Internal Control: Essential for Safeguarding Assets, Compliance With Laws and Regulations, and Reliable Financial Reporting
Released: 1998-04-01T00:00:00

Letter

Internal Control: Essential for Safeguarding Assets, Compliance With Laws and Regulations, and Reliable Financial Reporting

Mr. Chairman and Members of the Subcommittee: We are pleased to be here today to discuss the subject of internal control. Its importance cannot be understated, especially in the large, complex operating environment of the federal government. Internal control is the first line of defense against fraud, waste, and abuse and helps to ensure that an entity’s mission is achieved in the most effective and efficient manner. Although the subject of internal control usually surfaces for discussion after improprieties or inefficiencies are found, good managers are always aware of and seek ways to help improve operations through effective internal control. As you requested, my testimony today will discuss the following questions: (1) What is internal control? (2) Why is it important? and (3) What happens when it breaks down?

What Is Internal Control?

“The plan of organization and methods and procedures adopted by management to ensure that resource use is consistent with laws, regulations, and policies; that resources are safeguarded against waste, loss, and misuse; and that reliable data are obtained, maintained, and fairly disclosed in reports.”

Internal control should not be looked upon as separate, specialized systems within an agency. Rather, internal control should be recognized as an integral part of each system that management uses to regulate and guide its operations. Internal control is synonymous with management control in that the broad objectives of internal control cover all aspects of agency operations. Although ultimate responsibility for good internal control rests with management, all employees have a role in the effective operation of internal control that has been set by management. to name a few) that achieve the goal. All internal controls have objectives and techniques. In practice, internal control starts with defining entitywide objectives and then more specific objectives throughout the various levels in the entity. Techniques are then implemented to achieve the objectives.

In its simplest form, internal control is practiced by citizens in the daily routine of everyday life. For example, when you leave your home and lock the door or when you lock your car at the mall or on a street, you are practicing a form of internal control. The objective is to protect your assets against undesired access, and your technique is to physically secure your assets by locks. In another routine, when you write a check, you record the check in the ledger or on your personal computer. The objective is to control the money in your checking account by knowing the balance. The technique is to document the check amount and the balance. Periodically, you compare the checking account transactions and balances you have recorded with the bank statement. Your objective is to ensure the accuracy of your records to avoid costly mistakes. Your technique is to perform the reconciliation.

These same types of concepts form the basis for internal control in business operations and the operation of government. The nature of their operations is, of course, significantly larger and more complex, as is the inherent risk of ensuring that assets are safeguarded, laws and regulations are complied with, and data used for decision-making and reporting are reliable. Focusing a discussion on objectives and techniques, the acquisition, receipt, use, and disposal of property, such as computer equipment, can illustrate the practice of internal control in the operation of government activities.

Internal control at the activity level such as procuring equipment should be preceded, at a higher organizational level, by policy and planning control objectives and control techniques that govern overall agency operations in achieving mission objectives. Examples of high-level control objectives that logically follow a pattern include the following:

The mission of the agency should be set in accordance with laws, regulations, and administration and management policy.

Agency components should be defined in accordance with the overall mission of the agency.

Missions of the agency and components should be documented and communicated to agency personnel.

Plans and budgets should be developed in accordance with the missions of the agency and its components.

Policies and procedures should be defined and communicated to achieve the objectives defined in plans and budgets.

Authorizations should be in accordance with policies and procedures.

Systems of monitoring and reporting the results of agency activities should be defined.

Transactions should be classified or coded to permit the preparation of reports to meet management’s needs and other reporting requirements.

Access to assets should be permitted only in accordance with laws, regulations, and management’s policy.

Examples of control techniques to help achieve the objectives include the following: agency and component mission statements approved by management and its legal counsel; training of personnel in mission and objectives; long and short-range plans developed related to budgets; monitoring of results against plans and budgets; policies and procedures defined and communicated to all levels of the organization and periodically reviewed and revised based on internal reviews; authorizations defined, controls set to ensure authorizations are made, and classifications of accounts set to permit the capture and reporting of data to prepare required reports; and physical restrictions on access to assets and records, and training in security provided to employees.

The policy and planning control objectives and techniques provide a framework to conduct agency operations and to account for resources and results. Without that framework, administration and legislative goals may not be achieved; laws and regulations may be violated; operations may not be effective and efficient and may be misdirected; unauthorized activities may occur; inaccurate reports to management and others may occur; fraud, waste, and abuse is more likely to occur and be concealed; assets may be stolen or lost; and ultimately the agency is in danger of not achieving its mission. intended results. The procurement and management of computer equipment is an example of such a specific activity. Objectives and techniques should be established for each activity’s specific control. As examples of control objectives, vendors should be approved in accordance with laws, regulations, and management’s policy, as should the types, quantities, and approved purchase prices of computer equipment. As examples of related control techniques, criteria for approving vendors should be established and approved vendor master files should be controlled, and the purchase governed by criteria, such as obtaining competitive bids and setting specifications of the equipment to be procured. Likewise, control objectives should be set for the receiving process. For example, only equipment that meets contract or purchase order terms should be accepted, and equipment accepted should be accurately and promptly reported. Related control techniques include (1) detailed comparison of equipment received to a copy of the purchase order, (2) prenumbered controlled receiving documents that are accounted for, and (3) maintenance of receiving logs. Throughout the purchasing and receiving of equipment there needs to be appropriate separation of duties and interface with the accounting function to achieve funds control, timely payments, and inventorying and control of equipment received.

Equipment received should be safeguarded to prevent unauthorized access and use. For example, in addition to physical security, equipment should be tagged with identification numbers and placed into inventory records. Equipment placed into service should only be issued to authorized users and records of the issuances should be maintained to achieve accountability. Further, physical inventories should be taken periodically and compared with inventory records. Differences in counts and records should be resolved in a timely manner and appropriate corrective actions taken. Also, equipment retired from use should be in accordance with management’s policies, including establishing appropriate safeguards to prevent unauthorized information that may be stored in the equipment from being disclosed. carelessness. Also, procedures whose effectiveness depends on segregation of duties can be circumvented by collusion. Similarly, management authorizations may be ineffective against errors or fraud perpetrated by management. In addition, the standard of reasonable assurance recognizes that the cost of internal control should not exceed the benefit derived. Reasonable assurance equates to a satisfactory level of confidence under given considerations of costs, benefits, and risks.

Why Is Internal Control Important?

The cost of fraud, waste, and abuse cannot always be measured in dollars and cents. Such improper activities erode public confidence in the government’s ability to efficiently and effectively manage its programs. Management at a number of federal government agencies are faced with tight budgets and fewer personnel. In such an environment, related operating factors, such as executive and middle management turnover and the diversity and complexity of government operations, can provide a fertile environment for internal control weakness and the resulting undesired consequences.

It has been almost 50 years since the Congress formally recognized the importance of internal control. The Accounting and Auditing Act of 1950 required, among other things, that agency heads establish and maintain effective internal controls over all funds, property, and other assets for which an agency is responsible. However, the ensuing years up through the 1970s saw the government experience a crisis of poor controls.

To help restore confidence in government and to improve operations, the Congress passed the Federal Managers’ Financial Integrity Act of 1982. The Integrity Act required, among other items, that we establish internal control standards that agencies are required to adhere to, the Office of Management and Budget (OMB) issue guidelines for agencies to follow in annually assessing their internal controls, agencies annually evaluate their internal controls and prepare a statement to the President and the Congress on whether their internal controls comply with the standards issued by GAO, and agency reports include material internal control weaknesses identified and plans for correcting the weaknesses.

OMB has issued agency guidance that sets forth the requirements for establishing, periodically assessing, correcting, and reporting on controls required by the Integrity Act. Regarding the identification and reporting of deficiencies, OMB’s guidance states that “a deficiency should be reported if it is or should be of interest to the next level of management. Agency employees and managers generally report deficiencies to the next supervisory level, which allows the chain of command structure to determine the relative importance of each deficiency.” The guidance further states that “a deficiency that the agency head determines to be significant enough to be reported outside the agency (i.e., included in the annual Integrity Act report to the President and the Congress) shall be considered a ’material weakness.’” The guidance encourages reporting of deficiencies by recognizing that such reporting reflects positively on the agency’s commitment to recognizing and addressing management problems and, conversely, failing to report a known deficiency reflects adversely on the agency. separation of duties between authorizing, processing, recording, and qualified and continuous supervision to ensure that control objectives are achieved; and limiting access to resources and records to authorized persons to provide accountability for the custody and use of resources.

Finally, the audit resolution standard requires managers to promptly evaluate findings, determine proper resolution, and establish corrective action or otherwise resolve audit findings. Attachment I provides a complete definition of the standards and Standards for Internal Controls in the Federal Government provides additional explanation of the standards.

Financial Officers Act report whether each agency is maintaining financial management systems that comply substantially with federal financial management systems requirements, federal accounting standards, and the government’s standard general ledger at the transaction level.

Our report, The Statutory Framework for Performance-Based Management and Accountability (GAO/AIMD-98-52, January 28, 1998) provides more detailed information on the purpose, requirements, and implementation status of these acts. In addition, that report refers to a number of other critically important statutes that address debt collection, credit reform, prompt pay, inspectors general, and information resources management. Although these acts address specific problem areas, sound internal controls are an essential factor in the success of these statutes. For example, the Results Act focuses on results through strategic and annual planning and performance reporting. Sound internal control is critical to effectively and efficiently achieving management’s plans and for obtaining accurate data to support performance measures.

What Happens When Internal Controls Are Not Effective?

Weak internal controls pose a significant risk to government agencies. History has shown that serious neglect will result in losses to the government that can total millions, and even billions, of dollars over time. As previously mentioned, the loss of confidence in government that results can be equally serious. Although examples of poor internal controls could be drawn from many federal programs, three key areas illustrate the extent of the problems—health care, banking, and property.

Health Care

The Department of Human and Human Services Inspector General reported this past year that out of $163.6 billion in processed fee-for-service payments reported by the Health Care Financing Administration (HCFA) during fiscal year 1996—the latest year for which reliable numbers were available—an estimated $23.2 billion, or about 14.6 percent of the total payments, were improper. Consequently, the Inspector General recommended that HCFA implement internal controls designed to detect and prevent improper payments to correct four weaknesses where (1) insufficient or no documentation supporting claims existed, (2) medical necessity was not established, (3) incorrect classification (called coding) of information existed, and (4) unsubstantiated/unallowable services were paid.

Banking

During the 1980s, the savings and loan industry experienced severe financial losses. Extremely high interest rates caused institutions to pay high costs for deposits and other funds while earning low yields on their long-term portfolios. Many institutions took inappropriate or risky approaches in attempting to increase their capital. These approaches included accounting methods to artificially inflate the institutions’ capital position and diversifying their investments into potentially more profitable, but riskier, activities. The profitability of many of these investments depended heavily on continued inflation in real estate values to make them economically viable. In many cases, weak internal controls at these institutions and noncompliance with laws and regulations increased the risk of these activities and contributed significantly to the ultimate failure of over 700 institutions. This crisis cost the taxpayers hundreds of billions of dollars.

Making profitable loans is the heart of a successful savings and loan institution. Boards of directors and senior management did not actively monitor the loan award and administrative processes to ensure excessive risks in making loans were not taken. In fact, excessive risk-taking in making loans was encouraged, resulting in a lack of effective monitoring of loan performance that allowed poorly performing loans to continue to deteriorate. Also, loan documentation was a frequent problem that further evidenced weak internal supervision of loan officers and created difficulties in valuing and selling loans after the institutions failed.

Property

was not made available for reuse or effectively controlled against misuse or theft.

More recently, we reported that breakdowns exist in the Department of Defense’s (DOD) ability to protect its assets from fraud, waste, and abuse. We disclosed that the Army did not have accurate records for its reported $30 billion in real property or the $8.5 billion reported as government furnished property in the hands of contractors. Further, we reported that pervasive weaknesses in DOD’s general computer controls place it at risk of improper modification; theft; inappropriate disclosure; and destruction of sensitive personnel, payroll, disbursement, or inventory information.

High-Risk Areas

Beginning in 1990, we began a special effort to review and report on the federal program areas our work had identified as high risk because of vulnerabilities to waste, fraud, abuse, and mismanagement. This effort brought a much-needed central focus on problems that were costing the government billions of dollars. Our most recent high-risk series issued focuses of six categories of high risk: (1) providing for accountability and cost-effective management of defense programs, (2) ensuring that all revenues are collected and accounted for, (3) obtaining an adequate return on multibillion dollar investments in information technology, (4) controlling fraud, waste, and abuse in benefit programs, (5) minimizing loan program losses, and (6) improving management of federal contracts at civilian agencies. See attachment II for a listing of the high-risk reports and our most recent reports and testimony on the Year 2000 computing crisis.

Conclusion

In conclusion, effective internal controls are essential to achieving agency missions and the results intended by the Congress and the administration and as reasonably expected by the taxpayers. The lack of consistently effective internal controls across government has plagued the government for decades. Legislation has been enacted to provide a framework for performance-based management and accountability. Effective internal controls are an essential component of the success of that legislation.

However, no system of internal control is perfect, and the controls may need to be revised as agency missions and service delivery change to meet new expectations. Management and employees should focus not necessarily on more controls, but on more effective controls.

Mr. Chairman, this concludes my statement. I would be happy to respond to any questions that you or other Members of the Subcommittee may have at this time.

Standards for Internal Controls in the Federal Government

Internal control standards define the minimum level of quality acceptable for internal control systems to operate and constitute the criteria against which systems are to be evaluated. These internal control standards apply to all operations and administrative functions but are not intended to limit or interfere with duly granted authority related to the development of legislation, rule making, or other discretionary policy-making in an agency.

General Standards

1. Reasonable Assurance: Internal control systems are to provide reasonable assurance that the objectives of the systems will be accomplished. 2. Supportive Attitude: Managers and employees are to maintain and demonstrate a positive and supportive attitude toward internal controls at all times. 3. Competent Personnel: Managers and employees are to have personal and professional integrity and are to maintain a level of competence that allows them to accomplish their assigned duties, and understand the importance of developing and implementing good internal controls. 4. Control Objectives: Internal control objectives are to be identified or developed for each agency activity and are to be logical, applicable, and reasonably complete. 5. Control Techniques: Internal control techniques are to be effective and efficient in accomplishing their internal control objectives.

Specific Standards

1. Documentation: Internal control systems and all transactions and other significant events are to be clearly documented, and the documentation is to be readily available for examination. 2. Recording of Transactions and Events: Transactions and other significant events are to be promptly recorded and properly classified. 3. Execution of Transactions and Events: Transactions and other significant events are to be authorized and executed only by persons acting within the scope of their authority. 4. Separation of Duties: Key duties and responsibilities in authorizing, processing, recording, and reviewing transactions should be separated among individuals. 5. Supervision: Qualified and continuous supervision is to be provided to ensure that internal control objectives are achieved. 6. Access to and Accountability for Resources: Access to resources and records is to be limited to authorized individuals, and accountability for the custody and use of resources is to be assigned and maintained. Periodic comparison shall be made of the resources with the recorded accountability to determine whether the two agree. The frequency of the comparison shall be a function of the vulnerability of the asset.

Audit Resolution Standard

Prompt Resolution of Audit Findings: Managers are to (1) promptly evaluate findings and recommendations reported by auditors, (2) determine proper actions in response to audit findings and recommendations, and (3) complete, within established time frames, all actions that correct or otherwise resolve the matters brought to management’s attention.

GAO’s February 1997 High-Risk Series Reports and Recent GAO Reports and Testimony on the Year 2000 Computing Crisis

High-Risk Series Reports

High-Risk Series: An Overview (GAO/HR-97-1, February 1997).

High-Risk Series: Quick Reference Guide (GAO/HR-97-2, February 1997).

High-Risk Series: Defense Financial Management (GAO/HR-97-3, February 1997).

High-Risk Series: Defense Contract Management (GAO/HR-97-4, February 1997).

High-Risk Series: Defense Inventory Management (GAO/HR-97-5, February 1997).

High-Risk Series: Defense Weapons Systems Acquisition (GAO/HR-97-6, February 1997).

High-Risk Series: Defense Infrastructure (GAO/HR-97-7, February 1997).

High-Risk Series: IRS Management (GAO/HR-97-8, February 1997).

High-Risk Series: Information Management and Technology (GAO/HR-97-9, February 1997).

High-Risk Series: Medicare (GAO/HR-97-10, February 1997).

High-Risk Series: Student Financial Aid (GAO/HR-97-11, February 1997).

High-Risk Series: Department of Housing and Urban Development (GAO/HR-97-12, February 1997).

High-Risk Series: Department of Energy Contract Management (GAO/HR-97-13, February 1997).

High-Risk Series: Superfund Program Management (GAO/HR-97-14, February 1997).

High-Risk Program Information on Selected High-Risk Areas (GAO/HR-97-30 May 1997).

Year 2000 Computing Crises Reports and Testimony

Year 2000 Computing Crisis: Business Continuity and Contingency Planning (GAO/ AIMD-10-1.19, Exposure Draft, March 1998).

Year 2000 Readiness: NRC’s Proposed Approach Regarding Nuclear Powerplants (GAO/AIMD-98-90R, March 6, 1998).

Year 2000 Computing Crisis: Federal Deposit Insurance Corporation’s Efforts to Ensure Bank Systems Are Year 2000 Compliant (GAO/T-AIMD-98-73, February 10, 1998).

Year 2000 Computing Crisis: FAA Must Act Quickly to Prevent Systems Failures (GAO/ T-AIMD-98-63, February 4, 1998).

FAA Computer Systems: Limited Progress on Year 2000 Issue Increases Risk Dramatically (GAO/AIMD-98-45, January 30, 1998).

Defense Computers: Air Force Needs to Strengthen Year 2000 Oversight (GAO/ AIMD-98-35, January 16, 1998).

Year 2000 Computing Crisis: Actions Needed to Address Credit Union Systems’ Year 2000 Problem (GAO/T-AIMD-98-48, January 7, 1998).

Veterans Health Administration Facility Systems: Some Progress Made In Ensuring Year 2000 Compliance, But Challenges Remain (GAO/AIMD-98-31R, November 7, 1997).

Year 2000 Computing Crisis: National Credit Union Administration’s Efforts to Ensure Credit Union Systems Are Year 2000 Compliant (GAO/T-AIMD-98-20, October 22, 1997).

Social Security Administration: Significant Progress Made in Year 2000 Effort, But Key Risks Remain (GAO/T-AIMD-98-6, October 22, 1997).

Defense Computers: Technical Support Is Key to Naval Supply Year 2000 Success (GAO/AIMD-98-7R, October 21, 1997).

Defense Computers: LSSC Needs to Confront Significant Year 2000 Issues (GAO/ AIMD-97-149, September 26, 1997).

Veterans Affairs Computer Systems: Action Underway Yet Much Work Remains To Resolve Year 2000 Compliance (GAO/T-AIMD-97-174, September 25, 1997).

Year 2000 Computing Crisis: Success Depends Upon Strong Management and Structured Approach (GAO/T-AIMD-97-173, September 25, 1997).

Year 2000 Computing Crisis: An Assessment Guide (GAO/AIMD-10.1.14, September 1997).

Defense Computers: SSG Needs to Sustain Year 2000 Progress (GAO/AIMD-97-120R, August 19, 1997).

Defense Computers: Improvements to DOD Systems Inventory Needed for Year 2000 Effort (GAO/AIMD-97-112, August 13, 1997).

Defense Computers: Issues Confronting DLA in Addressing Year 2000 Problems (GAO/AIMD-97-106, August 12, 1997).

Defense Computers: DFAS Faces Challenges in Solving the Year 2000 Problem (GAO/AIMD-97-117, August 11, 1997).

Year 2000 Computing Crisis: Time Is Running Out for Federal Agencies to Prepare for the New Millennium (GAO/T-AIMD-97-129, July 10, 1997).

Veterans Benefits Computer Systems: Uninterrupted Delivery of Benefits Depends on Timely Correction of Year-2000 Problems (GAO/T-AIMD-97-114, June 26, 1997).

Veterans Affairs Computer Systems: Risks of VBA’s Year 2000 Efforts (GAO/AIMD-97-79, May 30, 1997).

Medicare Transaction System: Success Depends Upon Correcting Critical Managerial and Technical Weaknesses (GAO/AIMD-97-78, May 16, 1997).

Medicare Transaction System: Serious Managerial and Technical Weaknesses Threaten Modernization (GAO/T-AIMD-97-91, May 16, 1997).

Year 2000 Computing Crisis: Risk of Serious Disruption to Essential Government Functions Calls for Agency Action Now (GAO/T-AIMD-97-52, February 27, 1997).

Year 2000 Computing Crisis: Strong Leadership Today Needed To Prevent Future Disruption of Government Services (GAO/T-AIMD-97-51, February 24, 1997).

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