Fiscal Year 2010 U.S. Government Financial Statements: Federal Government Continues to Face Financial Management and Long-Term Fiscal Challenges
Released: 2011-03-09T00:00:00

Letter

Results of Our Audit of the U.S. Government’s Consolidated Financial Statements for Fiscal Years 2010 and 2009

Since the enactment of key financial management reforms in the 1990s, the federal government has made significant progress in improving financial management activities and practices. For fiscal year 2010, 20 of 24 Chief Financial Officers (CFO) Act agencies were able to attain unqualified audit opinions on their accrual-based financial statements within an accelerated reporting timeframe, up from 6 CFO Act agencies for fiscal year 1996. Also, accounting and financial reporting standards have continued to evolve to provide greater transparency and accountability over the federal government’s operations, financial condition, and fiscal outlook. Further, the preparation and audit of financial statements has identified numerous deficiencies, leading to actions to strengthen controls and systems. It is important for the individual federal departments and agencies to remain committed to maintain the progress that has been achieved in obtaining positive audit results and to build upon that progress to make needed improvements.

Although this progress is commendable, the federal government was unable to demonstrate the reliability of significant portions of the U.S. government’s accrual-based consolidated financial statements for fiscal years 2010 and 2009, principally resulting from limitations related to certain material weaknesses in internal control over financial reporting and other limitations on the scope of our work. As a result, we were unable to provide an opinion on such statements. Further, significant uncertainties (discussed in Note 26 to the consolidated financial statements), primarily related to the achievement of projected reductions in Medicare cost growth reflected in the 2010 Statement of Social Insurance, prevented us from expressing an opinion on that statement. We were, however, able to render unqualified opinions on the 2009, 2008, and 2007 Statements of Social Insurance. Given the importance of social insurance programs like Medicare and Social Security to the federal government’s long-term fiscal outlook, the Statement of Social Insurance is critical to understanding the federal government’s financial condition and fiscal sustainability.

The federal government did not maintain adequate systems or have sufficient, reliable evidence to support certain material information reported in the U.S. government’s accrual-based consolidated financial statements. The underlying material weaknesses in internal control, which generally have existed for years, contributed to our disclaimer of opinion on the U.S. government’s accrual-based consolidated financial statements for the fiscal years ended 2010 and 2009. Those material weaknesses relate to the federal government’s inability to satisfactorily determine that property, plant, and equipment and inventories and related property, primarily held by the Department of Defense (DOD), were properly reported in the accrual-based consolidated financial statements; reasonably estimate or adequately support amounts reported for certain liabilities, such as environmental and disposal liabilities, or determine whether commitments and contingencies were complete and properly reported; support significant portions of the reported total net cost of operations, most notably related to DOD, and adequately reconcile disbursement activity at certain federal entities; adequately account for and reconcile intragovernmental activity and balances between federal entities; ensure that the federal government’s accrual-based consolidated financial statements were (1) consistent with the underlying audited entities’ financial statements, (2) properly balanced, and (3) in conformity with U.S. generally accepted accounting principles (GAAP); and identify and either resolve or explain material differences between (1) certain components of the budget deficit reported in Treasury’s records that are used to prepare the Reconciliation of Net Operating Cost and Unified Budget Deficit, the Statement of Changes in Cash Balance from Unified Budget and Other Activities, and the Fiscal Projections for the U.S. Government (included in the Supplemental Information section of the Financial Report) and (2) related amounts reported in federal entities’ financial statements and underlying financial information and records.

These material weaknesses continued to (1) hamper the federal government’s ability to reliably report a significant portion of its assets, liabilities, costs, and other related information; (2) affect the federal government’s ability to reliably measure the full cost as well as the financial and nonfinancial performance of certain programs and activities; (3) impair the federal government’s ability to adequately safeguard significant assets and properly record various transactions; and (4) hinder the federal government from having reliable financial information to operate in an efficient and effective manner.

In addition to the material weaknesses that contributed to our disclaimer of opinion on the accrual-based consolidated financial statements, we found the following three other material weaknesses in internal control.

These other material weaknesses were the federal government’s inability to determine the full extent to which improper payments occur and reasonably assure that appropriate actions are taken to reduce improper payments, identify and resolve information security control deficiencies and manage information security risks on an ongoing basis, and effectively manage its tax collection activities.

Also, many of the CFO Act agencies continue to struggle with financial systems that are not integrated and do not meet the needs of management for reliable, useful, and timely financial information. Often, agencies expend major time, effort, and resources to develop financial information that their systems should be able to provide on a daily or recurring basis.

Addressing Impediments to an Opinion on the Accrual-Based Consolidated Financial Statements

Three major impediments continued to prevent us from rendering an opinion on the U.S. government’s accrual-based consolidated financial statements: (1) serious financial management problems at DOD that have prevented DOD’s financial statements from being auditable, (2) the federal government’s inability to adequately account for and reconcile intragovernmental activity and balances between federal entities, and (3) the federal government’s ineffective process for preparing the consolidated financial statements. Additional impediments, such as certain entities’ fiscal year 2010 financial statements that, as of the date of our audit report, received disclaimers of opinion or were not audited, also contributed to our inability to render an opinion on the U.S. government’s accrual-based consolidated financial statements. Extensive efforts by DOD and other entity officials and cooperative efforts between entity chief financial officers, Treasury officials, and Office of Management and Budget (OMB) officials will be needed to resolve these obstacles to achieving an opinion on the U.S. government’s accrual-based consolidated financial statements.

Improving Financial Management at DOD

Given DOD’s size and complexity, the resolution of its serious financial management problems is essential to achieving an opinion on the U.S. government’s consolidated financial statements. Reported weaknesses in DOD’s financial management and other business operations adversely affect the reliability of DOD’s financial data; the economy, efficiency, and effectiveness of its operations; and its ability to produce auditable financial statements. Several DOD business practices, including financial management, continue to be included on GAO’s list of high-risk programs designated as vulnerable to waste, fraud, abuse, and mismanagement or in need of transformation.

To transform its business operations, DOD management must have reliable financial information. Without it, DOD is severely hampered in its ability to make sound budgetary and programmatic decisions, monitor trends, make adjustments to improve performance, reduce operating costs, or maximize the use of resources.

DOD continues to take steps toward resolving the department’s long- standing financial management weaknesses. The department’s Financial Improvement and Audit Readiness (FIAR) Plan, which defines DOD’s strategy and methodology for improving financial management operations and controls, has continued to evolve and mature. DOD’s Comptroller has established two priority focus areas—first, strengthening processes, controls, and systems that produce budgetary information and support the department’s Statements of Budgetary Resources; and second, improving the accuracy and reliability of management information pertaining to mission-critical assets, including military equipment and real property, and validating improvement through existence and completeness testing. In 2010, DOD revised its FIAR strategy, governance framework, and methodology to support the DOD Comptroller’s direction and priorities.

We are supportive of this initiative and believe that a focused and consistent approach may increase DOD’s ability to demonstrate incremental progress toward auditability in the short term. Budgetary and asset-accountability information is widely used by DOD managers at all levels. As such, its reliability is vital to daily operations and management. In this regard, the U.S. Marine Corps (USMC) recently underwent an audit of its fiscal year 2010 Statement of Budgetary Resources (SBR). Although the auditors were unable to express an opinion on the USMC SBR, DOD indicated that the lessons learned from the audit will be applied to the fiscal year 2011 USMC SBR audit currently underway and shared with the other DOD components to assist them in their audit readiness efforts.

A key element of DOD’s strategy is successful implementation of Enterprise Resource Planning (ERP) systems. However, inadequate requirements management, inadequate systems testing, ineffective oversight over business system investments, and other challenges have hindered the department’s efforts to implement these systems on schedule and within budget. Effective and sustained leadership and oversight of the department’s ERP implementation will be important to ensure that these important initiatives result in the integrated capabilities needed to transform the department’s financial management and related business operations. which requires DOD’s financial statements to be validated as audit ready no later than September 30, 2017. The interim milestones shall include, for each military department and for the defense agencies and defense field activities, interim milestones for (1) achieving audit readiness for each major element of the Statement of Budgetary Resources, and (2) addressing the existence and completeness of each major category of assets, including military equipment, real property, and operating material and supplies; and examine the costs and benefits of alternative approaches to the valuation of DOD assets, select a valuation approach, and begin to prepare a business case analysis supporting the selected approach.

Important to the success of DOD’s current priorities and the FIAR program are high-quality, detailed plans, and effective implementation at all levels. Long-term, to achieve financial statement auditability and improve financial management information, it will be important that DOD establish sound strategic planning and effective implementation across the department, and at all levels, with efforts that can be sustained through leadership transitions.

We are encouraged by continuing congressional oversight of DOD’s business transformation and financial management improvement efforts and the commitment of DOD’s leaders to implementing sustained improvements in the department’s ability to produce reliable, useful, and timely information for decision making and reporting. We will continue to monitor DOD’s progress in addressing its financial management weaknesses and transforming its business operations.

Reconciling Intragovernmental Activity and Balances

Federal entities are unable to adequately account for and reconcile intragovernmental activity and balances. For both fiscal years 2010 and 2009, amounts reported by federal entity trading partners for certain intragovernmental accounts were not in agreement by significant amounts. Although OMB and Treasury require the CFOs of 35 significant federal entities to reconcile, on a quarterly basis, selected intragovernmental activity and balances with their trading partners, a substantial number of the entities did not adequately perform those reconciliations for fiscal years 2010 and 2009. As a result of these circumstances, the federal government’s ability to determine the impact of the unreconciled differences between trading partners on the amounts reported in the accrual-based consolidated financial statements is significantly impaired.

GAO has identified and reported on numerous intragovernmental activities and balances issues and has made several recommendations to Treasury and OMB to address those issues. Treasury and OMB have generally taken or plan to take actions to address these recommendations. Treasury continues to take steps to help resolve material differences in intragovernmental activity and balances. For example, during fiscal year 2010, Treasury established additional focus groups, consisting of Treasury and agency personnel, to begin identifying and resolving certain reported material differences. Resolving the intragovernmental transactions problem remains a difficult challenge and will require a strong commitment by federal entities to fully implement guidance regarding business rules for intragovernmental transactions issued by OMB and Treasury as well as continued strong leadership by OMB and Treasury.

Preparing the Consolidated Financial Statements

While further progress was demonstrated in fiscal year 2010, the federal government continued to have inadequate systems, controls, and procedures to ensure that the consolidated financial statements are consistent with the underlying audited entity financial statements, properly balanced, and in conformity with GAAP. For example, Treasury’s process did not ensure that the information in certain of the accrual-based consolidated financial statements was fully consistent with the underlying information in 35 significant federal entities’ audited financial statements and other financial data.

To make the fiscal years 2010 and 2009 consolidated financial statements balance, Treasury recorded net increases of $0.8 billion and $17.4 billion, respectively, to net operating cost on the Statement of Operations and Changes in Net Position, which it labeled “Unmatched transactions and balances.” Treasury recorded an additional net $3.8 billion and $8 billion of unmatched transactions in the Statement of Net Cost for fiscal years 2010 and 2009, respectively. Treasury is unable to fully identify and quantify all components of these unreconciled activities.

Treasury’s reporting of certain financial information required by GAAP continues to be impaired, and will remain so until federal entities, such as DOD, can provide Treasury with complete and reliable information required to be reported in the consolidated financial statements.

A detailed discussion of additional control deficiencies regarding the process for preparing the consolidated financial statements can be found on pages 240 through 243 of the Financial Report.

During fiscal year 2010, Treasury, in coordination with OMB, continued implementing corrective action plans and made progress in addressing certain internal control deficiencies we have previously reported regarding the process for preparing the consolidated financial statements. Resolving some of these internal control deficiencies will be a difficult challenge and will require a strong commitment from Treasury and OMB as they continue to execute and implement their corrective action plans.

Addressing Other Impediments

While not as significant as the major impediments noted above, financial management problems at the Department of Homeland Security (DHS) and the Department of Labor (Labor) also contributed to the disclaimer of opinion on the federal government’s accrual-based consolidated financial statements for fiscal year 2010. About $28 billion, or about 1 percent, of the federal government’s reported total assets as of September 30, 2010, and approximately $235 billion, or about 5 percent, of the federal government’s reported net cost for fiscal year 2010 relate to these two agencies. The auditors for DHS and Labor reported that they were unable to provide opinions on the financial statements because they were not able to obtain sufficient evidential support for certain amounts presented in financial statements. For example, only selected DHS financial statements were subjected to audit, and the auditors stated that DHS was unable to provide sufficient evidence to support certain financial statements balances at the Coast Guard and Transportation Security Administration; and auditors for Labor reported that the department was unable to provide sufficient support for certain accounts in Labor’s fiscal year 2010 financial statements.

The auditors for DHS and Labor made recommendations to address control deficiencies at the agencies, and management for these agencies generally expressed commitment to resolve the deficiencies. It will be important that management at each of these agencies remain committed to addressing noted control deficiencies and improving financial reporting.

Significant Uncertainties Result in Disclaimer of Opinion on 2010 Statement of Social Insurance

Because of significant uncertainties (as discussed in Note 26 to the consolidated financial statements), primarily related to the achievement of projected reductions in Medicare cost growth reflected in the 2010 Statement of Social Insurance, we were unable to, and we did not, express an opinion on the 2010 Statement of Social Insurance. The Statement of Social Insurance presents the actuarial present value of the federal government’s estimated future revenue to be received from or on behalf of participants and estimated future expenditures to be paid to or on behalf of participants, based on benefit formulas in current law and using a projection period sufficient to illustrate the long-term sustainability of the social insurance programs.

The significant uncertainties, discussed in further detail in Note 26 to the consolidated financial statements, include:  Medicare projections in the 2010 Statement of Social Insurance were based on full implementation of the provisions of the Patient Protection and Affordable Care Act (PPACA), including a significant decrease in projected Medicare costs from the 2009 Statement of Social Insurance related to (1) reductions in physician payment rates totaling 30 percent over the next 3 years and (2) productivity improvements for most other categories of Medicare providers. However, there are significant uncertainties concerning the achievement of these projected decreases in Medicare costs.  Management has noted that actual future costs for Medicare are likely to exceed those shown by the current-law projections presented in the 2010 Statement of Social Insurance due to the likelihood of modifications to the scheduled reductions. The extent to which actual future costs exceed the projected current-law amounts due to changes to the physician payments and productivity adjustments depends on both the specific changes that might be legislated and on whether legislation would include other provisions to help offset such costs.  Management has developed an illustrative alternative projection intended to provide additional context regarding the long-te rm sustainability of the Medicare program and to illustrate the uncertainties in the Statement of Social Insurance projections. The present value of future estimated expenditures in excess of future estimated revenue for Medicare, included in the illustrative alternative projection, exceeds the $22.8 trillion estimate in the 2010 Statement of Social Insurance by $12.4 trillion.

Effects of the Recent ion Economic Recess and Stabilization Efforts on the F Government’s Financial Condition

The recent economic recession and the federal government’s actions to stabilize financial markets and promote economic recovery contin significantly affect the federal government’s financial condition.

In December 2007, the United States entered what has turned out to be its deepest recession since the end of World War II. Gross domestic produ ct (GDP) fell 4.1 percent from the beginning of the recession through the second quarter of 2009, which marked the recession’s end. Since the end of the reces sion, GDP has grown slowly and unemployment remains at a high level.

As of September 30, 2010, the federal government’s actions to stabilize the financial markets and to promote economic recovery resulted in assets of over $400 billion, which is net of about $75 billion in valuation losses. In addition, the federal government reported incurring significant liabilities and related net cost resulting from these actions. Although the federal government has received positive returns from investments in certain large financial institutions, it continues to report significant costs overall related to these actions. Because the valuation of the related assets and liabilities is based on assumptions and estimates that are inherently subject to substantial uncertainty arising from the uniqueness of certain transactions and the likelihood of future changes in general economic, regulatory, and market conditions, actual results may be materially different from the reported amounts.

Actions taken to stabilize financial markets—including aid to the automotive industry—increased borrowing and added to federal debt hel by the public. The revenue decreases and spending increases enacted in the American Recovery and Reinvestment Act of 2009 also added to borrowing and federal debt held by the public. Federal debt held by the public increased from 40 percent of GDP as of September 30, 2008, to 62 d percent as of September 30, 2010. The economic downturn and the nature and magnitude of the actions taken to stabilize the financial markets and to promote economic recovery will continue to shape federal government’s near-term budget and debt outlook. While defic its are projected to decrease as federal support for states and the financial sector winds down and the economy recovers, the increased debt and related interest costs will remain.

The ultimate cost of the federal government’s actions to stabilize the financial markets and promote economic recovery will not be known for some time as these uncertainties are resolved and further federal government actions are taken in fiscal year 2011 and later. Looking ahead, it will be important for the federal government to continue to determine the most expeditious manner in which to bring closure to its financial stabilization initiatives while optimizing its investment returns.

Long-Term Fiscal Challenges

The 2010 Financial Report includes the first sustainability statement required under new financial reporting standards. This statement presents comprehensive long-term fiscal projections for the U.S. government, expanding on similar information presented in recent years’ financial reports and consistent with the fiscal simulations that GAO has published since 1992. This enhanced reporting will hopefully increase public awareness and understanding of the long-term fiscal outlook: both its overall size and the major drivers of that outlook. Information on the imbalance between revenues and spending currently built into the structure of the budget can help stimulate public and policy debates and help policymakers make more informed decisions about the overall sustainability of government finances.

For more than a decade, GAO has been running fiscal simulations to tell more about this longer-term story. The Congressional Budget Office (CBO) has also published long-term simulations for many years.

The federal government faced large and growing structural deficits—and hence rising debt—before the instability in financial markets and the economic downturn. Under the projections included in the Financial Report and under the most recent CBO and GAO simulations using a range of assumptions, these structural deficits—driven on the spending side primarily by rising health care costs and known demographic trends—lead to continuing increases in federal debt held by the public as a share of GDP, which is unsustainable.

Closing Comments

In closing, even though progress has been made in improving federal financial management activities and practices, much work remains given the federal government’s long-term fiscal challenges and the need for the new Congress, the administration, and federal managers to have reliable, useful, and timely financial and performance information to effectively meet these challenges.

The recent economic recession and the federal government’s actions to stabilize financial markets and promote economic recovery continued to significantly affect the federal government’s financial condition. The accrual-based consolidated financial statements for fiscal year 2010 include, as they did for fiscal year 2009, substantial assets and liabilities resulting from these actions. The valuation of certain assets and liabilities is based on assumptions and estimates that are inherently subject to substantial uncertainty arising from the uniqueness of certain transactions and the likelihood of future changes in general economic, regulatory, and market conditions. As such, there will be differences between the estimated values as of September 30, 2010, and the actual results, and such differences may be material. These differences will also affect the ultimate cost of the federal government’s market stabilization and economic recovery actions. Going forward, a great amount of attention will need to continue to be devoted to ensuring (1) that sufficient internal controls and transparency are established and maintained for all financial stabilization and economic recovery initiatives; and (2) that all related financial transactions are reported on time, accurately, and completely.

Further, sound decisions on the current and future direction of all vital federal government programs and policies are more difficult without reliable, useful, and timely financial and performance information. In this regard, for DOD, the challenges are many. We are encouraged by DOD’s efforts toward addressing its long-standing financial management weaknesses and its efforts to achieve auditability. Consistent and diligent top management oversight toward achieving financial management capabilities, including audit readiness, will be critical going forward. Moreover, the civilian CFO Act agencies must continue to strive toward routinely producing not only annual financial statements that can pass the scrutiny of a financial audit, but also quarterly financial statements and other meaningful financial and performance data to help guide decision makers on a day-to-day basis. Federal entities’ improvement of financial management systems will be essential to achieve this goal.

Moreover, of utmost concern are the federal government’s long-term fiscal challenges that result from large and growing structural deficits that are driven on the spending side primarily by rising health care costs and known demographic trends. This unsustainable path must be addressed soon by policymakers.

Finally, I want to emphasize the value of sustained congressional interest in these issues, as demonstrated by this Subcommittee’s leadership. It will be key that, going forward, the appropriations, budget, authorizing, and oversight committees hold the top leadership of federal entities accountable for resolving the remaining problems and that they support improvement efforts.

Mr. Chairman and Ranking Member Towns, this concludes my prepared statement. I would be pleased to respond to any questions that you or other members of the Subcommittee may have at this time.

GAO Contacts and Acknowledgments

For further information regarding this testimony, please contact Jeanette M. Franzel, Managing Director, or Gary T. Engel, Director, Financial Management and Assurance, at (202) 512-2600. Key contributions to this testimony were also made by staff on the Consolidated Financial Statement audit team.