key issues deserving  increased attention throughout government.  As stated in the President’s  Management Agenda—and we wholeheartedly agree—there are few items  more urgent than ensuring that the federal government is well run and  results-oriented.
The President’s Management Agenda, which is a starting point for  management reform, includes improved financial management  performance as one of the five governmentwide management goals.  Other  governmentwide initiatives of the President’s Management Agenda include  strategic management of human capital, competitive sourcing, expanded  electronic government, and budget and performance integration.
In particular, the improved financial management performance initiative is  aimed at ensuring that federal financial systems produce accurate and  timely information to support operating, budget, and policy decisions.   Also, this initiative focuses special attention on addressing erroneous  payments, credit card abuse in the federal government, and asset  management, areas for which we have reported problems and challenges.
Under the improved financial management performance initiative, agencies  are expected to improve the timeliness, enhance the usefulness, and ensure  the reliability of financial information.  The expected result is integrated  financial and performance management systems that routinely produce  information that is (1) timely, to measure and effect performance  immediately, (2) useful, to make more informed operational and investing  decisions, and (3) reliable, to ensure consistent and comparable trend  analysis over time and to facilitate better performance measurement and  decision making.  This result is a key to successfully achieving the goals set  out by the Congress in the CFO Act and other federal financial management  reform legislation.
Central to effectively addressing the federal government’s management  problems and providing a solid base for successful transformation efforts is  recognition that the five governmentwide initiatives cannot be addressed in  an isolated or piecemeal fashion from other major management challenges  and high risks facing federal agencies.  Rather, these efforts are mutually  reinforcing and must be addressed in an integrated way to ensure that they  drive a broader transformation of the cultures of federal agencies.
section_title: The Executive Branch Management Scorecard
paragraphs: The administration is using the Executive Branch Management Scorecard  to highlight federal agencies’ progress in achieving management and  performance improvements embodied in the President’s Management  Agenda.  The Executive Branch Management Scorecard grades selected  federal agencies’ performance regarding the five governmentwide  initiatives by using broad standards and a red-yellow-green coding system  to indicate the level at which agencies are meeting the standards.
In the financial management area, while recognizing the importance of  achieving an unqualified opinion from auditors on financial statements, the  scorecard focuses on the fundamental and systemic issues that must be  addressed in order to generate timely, accurate, and useful financial  information. The scorecard also measures whether agencies have any  material internal control weaknesses or material noncompliances with  laws and regulations, and whether agencies meet FFMIA requirements.   The December 31, 2002, scorecard’s results show dramatically the extent of  work remaining across government to improve financial and other  management areas.  For financial performance, most of the selected federal  agencies were scored in the red category.  This is not surprising,  considering the well-recognized need to transform financial management  and other business processes at federal agencies such as DOD, the results  of our analyses under FFMIA, and the various financial management  operations we have designated as high risk.  Some of the selected  agencies improved their scores from the initial baseline evaluation as of  September 30, 2001; however, other agencies’ scores declined, reflecting  increased challenges.
The focus that the administration’s scorecard approach brings to improving  management and performance, including financial management  performance, is certainly a step in the right direction.  The value of the  scorecard is not in the scoring per se, but in the degree to which scores  lead to sustained focus and demonstrable improvements.  This will depend  on continued efforts to assess progress and maintain accountability to  ensure that agencies are able to, in fact, improve their performance.  It will  be important that there be continuous rigor in the scoring process in order  for this approach to be credible and effective in providing the proper  incentives that produce lasting results.  Also, it is important to recognize  that many of the challenges the federal government faces, such as  improving financial management, are long-standing and complex, and will  require sustained attention.
section_title: Building on the Success of Unqualified Audit Opinions
paragraphs: Building on the success that has been achieved in obtaining unqualified  audit opinions, federal agency management must continue to work toward  fully resolving the pervasive and generally long-standing material  weaknesses that have been reported for the past 6 fiscal years. The  underlying causes of these issues are significant financial management  systems weaknesses, problems with fundamental recordkeeping and  financial reporting, incomplete documentation, and weak internal control.   In identifying improved financial management performance as one of its  five governmentwide initiatives, the President’s Management Agenda  stated that a clean (unqualified) financial audit opinion is a basic  prescription for any well-managed organization. It recognized that “most  federal agencies that obtain clean audits only do so after making  extraordinary, labor-intensive assaults on financial records.” Further, the  President’s Management Agenda stated that without sound internal control  and accurate and timely financial information, it is not possible to  accomplish the President’s agenda to secure the best performance and  highest measure of accountability for the American people.
Irrespective of the unqualified opinions on their financial statements, many  federal agencies do not have timely, accurate, and useful financial  information and sound controls with which to make informed decisions  and to ensure accountability on an ongoing basis.  While federal agencies  have continued to make progress in obtaining unqualified audit opinions on  annual financial statements, many of these opinions were obtained by  expending significant resources on extensive ad hoc procedures and  making billions of dollars in adjustments to derive the financial statements  months after the end of a fiscal year.  Several examples follow.  The need  for such resource-intensive procedures primarily results from inadequate  financial management systems.
After receiving a disclaimer of opinion for fiscal year 2001, NASA was  able to produce auditable financial statements for fiscal year 2002;  however, the auditors reported that significant weaknesses still existed  in NASA’s internal controls related to accounting for the International  Space Station and for equipment and materials held by contractors.   Because of these control weaknesses, the auditors found numerous  errors in property records and had to significantly expand the scope of  their testing.  To correct auditor-identified errors, NASA had to make  about $11 billion of adjustments to its records.  The auditors also  identified a material weakness related to NASA’s process for preparing  its financial statements and performance and accountability report.
Deficiencies included errors made in recording significant adjustments  to the statements and reports.  Auditors attributed the errors to  insufficient resources to address the volume of work needed to compile  the financial statements, lack of an integrated financial management  system, lack of understanding by NASA staff of new federal reporting  requirements, and lack of quality controls over financial reporting.
After 8 consecutive years of disclaimers of opinion, USDA received an  unqualified opinion on its fiscal year 2002 financial statements.  While  we consider this a positive step toward achieving financial  accountability, it took extraordinary efforts outside the normal business  processes by the department and its auditors, particularly at the Forest  Service.   The USDA Office of Inspector General’s transmittal letter for  the fiscal year 2002 Forest Service audit report stated that “the Forest  Service does not yet operate as an effective, sustainable, and  accountable financial management organization.  The fiscal year 2002  ending account balances were primarily derived from a 2-year audit  effort on beginning balances and numerous statistical samples of fiscal  year 2002 transactions.  As a result of these efforts, multiple adjustments  were processed to the general ledger and/or subsidiary ledgers.  For  example, the financial statement line item General Property, Plant and  Equipment, Net, was reduced by over $1 billion based on audit coverage.   The achievement of an unqualified opinion, therefore, did not  necessarily result from improvement in underlying financial  management systems, but rather as an extensive ad hoc effort.”  If USDA  is to achieve and sustain financial accountability, it must fundamentally  improve its underlying internal controls, financial management systems,  and operations to allow for the routine production of accurate, relevant,  and timely data to support program management.
Our unqualified opinions on IRS’s fiscal years 2002 and 2001 financial  statements were made possible by the extraordinary efforts of IRS  senior management and staff to develop processes to compensate for  serious internal control and systems deficiencies.  As noted earlier in  this testimony, IRS made significant progress during fiscal year 2002.   Nonetheless, it continued to require costly, resource-intensive  processes; statistical projections; external contractors; substantial  adjustments; and monumental human efforts to derive reliable year-end  balances for its financial statements. For example, IRS still does not  have a detailed record, or subsidiary ledger, for taxes receivable to allow  it to track and manage amounts due from taxpayers.  To enable it to  report a reliable taxes receivable balance in the absence of a subsidiary  ledger, IRS has, for the last 6 years, relied on a complex statistical  sampling approach that requires substantial human and financial  resources to conduct, takes months to complete, and yields tens of  billions of dollars of adjustments.  Similarly, while progress has been  made, IRS does not have an integrated property management system  that appropriately records property and equipment additions and  disposals as they occur and links costs on the accounting records to the  property records.
It will be increasingly difficult for federal agencies to continue to rely on  significant costly and time-intensive manual efforts to achieve or maintain  unqualified opinions until automated, integrated processes and systems are  implemented that readily produce the necessary information.  As a result,  many federal agencies must accelerate their efforts to improve underlying  financial management systems and controls, which is consistent with  reaching the financial management success measures envisioned by the  JFMIP Principals and called for by the President’s Management Agenda.
FFMIA requires auditors, as part of 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 (U.S. generally  accepted accounting principles), and (3) the federal government’s Standard  General Ledger (SGL) at the transaction level.  For fiscal year 2002,  auditors for 19 CFO Act agencies reported that the agencies’ financial  management systems did not comply substantially with one or more of  these three FFMIA requirements.  For the remaining 5 CFO Act agencies,  auditors provided negative assurance, meaning that nothing came to their  attention indicating that these agencies’ financial management systems did  not substantially meet FFMIA requirements. The auditors for these 5  agencies did not definitively state whether these agencies’ systems  substantially complied with FFMIA requirements, as is required under the  statute.  Meeting the requirements of FFMIA has presented long-standing,  significant challenges.  These challenges will be resolved only through  time, investment, and sustained emphasis on correcting deficiencies in  federal financial management systems.  GAO plans to report to the  Congress by October 1, 2003, on CFO Act agencies’ FFMIA implementation  for fiscal year 2002, as required by the act.
While federal agencies continue to make progress in addressing  weaknesses in their financial management systems, the serious  shortcomings reported for these systems result in the lack of reliable  financial information needed for making operating decisions day to day,  managing the federal government’s operations more efficiently and  effectively, measuring program performance, executing the budget,  maintaining accountability, and preparing financial statements.
For example, federal agency financial management systems are required to  produce information on the full cost of programs and projects.  This is not a  new expectation—the requirement for managerial cost information has  been in place for more than a decade, since 1990 under the CFO Act and  since 1998 stemming from applicable accounting standards.  Currently,  some federal agencies are only able to provide cost accounting information  at the end of the fiscal year through periodic cost surveys.  Some federal  agencies, such as the Department of the Interior’s Bureau of Land  Management, are experimenting with methods of accumulating and  assigning costs to obtain the managerial cost information needed to  enhance programs, improve processes, establish fees, develop budgets,  prepare financial reports, and report on performance. Having such  financial information is the goal of FFMIA and the CFO Act, necessary for  implementing GPRA, and critical to the transition to a more results- oriented federal government as envisioned in the President’s Management  Agenda.
To remedy financial management systems weaknesses and carry out the  President’s Management Agenda for improving financial management,  OMB, and the CFO Act agencies will need to aggressively and rigorously  collaborate. Our work to identify financial management best practices in  world-class organizations has identified key factors for successfully  modernizing financial systems, including (1) reengineering business  processes in conjunction with implementing new technology, (2)  developing systems that support the partnership between finance and  operations, and (3) translating financial data into meaningful data.  We  identified other financial management best practices as well, such as   (1) providing clear, strong executive leadership, (2) making financial  management an entitywide priority, and (3) building a culture of control  and accountability.
The size and complexity of many federal agencies and the discipline  needed to overhaul or replace their financial management systems present  a significant challenge—not simply a challenge to overcome a technical  glitch, but a demanding management challenge that requires attention from  the highest levels of the federal government along with sufficient human  capital resources to effect lasting change.  This will be a particular  challenge at the new Department of Homeland Security (DHS), where  federal agencies, many of which have ongoing challenges in their systems,  processes, or internal controls over financial information, are becoming  part of the new department. DHS, along with other federal agencies, has a  stewardship obligation to prevent fraud, waste, and abuse, to use tax  dollars appropriately, and to ensure financial accountability to the  President, the Congress, and the American people. In addition to  addressing incoming agencies’ challenges, DHS will need to focus on  building future systems as part of its enterprise architecture approach to  ensure an overarching framework for the agency’s integrated financial  management processes.  Plans must be developed and implemented to  bridge the many financial environments in which incoming agencies  currently operate to an integrated DHS system.
We recognize that it will take time, investment, and sustained emphasis on  correcting deficiencies to improve federal financial management systems  at DHS and other federal agencies to the level required by FFMIA.  The  JFMIP Principals’ leadership, commitment, and oversight will be important  to provide the needed impetus to meet this challenge.
section_title: Addressing Major Impediments to an Opinion on Consolidated Financial Statements
paragraphs: As I mentioned earlier, for the past 6 fiscal years, the federal government  has been required to prepare, and have audited, consolidated financial  statements.  Successfully meeting this requirement is tightly linked to the  requirement for the 24 CFO Act agencies to also have audited financial  statements.  This has stimulated extensive cooperative efforts and  considerable attention by agency chief financial officers, inspectors  general, Treasury and OMB officials, and GAO.  With the benefit of several  years’ experience by the federal government in having the required  financial statements subjected to audit, the time has come to focus even  more intensified attention on the most serious obstacles to achieving an  opinion on the U.S. government’s consolidated financial statements.  In this  regard, the JFMIP Principals have discussed plans and strategies for  addressing impediments to an opinion on the U.S. government’s  consolidated financial statements.  Three major impediments to an opinion  on the consolidated financial statements are (1) serious financial  management problems at DOD, (2) the federal government’s inability to  fully account for and reconcile billions of dollars of transactions between  federal entities, and (3) the federal government’s inability to properly  prepare the consolidated financial statements.
subsections: section_title: Reforming Financial Management at DOD
paragraphs: Essential to achieving an opinion on the consolidated financial statements  is resolution of the serious financial management problems at DOD, which  we have designated as high risk since 1995.  In accordance with provisions  of the National Defense Authorization Act for fiscal year 2002, DOD  reported that the department’s financial management systems were not  able to provide adequate evidence supporting material amounts in its fiscal  year 2002 financial statements.  DOD asserted that it is unable to comply  with applicable financial reporting requirements for (1) property, plant, and  equipment, (2) inventory and operating materials and supplies, (3) military  retirement health care actuarial liability, (4) environmental liabilities, (5)  intragovernmental eliminations and related accounting adjustments, and  (6) cost accounting by suborganization/responsibility segment and major  program.  Based largely on DOD’s assertion, the DOD inspector general  again disclaimed an opinion on DOD’s financial statements for fiscal year  2002 as it had for the previous 6 fiscal years.
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 DOD’s financial management systems, operations, and  internal control, including an inability to compile financial statements that  comply with generally accepted accounting principles.  The department  has made progress in a number of areas but is far from solving a range of  serious financial management problems.  Their resolution, however, is key  to having auditable consolidated financial statements because DOD had  budget authority of $385 billion for fiscal year 2002, or about 18 percent of  the entire federal budget; is accountable for a vast amount of government  assets worldwide; and incurs a substantial amount of the reported  liabilities.
DOD’s financial management deficiencies adversely affect not only the  department’s ability to prepare auditable financial statements, but also its  ability to control costs, ensure basic accountability, anticipate future costs  and claims on the budget (such as for health care, weapons systems, and  environmental liabilities), measure performance, maintain control of funds,  prevent fraud, and address pressing management issues.  For example, we  recently reported on fundamental flaws in DOD’s systems, processes, and  overall internal control environment, such as those related to  pervasive purchase and travel card breakdowns that resulted in  numerous instances of potentially fraudulent, improper, and abusive  transactions and increased DOD’s vulnerability to theft and misuse of  government property;  adjustments to DOD’s closed appropriations that resulted in about $615  million in adjustments that should not have been made, including $146  million that were illegal; and  accountability over critical items, such as chemical and biological  protective garments, that resulted in DOD’s excessing and selling  unused garment sets for about $3 each, while simultaneously procuring  hundreds of thousands of similar garment sets for over $200 per set.
As discussed in our recent reporting on the management challenges  facing the government, overhauling DOD’s financial management  operations represents a major challenge that goes far beyond financial  accounting to the very fiber of the department’s range of business  operations and management culture. In prior years, DOD expended  significant resources and made material amounts of adjustments to derive  its financial statements. However, such statements were determined to be  unauditable. In this regard, as previously mentioned, section 1008 of the  National Defense Authorization Act for fiscal year 2002 provides a  framework for redirecting the department’s resources from the preparation  and audit of financial statements to improving DOD’s financial  management systems and financial management policies, procedures, and  internal controls.  Administrations over the past 12 years have attempted to  address these problems in various ways but have largely been unsuccessful  despite good intentions and significant effort.
As we testified in March 2002 and highlighted in our more recent reports,  four underlying causes of problems have impeded past reform efforts at  DOD:   The lack of accountability and sustained top-level leadership hinders  DOD’s ability to meet its performance goals.  Major improvement  initiatives must have the direct, active support and involvement of  the Secretary and Deputy Secretary of Defense to ensure that daily  activities throughout the department remain focused on achieving  shared, agencywide outcomes and success.  Furthermore, sustaining  commitment by top leadership to performance goals is a particular  challenge for DOD because the average tenure of DOD’s top political  appointees is only 1.7 years.  Based on our survey of best practices of  world-class financial management organizations, it is clear that  strong executive leadership is essential to (1) making financial  management an entitywide priority, (2) redefining the role of finance,  (3) providing meaningful information to decision makers, and (4)  building a team of people that delivers results.
Cultural resistance to change and stovepiped operations have  impeded DOD’s ability to implement broad-based management  reforms.  We found that the effectiveness of the Defense Management  Council, established in 1997, was impaired because members were  not able to put aside their particular military services’ or DOD  agencies’ interests to focus on departmentwide approaches.  DOD’s  stovepiped approach is most evident in its current financial  management systems environment, which DOD recently estimated to  include 1,800 systems and system development projects—many of  which were developed in piecemeal fashion and evolved to  accommodate different organizations, each with its own policies and  procedures.
Lack of clear, linked goals and performance measures impedes  DOD’s ability to attain strategic goals with the risk that units are  operating autonomously, rather than collectively.  In our assessment  of DOD’s fiscal year 2000 Financial Management Improvement  Plan—its most recent plan—we found that it presented the military  services’ and DOD components’ individual improvement initiatives  but did not clearly articulate how their individual efforts would result  in a collective, integrated DOD-wide approach to financial  management improvement.  In addition, the plan did not include  performance measures to assess DOD’s progress in resolving  financial management problems.  Furthermore, while DOD plans to  invest billions of dollars in modernizing its financial management  systems, it is in the initial stages of developing an overall blueprint,  or enterprise architecture, to guide and direct these investments.
Lack of incentives to change existing “business-as-usual” processes,  systems, and structures contributes to DOD’s inability to carry out  needed fundamental reform.   Traditionally, DOD has focused more  on justifying its need for more funding and moving programs and  operations through the process than on achieving better program  outcomes.  It does not (1) reward behaviors that contribute to DOD- wide and congressional goals, (2) develop motivational incentives for  decision makers to guide them toward better program outcomes, or  (3) provide congressional focus on more results-oriented and  resource allocation decisions.
On September 10, 2001, Secretary of Defense Rumsfeld recognized the far- reaching nature of DOD’s financial management problems and announced a  broad, top-priority initiative intended to “transform the way the department  works and what it works on.”  This new broad-based business  transformation initiative, led by DOD’s Senior Executive Council and the  Business Initiative Council, incorporates a number of defense reform  initiatives begun under previous administrations but also encompasses  additional fundamental business reform proposals.  In announcing his  initiative, Secretary Rumsfeld recognized that transformation would be  difficult and expected the needed changes would take 8 or more years to  complete.  The Secretary’s initiative is consistent with the findings of an  independent study he commissioned that concluded that DOD would have  to undergo “a radical financial management transformation” and that it  would take more than a decade to achieve.  Secretary Rumsfeld recently  included improving DOD’s financial management as one of his top 10  priorities, and DOD has already taken a number of actions intended to  address its serious financial management problems. In addition, as I  previously mentioned, DOD has a major effort under way to develop a DOD  enterprise architecture that is intended to prescribe a blueprint for  operational and technological changes in its financial and related business  systems operations.  While DOD has a long way to go, its efforts over the  past year represent important progress.  The level of top leadership that  has been brought to bear on this challenge will have to be sustained with a  goal of achieving lasting improvement that truly transforms DOD’s business  systems and operations and enables the department to meet the mandate of  the CFO Act and achieve the President’s Management Agenda’s goal of  improved financial management performance.
section_title: Addressing Intragovernmental Transactions
paragraphs: OMB and Treasury require CFO Act agencies to reconcile selected  intragovernmental activity and balances with their “trading partners” and  to report on the extent and results of intragovernmental activity and  balances reconciliation efforts.  The inspectors general reviewed these  reports and communicated the results of their reviews to OMB, Treasury,  and GAO. A substantial number of the CFO Act agencies did not fully  perform the required reconciliations for fiscal years 2002 and 2001, citing  reasons such as (1) trading partners not providing needed data, (2)  limitations and incompatibility of agency and trading partner systems, and  (3) human resource issues.  For both of these years, amounts reported for  federal agency trading partners for certain intragovernmental accounts  were significantly out of balance.  In addition, significant differences in  other intragovernmental accounts, primarily related to appropriations, will  need to be resolved.
As we reported last year, the heart of the intragovernmental transactions  issue is that the federal government lacked clearly articulated business  rules for these transactions so that they would be handled consistently by  agencies. To address certain issues that contributed to the out of balance  condition for intragovernmental activity and balances, OMB has  established a set of standard business rules for governmentwide  transactions among trading partners and is requiring quarterly  reconciliations of intragovernmental activity and balances beginning in  fiscal year 2003.  For example, in accordance with one of the business  rules, beginning in fiscal year 2003 for intragovernmental investments with  Treasury’s Bureau of the Public Debt (BPD), BPD and trading partner  agencies are required to use the same method for recording amortization  on market-based notes, bonds, and zero coupon securities.  In the past,  differences in the amortization methods being used have caused out of  balance conditions for related intragovernmental activity and balances.   Resolving the intragovernmental transactions problem remains a difficult  challenge and will require a commitment by the CFO Act agencies and  continued strong leadership by OMB.
section_title: Preparing the Consolidated Financial Statements
paragraphs: The federal government did not have adequate systems, controls, and  procedures to properly prepare its consolidated financial statements, as  described below. Also, disclosure of certain financial information was not  presented in the consolidated financial statements in conformity with U.S.  generally accepted accounting principles.
subsections: section_title: Consolidated Financial Statement Compilation
paragraphs: Due to the current financial statement compilation process, the federal  government could not adequately ensure that the information for each  federal agency included in the consolidated financial statements was  consistent with the underlying agency financial statements.  This process  also requires significant human and financial resources and does not  adequately leverage the existing work and work products resulting from  federal agencies’ audited financial statements.  The problems are further  compounded by the need for broad changes in the structure of the  government’s SGL accounts and the process for maintaining the SGL.
The net position reported in the consolidated financial statements is  derived by subtracting liabilities from assets, rather than through balanced  accounting entries.  To make the fiscal years 2002 and 2001 consolidated  financial statements balance, Treasury recorded a net $17.1 billion and  $17.3 billion decrease to net operating cost, respectively, on the Statement  of Operations and Changes in Net Position, which it labeled unreconciled  transactions.  An additional net $12.5 billion and $3.9 billion of  unreconciled transactions were improperly recorded in net cost for fiscal  years 2002 and 2001, respectively.  Treasury attributes these net  unreconciled transaction amounts primarily to the federal government’s  inability to properly identify and eliminate transactions between  governmental entities, federal agency adjustments that affected net  position, and other errors. Treasury was unable to adequately identify and  explain the gross components of such amounts. Unreconciled transactions  also may exist because the federal government does not have effective  controls over reconciling net position.
The federal government did not have an adequate process to reconcile the  operating results, which for fiscal year 2002 showed a net operating cost of  $364.9 billion, to the budget results, which for the same period showed a  unified budget deficit of $157.7 billion.
Treasury is currently developing a new system and procedures to prepare  the consolidated financial statements beginning with fiscal year 2004.   These actions are intended to, among other things, directly link information  from federal agencies’ audited financial statements to amounts reported in  the consolidated financial statements and facilitate the reconciliation of net  position. Resolving the consolidated financial statement compilation  process issues will require continued strong leadership by Treasury  management.
section_title: Elimination of Intragovernmental Activity and Balances from the Consolidated Financial Statements
paragraphs: Consolidated financial statements are intended to present the results of  operations and financial position of the components that make up a  reporting entity as if the entity were a single enterprise.  When preparing  the consolidated financial statements, the preparer must eliminate  intragovernmental activity and balances between the federal agencies.   Because of federal agencies’ problems in handling their intragovernmental  transactions, Treasury’s ability to eliminate these transactions is impaired.   Significant differences reported in intragovernmental accounts, as noted  above, have been identified.  To help federal agencies better perform their  reconciliations, Treasury recently began providing agencies with detailed  trading partner information.  Intragovernmental activity and balances are  “dropped” or “offset” in the preparation of the consolidated financial  statements rather than eliminated through balanced accounting entries.   This contributes to the federal government’s inability to determine the  impact of these differences on amounts reported in the consolidated  financial statements.  The continued strong leadership of Treasury will be  important to resolving the issues surrounding the elimination of  intragovernmental activity and balances from the consolidated financial  statements.
section_title: Protecting the Public Interest
paragraphs: Two audit matters have come to the fore and are key to protecting the  public interest.  One matter involves auditors’ responsibilities for reporting  on internal control, and the other concerns auditor independence.
subsections: section_title: Auditors’ Responsibilities for Reporting on Internal Control
paragraphs: We have long believed that auditors have an important responsibility to  provide an opinion on the effectiveness of internal control over financial  reporting and compliance with laws and regulations.  Currently, this is not  required by American Institute of Certified Public Accountants (AICPA)  auditing standards or by OMB in its guidance to auditors conducting  federal agency financial statement audits.
For financial statements audits that we conduct—which include the U.S.  government’s consolidated financial statements, the financial statements of  the IRS, the Schedules of Federal Debt managed by the Bureau of the  Public Debt, and the financial statements of the Federal Deposit Insurance  Corporation Funds and numerous small entities’ operations and funds—we  issue a separate opinion on the effectiveness of internal control over  financial reporting and compliance with laws and regulations.
For years we have provided opinions on internal control effectiveness  because of the importance of internal control to protecting the public’s  interest.  Our reports have engendered major improvements in internal  control.  As you might expect, as part of the annual audit of our own  financial statements, we practice what we recommend to others and  contract with an independent public accounting firm for both an opinion on  our financial statements and an opinion on the effectiveness of our internal  control over financial reporting and compliance with laws and regulations.
Although OMB requires testing of these internal controls, auditors are not  required to provide an opinion on internal control effectiveness.  However,  we found that 3 of the 24 CFO Act agency auditors (those for the General  Services Administration, SSA, and the Nuclear Regulatory Commission)  provided an opinion on the effectiveness of internal control as of  September 30, 2002.  Our hope is that all CFO Act agencies and the new  DHS will follow suit in future years.  In this regard, last year, in response to  major breakdowns in corporate accountability, auditing, and corporate  governance in the private sector, the Congress passed the Sarbanes-Oxley  Act of 2002 to, among other things, improve quality and transparency in  financial reporting and independent audits of publicly traded companies  (“issuers”).  In the area of internal control reporting, issuers are required to  establish and maintain adequate internal control structure and procedures  for financial reporting and include in the annual report a statement of  management’s responsibility for and management’s assessment of the  effectiveness of those controls and procedures.  In addition, an issuer’s  auditor is required to attest to, and report on, the assessment made by the  management of the issuer on the effectiveness of internal control over  financial reporting.  In other words, an issuer’s auditor will provide an  attestation, or opinion, on management’s assertions about the effectiveness  of internal controls over financial reporting.   “Internal controls and procedures for financial reporting” is generally  defined as controls that pertain to the preparation of external financial  statements that are fairly presented in conformity with generally accepted  accounting principles.  Specifically, controls over financial reporting  include the objectives of ensuring that transactions are properly recorded,  processed, and summarized to permit the preparation of financial  statements in conformity generally accepted accounting principles.
GAO strongly believes that auditor reporting on internal control is a critical  component of monitoring the effectiveness of an organization’s internal  control and accountability.  By giving assurance about internal control,  auditors of federal financial statements can better serve their clients and  other financial statements users and better protect the public interest by  having a greater role in providing assurances of the effectiveness of  internal control in deterring fraudulent financial reporting, protecting  assets, and providing an early warning of internal control weaknesses.
section_title: Auditor Independence and Government Auditing Standards
paragraphs: The independence of auditors—both in fact and appearance—is critical to  the credibility of financial reporting.  Auditors have the capability of  performing a range of valuable services for their clients, and providing  certain nonaudit services can ultimately be beneficial to federal entities.   However, in some circumstances, it is not appropriate for auditors to  perform both audit and certain nonaudit services for the same client.  In  these circumstances, the auditor, the client, or both will have to make a  choice as to which of these services the auditor will provide.
These concepts, which I continue to strongly believe are in the public  interest, were reflected in the revisions to auditor independence  requirements for government audits, which GAO issued last year as part  of Government Auditing Standards.  The standard, among other things,  strengthens the rules associated with providing nonaudit services and  includes a principle-based approach to addressing this issue, supplemented  with certain safeguards.  The two overarching principles in the standard for  nonaudit services are that   auditors should not perform management functions or make   auditors should not audit their own work or provide nonaudit services  in situations where the amounts or services involved are significant or  material to the subject matter of the audit.
In making judgments on independence under Government Auditing  Standards and applying the independence standard’s principles and  safeguards, audit organizations should take a “substance over form”  approach and consider the nature and significance of the services provided  to the audited entity—the facts and circumstances.  Before an audit  organization agrees to perform nonaudit services, it should carefully  consider the need to avoid situations that could lead reasonable third  parties with knowledge of the facts and circumstances to conclude that the  auditor is not able to maintain independence in conducting audits.  It is  imperative that auditors always be viewed as independent in fact and  appearance.
Understandably, GAO received many inquiries about the new independence  standard due to its significant effect on auditors in connection with audits  of those who are required to use or have adopted the use of Government  Auditing Standards.  Working with the Comptroller General’s Advisory  Council on Government Auditing Standards and other interested parties,  we issued further guidance in the form of questions and answers related to  the independence standard’s implementation time frame, underlying  concepts, and application in specific nonaudit circumstances.
The independence standard and the recently issued question and answer  document are the initial steps in GAO’s continuing efforts to enhance  Government Auditing Standards and educate auditors on revisions to  these standards and on implementation issues surrounding the  independence standard.  Within the next several months, GAO will issue  revisions to Government Auditing Standards to help ensure that the  standards continue to meet the needs of the audit community and the  public it serves.  The revision will expand and change (1) the types of  audits and services that can be performed under the standards and (2) the  application of the standards, where relevant, to be consistent with the  various types of audits.  Changes are also being made to enhance the  understandability of the standards.  To educate the audit community about  the revised standards as well as the independence standard, GAO  continues to provide many presentations to government auditors and  private practitioners, in addition to answering hundreds of questions  regarding implementation issues.
section_title: Closing Comments
paragraphs: Our report on the U.S. government’s consolidated financial statements for  fiscal years 2002 and 2001 highlights the need to continue addressing the  government’s serious financial management weaknesses.  Looking beyond  current progress by federal agencies in attaining unqualified opinions on  financial statements, it will be essential for the federal government to begin  moving away from the extraordinary efforts many federal agencies  continue to use to prepare financial statements and toward giving  prominence to strengthening the government’s financial systems, reporting,  and controls.  This approach becomes even more critical as the federal  government progresses to an accelerated financial statement reporting  time frame, and it is the only way the government can meet the end goal of  making timely, accurate, and useful financial information routinely  available to the Congress, other policymakers, and the American public.
The requirement for timely, accurate, and useful financial and performance  management information is greater than ever, as the Congress and the  administration prepare to meet tomorrow’s fiscal challenges.  This type of  financial information is central to managing the federal government’s  operations more efficiently, effectively, and economically and in supporting  GPRA.  Moreover, meaningful financial and performance information can  form the basis for reconsidering the relevance or “fit” of any federal  program or activity in today’s world and for the future.
In closing Mr. Chairman, I want to underscore the importance of the  additional impetus provided by President Bush through his President’s  Management Agenda and the Executive Branch Management Scorecard for  coming to grips with federal financial management problems, indeed  management problems across the board. Regarding DOD in particular,  Secretary of Defense Rumsfeld’s vision and approach for transforming the  department’s full range of business processes is serious and encouraging.   These efforts will be key to fulfilling the President’s Management Agenda  and addressing the largest obstacle to an opinion on the U.S. government’s  consolidated financial statements.  The cooperative efforts spearheaded by  the JFMIP Principals have been most encouraging in developing the short-  and long-term strategies and plans necessary to address many of the  problems I have discussed this morning.  In addition, GAO has probably  never had a better working relationship with OMB and cabinet level and  other key officials on a range of “good government issues” that are of  critical importance and are inherently non-partisan in nature.  While these  and other factors provide an enhanced likelihood for success, in the end it  is results that count.
Finally, I want to reiterate the value of sustained congressional interest in  these issues, as demonstrated by this hearing and those the former  Subcommittee on Government Efficiency, Financial Management, and  Intergovernmental Relations held over the past several years to oversee  financial management reform.  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.
section_title: 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: CFO Act Agencies: Fiscal Year 2002 Audit Results, Principal Auditors, and Number of Other Audit Contractors
paragraphs: R. Navarro & Associates, Inc.