IRS’ mission is to provide taxpayers with top-quality service by helping them to understand and meet their tax responsibilities and by applying the tax law with integrity and fairness. In fiscal year 2000, IRS collected over $2 trillion in tax revenue, issued about $194 billion in tax refunds, and had net taxes receivable at year-end of $22 billion. Although most of the revenue was collected by intermediaries such as financial depository institutions and transferred directly to the Department of the Treasury’s general fund, IRS offices and lockbox banks collected $435 billion in fiscal year 2000. IRS has 10 campuses nationwide that have collection, refund, and enforcement responsibilities. IRS also has other field offices to assist taxpayers and perform collection and enforcement activities. Ten commercial lockbox banks also receive and process taxpayer receipts, then forward the data to IRS for input and processing. In response to congressional concerns as embodied in the Internal Revenue Service Restructuring and Reform Act of 1998, IRS instituted a reorganization that has significantly affected the roles and responsibilities of its offices. Fiscal year 2000 marked the first time IRS was able to produce combined financial statements covering its tax custodial and administrative activities that were fairly stated in all material aspects. This achievement required extraordinary human effort and extensive reliance on compensating processes to work around IRS’ serious system and control weaknesses to derive reliable year-end balances for its financial statements. However, this approach does not fix its fundamental weaknesses nor produce the reliable, useful, and timely financial and performance information IRS needs for ongoing decision-making consistent with the CFO Act of 1990. The objectives of this report are to (1) provide a status of previously reported internal control and compliance issues and related recommendations and (2) present new issues identified during our audit of IRS’ fiscal year 2000 financial statements along with new recommendations. Appendix I provides further details on our scope and methodology. We performed our work from April 2000 through February 2001 in accordance with U.S. generally accepted government auditing standards. During fiscal year 2000, IRS continued to have serious internal control deficiencies that affected its reporting and management of unpaid assessments. IRS’ lack of an appropriate general ledger system prevented it from properly and routinely classifying unpaid assessments without substantial use of specialized computer programs and manual intervention. Additionally, significant delays and errors in recording taxpayer payments and other information adversely affected the accuracy of taxpayer accounts and thus IRS’ ability to ensure taxpayers were not unduly harmed or burdened. Also, the lack of valid and timely cost-benefit data hindered IRS’ ability to make or justify resource allocation decisions that directly affect the management of unpaid assessments and, thus, the collection of federal revenue. Collectively, these issues are indications of serious internal control deficiencies and constitute a material weakness in unpaid assessments. Additionally, the continued existence of these issues could result in lost revenue to the government, erode taxpayer confidence in the equity of the tax system, and adversely affect future compliance. Table 1 summarizes the issues we identified related to unpaid assessments, their effects, and IRS’ actions to address these issues. These issues were also identified in prior years’ audits, for which recommendations have already been made. Consequently, we are not making any new recommendations related to unpaid assessments. Appendix II lists these previous recommendations and IRS’ actions to address them. In an integrated financial management system, the general ledger is supported by subsidiary ledgers, which contain detailed records of transactions and automatically update the appropriate general ledger account balances as transactions occur. Throughout the year, detailed records in the subsidiary ledger would then support key account balances in the general ledger. However, throughout fiscal year 2000, IRS continued to lack an effective subsidiary ledger system that could accumulate and track the status of unpaid assessments on an ongoing basis. This deficiency continued to necessitate the use of an extensive workaround process in order for IRS to derive the balances in the three categories of unpaid assessments as defined by federal accounting standards—taxes receivable, compliance assessments, and write-offs—for year-end financial reporting. This workaround process is costly, labor-intensive, and time-consuming. It involves the use of a specialized computer program to extract all unpaid assessment data from IRS’ master files—its only detailed database of taxpayer information—and classify them for financial reporting. However, the master files do not contain all the details necessary to properly and fully classify unpaid assessment accounts. Therefore, the workaround process also includes the need to select statistical samples of IRS’ unpaid assessments and manually review the sampled accounts to (1) determine their proper classification and (2) estimate collectibility for those assessments properly classified as taxes receivable. As in past years, this statistical sampling has resulted in the need to materially adjust the amounts generated by the computer extraction program—by tens of billions of dollars—to produce reliable amounts for taxes receivable and other unpaid assessments. In fiscal year 2000, of a total of 474 unpaid assessment sample items selected for detail testing that IRS’ computer extraction program originally classified as taxes receivable, 158 items were misclassified and were actually write-offs or partial write-offs, compliance assessments, or were deemed not to be unpaid assessments. Based on our work, we estimate that 12.6 percent of unpaid assessments originally classified by IRS’ computer extraction program as taxes receivable were misclassified. Figure 1 below illustrates the problem by showing the level of adjustments needed to the amounts generated by the computer extraction program in fiscal year 2000 to arrive at reliable amounts for each category of unpaid assessments. Although the workaround processes allowed IRS to report reliable year-end information for unpaid assessments in its financial statements, these balances are reliable only for a single point in time and are not available until several months after the end of the fiscal year. Additionally, the magnitude of the adjustments needed demonstrate that the data provided by IRS’ automated system for unpaid assessments but not supplemented by these workaround procedures and adjustments are unreliable for financial reporting. They cannot be used to track the overall status of IRS’ unpaid assessments and cannot be relied upon by IRS management and Congress to make policy and budgetary decisions. Maintaining accurate taxpayer accounts is important for properly managing activity and ensuring the fair and equitable treatment of taxpayers, and it is necessary for reliable financial reporting. However, significant delays and errors in updating taxpayers’ accounts further exacerbated problems related to the reliability of unpaid assessment balances in general and the reliability and management of individual taxpayer accounts in particular throughout the fiscal year. Errors and delays in recording activity also continued to lead to instances in which tax liens were not promptly released or not released at all during the period covered by our audit. These conditions continued to result in instances of taxpayer burden and lost opportunities to collect outstanding taxes owed. As in previous years, we found delays and errors in recording payments for unpaid payroll taxes where separate accounts are established and assessments recorded for a related tax liability. IRS' systems cannot automatically link to each other the multiple assessments made for the one tax liability. Consequently, IRS’ systems are unable to automatically reduce the balance in the related account (or accounts) if the business or an officer pays some or all of the outstanding taxes. To compensate, IRS established procedures to manually link the related accounts. However, we still found many instances in which payments were not posted to accounts that had been linked. The statistical sample of 474 unpaid tax assessment cases reviewed included 68 unpaid payroll cases involving multiple assessments. Of these 68, we found that 29 cases contained payments that IRS either had not recorded, or had failed to record in a timely manner, to all related accounts. Some of these amounts were paid by taxpayers in the late 1980s. Based on the results of our work, we estimate that 42 percent of the population of unpaid payroll tax accounts involving multiple assessments as of September 30, 2000, had this characteristic; and of these 29 cases, 28 (96 percent) had a manual code cross-referencing them to related accounts, yet the payments were still not recorded in all of the related accounts. We also found other delays and errors. For example, we found that IRS’ failure to enter or reverse status or freeze codes into the taxpayers’ accounts resulted in improper refunds being issued—in two cases, more than $4,000 each—to taxpayers who had other outstanding liabilities. In another case, IRS recorded an estate payment of $68 million to the wrong taxpayer account. Though the taxpayer’s estate was owed a refund of almost $7 million, this error was not corrected until almost 2 years later, and thus the refund was not issued for nearly 2 years after it was owed. Delays and errors in recording activity in taxpayer accounts complicate IRS’ efforts to derive a reliable balance for taxes receivable and other unpaid assessments in its financial statements. The accuracy of taxpayer accounts affects the determination of both the appropriate classification of these accounts under federal accounting standards and the basis for estimating collectibility for those accounts determined to represent taxes receivable. For example, to determine whether an unpaid payroll tax liability related to a defunct business should be classified as a write-off, IRS must first determine that no outstanding penalty assessments against officers of the business exist or have any future collection potential. If the accounts representing penalty assessments against officers continue to show outstanding balances solely because payments have not been appropriately recorded in these accounts, IRS could erroneously conclude that the unpaid tax owed by the business still has some collection potential from the officers and thus erroneously classify the account as a tax receivable. Delays in updating taxpayer accounts and taking appropriate actions also led to instances in which IRS did not release federal tax liens applied against the property of taxpayers within 30 days after the taxpayers had satisfactorily discharged their tax liabilities as required by Section 6325 of the Internal Revenue Code. In fiscal year 2000, we found that IRS continued to experience significant delays in releasing some tax liens. Specifically, in 3 of the 38 tax lien cases we reviewed in fiscal year 2000, we found that it took IRS more than 100 days, and in one case 583 days, to release the liens against the taxpayers’ properties after the taxpayers had satisfied their outstanding tax liabilities. Based on our work, we estimate that during fiscal year 2000, for 11 percent of resolved unpaid assessment cases that had tax liens, IRS did not release the liens within the 30-day requirement. The failure to promptly release liens could cause undue hardship and burden to taxpayers who may want to sell property or apply for commercial credit. As with any large agency, IRS is confronted by the ongoing management challenge of allocating its limited resources among competing priorities. However, IRS does not have the management data necessary to prepare reliable cost-benefit analyses to make more informed decisions about how best to allocate its resources. Consequently, IRS is hindered in its ability to determine whether it is devoting the appropriate level of resources to identifying and pursuing collection of unpaid taxes relative to the costs and potential benefits involved. During fiscal year 2000, we continued to find that IRS was closing delinquent tax cases without working them—that is, without making collection contact with taxpayers through either telephone calls or field visits. This type of case closure is referred to as “shelving.” The process of shelving cases began in mid 1999 in response to an increasing inventory workload and IRS’ assessment that resource constraints and decisions regarding where to deploy these resources would not permit it to actively pursue the cases. According to IRS records, as of September 30, 2000, 1.8 million cases totaling $8.6 billion—compared to 648,000 cases totaling $2.4 billion at September 30, 1999—were shelved because IRS judged that resource constraints would not allow it to actively pursue collection on these cases. We also continued to find unpaid assessment cases that had collection potential but were not being actively worked by IRS. We found at least six cases in our testing of unpaid assessments constituting taxes receivable for which information in the case files indicated some collection potential, but for which IRS had taken no collection action. In two of these cases, IRS was not actively pursuing collection of taxpayers who owed $23,000 and $88,000, respectively, in outstanding taxes and who each had annual incomes in subsequent years of at least $110,000. How IRS derives its balance for taxes receivable in its financial statements is affected by actions taken by IRS to collect outstanding taxes. In estimating collectibility for those accounts in its statistical samples that are appropriately classified as taxes receivable, IRS reviews case file information and considers whether the agency is pursuing collection through such means as levies, seizures, offers-in-compromise, or installment agreements. To the extent these files contain no evidence of such efforts, IRS must assess collectibility for the account at zero. This ultimately affects the balance of both net taxes receivable and the related allowance for doubtful accounts reported in its financial statements. IRS’ failure to pursue delinquent taxpayers with at least some ability to pay is part of a broader and continued decline in IRS’ enforcement activities and disposition of delinquent tax cases. For example, according to IRS records, between fiscal years 1998 and 2000, enforcement activities such as levy notifications experienced a substantial decline, from more than 9 percent to less than 1 percent of these unpaid assessment accounts. During the same period, the dispositions of delinquent accounts and investigations as a percentage of total outstanding cases decreased from 6.1 to 3.5 percent, a reduction of more than 43 percent. According to IRS records, collections on delinquent taxpayer accounts also decreased by 28 percent during this period, from $5.3 billion in fiscal year 1998 to $3.8 billion in fiscal year 2000. While there is a point at which it ceases to be cost effective to pursue collection, we believe that these decisions should be based on reliable cost- benefit data. Without valid cost-benefit analyses, IRS is hindered in its ability to make sound comparisons among competing priorities and to most effectively allocate resources among these priorities. One element that is critical to such a cost-benefit analysis is a measure of taxpayers’ voluntary compliance with the nation’s tax laws. However, as we have previously reported, IRS lacks such a measure. Consequently, it does not know the impact of the recent declines in enforcement activities and delinquency collections on taxpayer compliance. Congress and tax practitioners have expressed concerns that declines in pursuing potential unpaid taxes and in enforcing and collecting on delinquent accounts may increase incentives for taxpayers either to not report or to underreport their tax obligations. The lack of reliable cost-benefit information with which to make informed decisions could result in billions of dollars in outstanding amounts going uncollected and could lead to further erosion in taxpayers’ confidence in the equity of the tax system and adversely affect future compliance. During fiscal year 2000, IRS disbursed over 101 million tax refunds totaling about $194 billion. However, because of long-standing weaknesses in IRS’ controls over refund disbursements and other management challenges, the federal government continued to be exposed to material losses through the issuance of improper refunds, particularly with respect to EITC claims. Time constraints, high volume, reliance on information supplied by taxpayers, and the timing of filing of information returns by third parties create inherent limitations in IRS’ options for addressing the problem of improper refunds. Consequently, in fiscal year 2000 IRS continued to (1) issue improper refunds associated with invalid EITC claims and (2) rely extensively on post-refund (detective) controls that were not fully effective in identifying and limiting the losses associated with improper refunds. This, in turn, continued to expose the government to financial losses, possibly in the billions of dollars, through the disbursement of improper refunds. Table 2 summarizes issues we found relating to refund processing controls, their effects, and IRS’ actions to address these issues. These issues were also identified in prior years’ audits, for which recommendations have already been made. Consequently, we are not making any new recommendations related to refund processing controls. Appendix II lists the previous recommendations and IRS’ actions to address them. The options available to IRS in its efforts to ensure that only valid refunds are disbursed are currently limited. For example, while it processes hundreds of millions of tax returns each filing season, IRS must also issue refunds within certain time constraints or be subject to interest charges. At the same time, IRS must contend with the fact that third-party information, such as form 1099s, are not required to be filed prior to the start of the tax filing season. Comparison of such information with tax return data is problematic because IRS does not have time to prepare the third-party data for matching prior to the receipt of individual tax returns. Nonetheless, IRS does have some preventive controls which, if effectively implemented, could help to reduce the level of risk associated with issuing improper refunds related to EITC claims. For example, IRS’ Examination Branch is responsible for performing examinations on tax returns with potentially invalid EITC refund claims to determine the validity of the claim. However, it has not performed a cost-benefit analysis to determine whether it is focusing the appropriate level of resources on this effort. Without this, IRS is unable to determine the extent to which refunds associated with invalid EITC claims could be prevented or minimized had IRS devoted more resources to its examination efforts. The Electronic Fraud Detection System (EFDS) is an automated screening tool IRS’ Criminal Investigation Division (CI) uses to identify EITC refund claims with the highest potential to be fraudulent or invalid. CI uses EFDS to score each EITC claim, using a set of screening criteria. CI retains those cases that indicate a high potential for fraud for follow-up and forwards all other cases that score above a certain level to the Examination Branch. For each of its 10 campuses, the Examination Branch determines a set number of cases that it perceives as the workload each campus’s resources can handle. It then refers cases to each campus for examination up to that campus’s established workload amount. During fiscal year 2000, the Examination Branch reduced the number of cases referred by CI for examination by choosing a higher minimum score level for each case and reviewing other factors such as how recently the taxpayer was last examined. Additionally, it discontinued referring cases associated with a particular campus once it reached the determined workload level it established for that campus. Consequently, the number of EITC refund claims subject to examination by IRS was predetermined by the available resources rather than based on an analysis of what the optimum score level should be for selecting cases to examine based on the expected yield at each level and the associated resource cost. The government could be losing billions of dollars through improper refunds associated with invalid EITC claims. For example, in a study of tax year 1997 returns, IRS estimated that of approximately $30.3 billion EITC claims received, about $9.3 billion (30.6 percent) were invalid claims. IRS did not know the exact amount of the related improper refunds, but based on IRS’ fiscal year 1998 refund rate of about 78 percent of EITC claims, we estimate the amount of improper EITC refunds to be about $7.3 billion. In the same study, IRS estimated that it would not be able to recover 84 percent of the total invalid EITC claims. Applying this rate to the refunds portion only, we estimate that $6.1 billion of the improper refunds could be unrecoverable. With such a potential for invalid refunds, IRS must better ensure that it is devoting the appropriate level of resources to examining these claims. IRS’ primary detective controls are its automated matching programs to match tax returns against third-party data. Identified discrepancies may indicate underreported tax liabilities and possible improper refunds, to the extent that the underreporting resulted in refunds being disbursed. IRS has separate automated matching programs for individual and employer tax returns which are performed several months after the returns are filed. However, IRS did not perform follow-up examinations on millions of identified tax returns estimated to have billions of dollars of underreported tax liabilities. As a result, to the extent these taxpayers had received improper refunds by underreporting their taxes, IRS did not pursue recovery of these refunds. Table 3 presents IRS’ workload for the matching program for individual returns referred to as the Automated Underreporter Program (AUR). As shown in this table, in tax years 1996 through 1998, IRS did not investigate over 30 million AUR cases with about $30 billion in estimated underreported taxes which may have also resulted in the issuance of improper refunds. Because IRS did not investigate these cases, the exact amount of underreported taxes due and any resulting improper refunds disbursed are unknown. IRS’ decision to forgo follow-up examinations and collection efforts on potentially underreported tax liabilities, improper refunds, and invalid EITC claims was based on perceived resource constraints. However, as discussed later in this report, IRS’ financial management systems do not currently provide reliable information for cost-benefit analyses. Consequently, IRS management cannot determine whether the cost associated with the level of resources it expends on various refund control projects is commensurate with the benefits that could be realized from such efforts. Additionally, IRS cannot determine whether it is effectively directing its resources to the areas with the most potential benefit. As a result, billions of dollars of improper refunds could be disbursed as a result of invalid EITC claims and underreported tax liabilities and could remain uncollected. This in turn could erode taxpayer confidence in the equity of the tax system and reduce compliance with the tax laws. IRS’ controls over cash, checks, and related hard-copy taxpayer data it receives from taxpayers continue to be inadequate. While IRS has made some improvements, further action and policy changes are needed to further mitigate risks. Without adequate controls, IRS cannot ensure proper safeguarding of assets and taxpayer data. Table 4 summarizes the issues we identified in this area, their effects, and IRS’ actions to address these issues. Most of these issues were also identified in prior years’ audits, for which recommendations have already been made. Appendix II lists these previous recommendations and IRS’ actions to address them. As part of its procedures to determine suitability of an applicant for employment, IRS requires permanent and temporary applicants to undergo a fingerprint prescreening check. During a fingerprint check, an applicant’s fingerprints are processed through the FBI’s national database to identify those with arrest records. However, further review of the disposition of the case is necessary to determine if the applicant was convicted of the crime. We previously reported on several weaknesses related to this fingerprinting process. Although IRS significantly improved the turnaround time for obtaining the fingerprint results, other weaknesses persisted. IRS issued new policies to address these weaknesses. However, we found that the new policies were not consistently applied throughout IRS during fiscal year 2000. Additionally, Treasury Inspector General for Tax Administration (TIGTA) auditors found that the IRS’ current fingerprinting process was ineffective in screening out juvenile applicants with questionable backgrounds. In response to a recommendation we had made previously, IRS issued, on April 3, 2000, a policy that prohibited the hiring and placement of an applicant at any IRS location until the applicant’s fingerprint checks had been received and case disposition evaluated. This policy applied to permanent and temporary employees. However, we found that IRS offices did not consistently comply with this new hiring policy. Out of the approximately 19,600 employees hired during fiscal year 2000, about 4,900 (25 percent) were hired and began working prior to IRS’ receipt and evaluation of their fingerprint checks. As IRS did most of its hiring from October through April in preparation for the peak tax-filing period, the new policy was not in place in time to affect many of these new hires. Nonetheless, there were about 2,700 persons hired after the April 2000 policy was issued, of which 145 (5 percent) were hired and began working with taxpayer receipts and sensitive taxpayer data without IRS first receiving the results of their fingerprint checks. The following table shows, on a monthly basis, the number of persons who were hired and reported for duty without IRS having first received the results of their fingerprint checks out of the total number hired after the issuance of the April 3, 2000, hiring policy. Although the table shows a downward trend in the number of violations after the April 2000 policy, we cannot determine to what extent this is due to compliance with the new policy or due to IRS’ not hiring as many staff in May through September. To compound this problem, IRS staff also did not comply with its April and June 1999 policies which require the fingerprinting of all filing season applicants at the earliest possible time in the job application process. According to IRS’ personnel database, about 2,200 employees out of approximately 19,600 (11 percent) hired during fiscal year 2000 were not fingerprinted until they first reported for duty or several days—and in some instances months—later. The delays in initiating the fingerprinting process delayed IRS management’s receipt of the fingerprint results. This, combined with the pressing need for more resources to meet the increased workload during the tax-filing period, was a contributing cause for new employees entering on duty before the results of fingerprints were received. Consequently, as a result of noncompliance with IRS’ hiring policies, IRS managers could have unknowingly allowed employees with unsuitable backgrounds to handle cash, checks, and sensitive taxpayer information, thus increasing their risk of theft and misuse. In fact, from April through September, of the 145 persons who entered on duty before IRS received their fingerprint checks, 22 (15 percent) were subsequently found to have had potentially unsuitable backgrounds, such as drug use and assault. Additionally, a TIGTA audit completed in May 2000 found that IRS’ fingerprint prescreening procedures were ineffective for juvenile applicants, i.e., those under 18 years of age, due to mitigating circumstances involving the release of juvenile records. IRS campuses often hire high school students to fill short-term positions to process income taxes. IRS’ policy to complete fingerprint prescreening checks applies to all new hires, even short-term temporary employees. As of April 2000, TIGTA found that at the two campuses it reviewed, 192 juveniles were hired to work in the receipts processing areas and all of them had fingerprint checks completed. However, 18 U.S.C. 5038 states that information about a juvenile’s record may not be released when the request for information is related to an application for employment. It further states that responses to such inquiries shall not be different from responses made about persons who have never been arrested. Therefore, the case disposition from any juvenile arrest could not be released or otherwise known. According to TIGTA, because juveniles’ records are sealed, it was not certain whether local authorities, which provide information for the FBI’s national database, forward juvenile arrest records to the FBI. Even if the fingerprint check identified a juvenile arrest record, current laws prevent investigators from determining whether the juvenile was convicted or acquitted. TIGTA recommended that IRS develop a process to more effectively screen out juvenile applicants with questionable backgrounds for receipt processing positions. IRS agreed to look into this matter. IRS’ lack of a process to screen out juvenile applicants with questionable backgrounds could result in IRS’ unknowingly hiring persons with unsuitable backgrounds to process receipts and sensitive taxpayer data, thus increasing the risk of theft. In fact, TIGTA special agents have already investigated juvenile employees for theft of receipts. Given these risks, we agree with TIGTA’s recommendation for IRS to develop procedures to more effectively screen out juvenile employees with questionable backgrounds. We found that the scope of background checks required of lockbox bank employees was inconsistent with IRS’ hiring policy and was less than that required of IRS employees. The Treasury’s Financial Management Service (FMS) contracts with 10 commercial banks to process taxpayers’ payments and tax data for IRS. Lockbox banks are staffed with both permanent bank employees and temporary employees. As previously discussed, the new IRS hiring policy prohibits the hiring and placement of an IRS applicant, for permanent or temporary position, at any IRS location until the applicant’s fingerprint checks have been received and evaluated. Despite the fact that lockbox employees also handle taxpayer receipts and data, IRS’ new hiring policy does not apply to them. At two lockbox banks we visited, we found that 63 permanent employees were hired and began working in fiscal year 2000 prior to the banks’ receipt of their fingerprint checks. We also found that fingerprint checks were not required at all for temporary lockbox employees. Neither the IRS guidelines for lockbox operations nor the FMS contracts with lockbox banks required fingerprint checks for temporary employees of the lockbox. The lockbox guidelines required only a police check for all temporary employees. However, a police check, which is a records check for arrests and legal proceedings, is limited to the jurisdictions that the employee states he or she resided in within the past 7 years. In contrast, the FBI fingerprint checks required of IRS applicants do not depend on the individual to accurately state where he or she lives because the FBI obtains information for its national database from law enforcement agencies. We also found that the length of time it took for the lockbox banks to get the results of fingerprint checks varied widely. For example, officials at one of the lockbox banks we visited informed us they received the results of the fingerprint checks in 8 business days while the officials at a second lockbox bank stated they received the results in 3 to 6 months. As a result of the above weaknesses in lockbox hiring practices, taxpayers and the government were unnecessarily exposed to potential financial losses and fraud that could have occurred if lockbox employees with unsuitable backgrounds were unknowingly hired to process sensitive taxpayer information and receipts. We previously reported on various security weaknesses related to courier services. IRS uses couriers to transport deposits of taxpayer receipts to financial institutions. On March 14, 2000, IRS issued a revision to its minimum courier service requirements for IRS campuses to address the security weaknesses we previously reported. As a result of this new policy, we noted additional improvements over courier security that helped reduce the vulnerability of taxpayer receipts and taxpayer data recorded on checks from theft, loss, or misuse. For example, the revised courier standards limit courier access on campus premises and require campus personnel to deliver the deposits to a designated point of transfer. At two campuses we visited, we observed that the campus personnel complied with this policy. However, some weaknesses still remain. For example, the courier standards require two courier service employees to pick up and deliver deposits in order to increase security and help ensure that such deposits are never left unattended while in the courier service’s custody. At one of the campuses we visited, only one courier showed up to pick up the deposits. According to IRS campus officials, this was because IRS did not directly contract with the courier service. Instead, the contract was between the depository institution and the courier service. Therefore, IRS had less control over the security requirements included in the courier contract. Regardless of who contracts directly with the courier service, IRS has a fiduciary responsibility to the taxpayers and the government to safeguard taxpayer receipts with which it was entrusted. An IRS official stated that IRS plans to issue new guidance that will require all IRS campus courier service contracts to include IRS’ minimum courier security standards, regardless of who contracts for the courier services. Recognizing its responsibility to protect taxpayer information and receipts, IRS has clearly made a concerted effort to address courier security weaknesses by adopting a more stringent requirement on courier security standards. However, unless IRS consistently implements this policy, taxpayers and the government will still be unnecessarily exposed to financial losses. We also found that lockbox banks were not required to have the same level of courier security as IRS campuses. The lockbox courier service requirements are listed in the Lockbox Processing Guidelines. Based on our comparison of the January 2000 lockbox processing guidelines to IRS’ courier requirements in effect during our review, significant requirements from IRS’ courier guidelines were absent from the lockbox processing guidelines. For example, the lockbox guidelines did not require use of two insured couriers nor did they require all courier service employees to pass a limited background investigation. During our site visits at two lockbox banks, we noted that a single courier was used at both locations. IRS officials stated that the fiscal year 2002 lockbox contracts would contain courier standards for lockbox banks consistent with requirements at IRS campuses. However, until these standards are required and implemented, taxpayer receipts and data are unnecessarily exposed to theft and fraud, such as identity theft schemes, while in the custody of the lockbox courier services. Despite some improvements, we continued to find other internal control weaknesses over the safeguarding and accounting of manual payments and taxpayer data. Appendix II lists the improvements IRS made in this area during fiscal year 2000. However, during our fiscal year 2000 visits to various IRS locations and lockbox banks, we found that other previously reported weaknesses, such as the issues outlined in table 4, persisted. For example, we continued to find weaknesses regarding access to receipt processing areas. IRS security guidelines designate the receipts processing area as a restricted area to be accessed only by authorized personnel. As such, this area should be physically secured from the rest of the processing units of the IRS campus. Nonauthorized persons entering the receipt processing area must sign in with a door monitor, wear a special badge, and be escorted. Cleaning personnel are only to be allowed access to this area during operating hours when they can be observed. However, at one campus, a GAO auditor was allowed access through the rear entrance of the receipt processing area by an employee who did not know the auditor, and the auditor had unescorted access once inside. At four field offices, we found similar access problems where entrances to walk-in payment processing areas were left open or were inadequate to prevent nonemployees from entering. In the same TIGTA review discussed earlier, TIGTA found that physical barriers for receipt processing areas at two other campuses were not adequate for various reasons, such as (1) receipt processing areas with walls or partitions that were inadequate to secure the areas and not supplemented by intrusion detecting devices, (2) doors that were left open after hours, and (3) door locks that did not meet minimum security standards. At the same campuses, they also found that cleaning personnel were allowed unescorted access to receipt processing areas during nonoperating hours. At one of these campuses, the security guards did not respond to motion sensor alarms set off by a TIGTA auditor before regular duty hours because, according to the guards, they assumed that the alarms were set off by the janitor who was generally in that area at that time. We have previously reported, and continued to find, receipts in receipt processing areas vulnerable to theft or loss because accountability for them was not always established as soon as they were received and because the receipts were stored in easily accessible containers. As such, physical access controls to these areas are particularly important to reduce the risk of theft of taxpayer receipts and data. The weaknesses cited above unnecessarily expose taxpayer receipts and accompanying data to theft by unauthorized persons. During fiscal year 2000, IRS made progress in improving the reliability of its property and equipment (P&E) inventory records. IRS began implementing a new process for managing and maintaining records for its automated data processing (ADP) P&E, assigned a senior-level official responsibility for management and control of ADP P&E, and conducted an officewide inventory of all P&E. IRS also continued to develop and implement interim procedures to compensate for fundamental deficiencies in its financial accounting system. Specifically, it developed manual procedures to extract the costs of P&E acquisitions from its accounting records. Although these efforts allowed IRS to report in its fiscal year 2000 financial statements a P&E balance that was fairly stated, these compensating procedures were labor intensive and required extensive contractor support to arrive at a reliable P&E balance months after fiscal year-end. Additionally, these procedures did not address long-standing, fundamental weaknesses in IRS’ property and financial systems. As a result, we continued to find problems with (1) the accuracy and reliability of IRS’ P&E inventory records and (2) IRS’ ability to record P&E transactions in its financial system as transactions occur. Until these problems are addressed, IRS will continue to rely on costly and labor-intensive compensating procedures to arrive at a P&E balance that is only reliable for its year-end financial statements. More importantly, the procedures IRS employed during fiscal year 2000 did not provide management with reliable, useful, and timely P&E information throughout the year for day-to-day decision- making, thus hindering IRS’ ability to properly manage $1.3 billion in assets. Table 6 summarizes the issues relating to P&E, along with their effects and IRS’ actions to address these issues. For many years, IRS’ P&E records were not adequate for maintaining accountability over its property. IRS has acknowledged the deficiencies in its property management controls since 1983. In the long-term, IRS plans to acquire and implement a new P&E inventory management system to address the deficiencies in its current P&E inventory systems. In the interim, IRS has taken steps to improve the reliability of its P&E inventory records during fiscal year 2000. However, these interim measures have not been fully implemented, and we continued to find errors in IRS’ P&E inventory records during our fiscal year 2000 financial audit. IRS maintains two P&E inventory systems, one to manage ADP P&E and another to track non-ADP P&E. These systems provide data, such as a description of the item, its location, and current status (e.g., disposed versus in service) that assist property managers and officials in managing property. In an effort to address its long-standing inability to maintain complete and accurate records in the ADP inventory system, IRS issued interim Single Point Inventory Function (SPIF) operating guidelines and procedures in June 2000. SPIF centralized responsibility for managing ADP property and maintaining ADP inventory records into a single dedicated unit at each IRS location, thus establishing clear accountability for the receipt, management, and disposal of ADP assets. Although this was a significant step, we found during our visits to IRS campuses and field offices in September 2000 that SPIF teams had not been fully staffed and SPIF procedures had not been fully implemented at all IRS facilities. Thus, as in prior years, we found that IRS’ procedures for recording P&E acquisitions, disposals, and transfers still did not ensure that transactions were promptly recorded. Specifically, we found that 35 of 220 P&E items we selected from IRS records at 22 sites could not be located at the time of our review. These items were eventually accounted for when IRS later reported that 23 of the items had been disposed of months earlier (including one disposed of in 1998) but IRS had failed to update the records, 8 items were subsequently located, and 4 items were erroneous records of software. Nonetheless, based on our work, we estimate that 16 percent of the items in IRS’ P&E inventory records at September 30, 2000, were erroneously included as IRS assets. The GAO Standards for Internal Control in the Federal Government requires that qualified and continuous supervision be provided to ensure that internal control objectives are achieved. It is particularly important for IRS to have strong management oversight to help compensate for the limitations of its current P&E systems. IRS partially addressed the issue of management oversight in November 1999 by providing its Chief Information Officer (CIO) the authority over and overall responsibility for ownership, management, and control of all ADP property. In addition, SPIF procedures assigned ADP property managers responsibility for reviewing the accuracy and completeness of P&E information. Specifically, the IRS policy states that ADP property managers are responsible for maintaining a management and quality review program to ensure the timeliness, completeness, and accuracy of the inventory records and to conduct annual property management evaluations at selected sites. These types of managerial review serve as a key internal control in ensuring the accuracy, completeness, and timely recording of inventory data that will subsequently be used to prepare reports for management decision-making. However, based on the errors we found during our testing of the P&E inventory records, these managerial reviews did not appear to be effective. Consequently, the information in IRS’ P&E inventory tracking systems was unreliable and fell short of meeting management reporting needs. As in prior years, IRS was unable to record P&E assets and corresponding liabilities in its accounting system as the transactions occurred due to inadequate accounting procedures and systems design flaws. Consequently, IRS hired a contractor who implemented extensive and time- consuming manual procedures to derive a reliable P&E balance for IRS’ financial statements. IRS did not have policies and procedures in accordance with federal accounting standards to identify and record in its general ledger accounts its P&E assets and corresponding liabilities as the transactions occurred. For example, federal accounting standards require agencies to record a capital lease asset and its corresponding liability at the inception of the lease agreement.However, neither IRS’ inventory system nor its accounting system was designed to capture key information on capital leases to enable it to report the asset or the corresponding capital lease liability as the transactions occurred. IRS expensed all property purchases during the year, including major acquisitions such as capital leases, leasehold improvements, and major systems. A contractor then analyzed and extracted from IRS’ automated expense records purchases of P&E, leasehold improvements, major systems, and capital leases based on codes within IRS’ accounting system to derive the fiscal year-end amounts that should have been capitalized as P&E. IRS then recorded adjusting entries to transfer these P&E acquisitions to the appropriate general ledger account. This process was time-consuming and did not always result in accurate information as we found during our review of fiscal year 2000 nonpayroll expenses and P&E transactions. For example: Of 156 statistically sampled nonpayroll expenses we reviewed, 3 transactions totaling $1.7 million that should have been recorded as P&E had not been properly extracted by the contractors from the population of fiscal year 2000 expenses and transferred to the P&E general ledger account. Based on our work, we estimate that the most likely understatement of the P&E balance as a result of P&E transactions being incorrectly recorded as expenses was $50 million, with an upper error limit of $127 million. Of 60 statistically sampled P&E transactions we reviewed, 8 transactions totaling $879,000 were inappropriately identified by the contractors as fiscal year 2000 P&E acquisitions. Two of the 8 transactions were fiscal year 1999 transactions, and the remaining 6 items were non-P&E items that should have remained as expenses. Based on our work, we estimate that the most likely overstatement of the P&E balance as a result of transactions incorrectly recorded as fiscal year 2000 P&E was $61 million, with an upper error limit of $106 million. Additionally, IRS uses financial accounting codes that classify expenses by type to extract P&E, leasehold improvements, major systems, and capital leases from its automated records of expenses. These Sub-Object Class (SOC) codes appear on all basic accounting documents and provide detailed cost data on the types of expenses that are significant to IRS’ operations. However, IRS recorded both capitalizable and noncapitalizable P&E transactions under the same SOC codes. This complicated the process of extracting capitalizable P&E transactions based on SOC codes because additional analysis was required to determine whether the transactions represented an expense or a capitalizable P&E purchase. For example, in fiscal year 2000, the contractor determined that more than $43 million in software license fees, which should have been expensed, were charged to an SOC code defined as capitalized software. IRS’ costly, time-consuming process for determining a year-end P&E balance was necessary because IRS’ procurement system, inventory tracking systems, and the general ledger are not integrated. In an integrated financial management system, the general ledger is supported by subsidiary ledgers, which contain detailed records of transactions and automatically update the appropriate general ledger balances as transactions occur. Therefore, on an on-going basis, detailed records in the subsidiary ledgers should support the P&E balances in the general ledger. However, during fiscal year 2000 IRS did not have subsidiary ledgers for its P&E. Instead, the two inventory tracking systems served as subsidiary records for P&E. However, property acquisitions and dispositions recorded in the inventory tracking systems did not automatically update appropriate P&E balances in the general ledger system because the two systems were not integrated. Additionally, unlike true subsidiary ledgers, the inventory tracking systems did not record the cost of assets that tie to the general ledger balances at a summary level. Consequently, P&E balances recorded in general ledger P&E accounts could not be easily reconciled to IRS’ subsidiary records to verify that such balances were supported by actual assets recorded in the inventory tracking systems. IRS plans to install an integrated financial system by late 2004 to address the design flaws of its current systems. In the meantime, due to the systems and control weaknesses discussed above, IRS management continues to rely on a contractor and a labor-intensive procedure to derive a reliable P&E balance for its financial statements. Because this procedure only provides a reliable balance for the fiscal year-end date, IRS does not have reliable P&E data on an ongoing basis to make operational decisions related to the purchase, disposition, and use of its P&E. Moreover, errors in IRS’ inventory tracking systems continue to compromise IRS management’s ability to safeguard $1.3 billion of government assets. To address weaknesses in the timely recording of P&E transactions while an integrated P&E financial system is being developed, we recommend that IRS implement policies and procedures to record capitalizable acquisition costs for property and equipment, capital leases, leasehold improvements, and major systems in the appropriate P&E general ledger accounts as transactions occur. To ensure that SOC codes facilitate compilation of capitalizable P&E transactions in the proper general ledger asset accounts and, if applicable, lease liability accounts, we recommend that IRS revise the definitions of SOC codes pertaining to P&E or establish new codes so that individual SOC codes cannot be used for both capitalizable purchases (assets) and noncapitalizable purchases (expenses). For example, the SOC code used to record capitalizable software costs should not be used to record noncapitalizable software license fees. In fiscal year 2000, IRS made substantial progress in addressing previously identified budgetary control weaknesses. IRS (1) reduced the number of employees with authority to override automated spending controls; (2) decreased the number, dollar amount, and duration of items held in suspense; and (3) implemented procedures to deobligate funds no longer required for a specific purpose. Despite this progress, IRS’ internal controls were inadequate for providing reasonable assurance that the $8.3 billion in fiscal year 2000 budgetary authority was routinely accounted for, reported, and controlled. Specifically, we found that IRS (1) incurred costs prior to establishing an obligation, (2) inappropriately recorded unrelated activities as adjustments to obligations, and (3) failed to reduce undelivered orders when goods and services were received. As a result, IRS was unable to ensure the reliability of key budgetary information it needs on an ongoing basis to effectively manage its operations and ensure that its resources do not exceed budgetary authority. While these conditions in isolation may not rise to the level of material weakness, collectively they are indications of serious deficiencies in internal controls over appropriated funds. Table 7 summarizes the issues we identified related to obligations and undelivered orders, along with their effects and IRS’ actions to address these issues. In the federal budgeting process, agencies’ operations are funded by appropriations. Appropriations typically provide agencies with budgetary authority, i.e., the legal right to obligate—and ultimately to spend—funds for specific purposes, within a specific period of time, up to a specific amount. An obligation is a definite commitment by an agency of the government, which creates a legal liability to another party. To prevent obligations in excess of available funding, OMB Circular A-34 gives instructions to federal agencies as to when an obligation of funds should be recorded in the agency’s financial system. For example, an obligation for reimbursable travel expenses incident to employee relocation should be recorded when a travel order is approved; an obligation for a contract should be recorded in the month that the contract is let; and an obligation for an order for goods or services is to be recorded at the time the order is placed. In addition, GAO’s Standards for Internal Control in the Federal Government requires that transactions be promptly recorded to maintain their relevance and value to management in controlling operations and making decisions. However, during our fiscal year 2000 audit, we found that IRS did not always record obligations in its accounting system prior to incurring costs. For example: IRS received software maintenance services for the period May 1, 2000, through April 31, 2001, totaling $415,000. However, IRS did not generate a purchase order to record the obligation of funds until July 28, 2000— almost 3 months after the services were received. An IRS site accepted delivery of services for which funds were not available at that site. In this instance, a contracting officer at an IRS site ordered services totaling more than $15,000 for transporting and installing systems furniture in June 1999. However, the obligation was not recorded before the cost was incurred. When the voucher was submitted in November 1999, IRS discovered that the amount exceeded what was available to the site at the time the order was placed. Although IRS was able to make up for the deficiency by transferring fiscal year 1999 funds from another site, had there not been funds available at that time IRS may have run the risk of spending more than it was authorized to spend. As a result of not recording obligations in a timely manner, IRS cannot routinely rely on its financial records to provide reliable information on the status of its budgetary resources for day-to-day decision-making. Until the obligation of funds is recorded, the balance in obligations incurred would be understated. This could lead IRS management to believe that the agency has more funding than is actually available. Consequently, IRS management and personnel might enter into additional obligations in excess of the budgetary authority made available by Congress. During fiscal year 2000, IRS recorded certain activities as adjustments to prior years’ obligations that were not valid adjustments to those obligations. In fiscal year 2000, $167 million of the $277 million (over 60 percent) that were recorded in IRS’ accounting system as adjustments to prior years’ obligations were not valid upward or downward adjustments. IRS subsequently adjusted its records to correct these erroneous transactions. However, these errors adversely affected IRS’ ability to routinely report accurate and reliable information on total budgetary resources and obligations. GAO’s Standards for Internal Control in the Federal Government requires that transactions and other significant events be properly classified to maintain their relevance and value to management in controlling operations and making decisions. Furthermore, transactions and events are to be completely and accurately recorded and classified in the summary records from which reports and financial statements are prepared. Adjustments to prior years’ obligations are recorded when the obligation amount that was previously recorded is affected by a subsequent event, such as a change in the price or quantity of goods or services. For example, if an undelivered order for a good was established for $1,000, but the good was delivered in a later year at $1,250, then an upward adjustment of $250 to obligations would be recorded. An upward adjustment would increase obligations incurred and reduce the unobligated balance. Similarly, if an undelivered order was established for $1,000 but the good was delivered in a later year for $750, then a downward adjustment to prior years’ obligations of $250 would be recorded. However, we found that IRS overstated both the upward and downward adjustment accounts during fiscal year 2000. Many activities that were recorded as adjustments to the prior years’ obligations were not actual upward or downward adjustments but were related to changes in accounting codes, travel, and adjustments for doubtful accounts. Of the $277 million in adjustments IRS recorded in its accounting system in fiscal year 2000, $82 million in upward adjustments and $85 million in downward adjustments were not valid adjustments to the prior years’ obligated balance. These errors were attributed to IRS’ accounting system, which, according to IRS personnel, recorded all adjustments that affect a prior year’s appropriation, including those that did not affect the obligated amount, as upward or downward adjustments to prior years’ obligations. Through adjusting entries totaling $167 million, IRS was able to correct these errors in time to prevent the financial statements from being misstated. However, upward adjustments to prior years’ obligations are also reported on the SF133 Report on Budget Execution and Budgetary Resources that federal agencies submit to OMB quarterly as “obligations incurred,” while downward adjustments to prior years’ obligations are reported on the SF133 as “recoveries to prior year obligations.” Because the upward and downward adjustment accounts were misstated during the year, data IRS reported to OMB on its budgetary activities may not be reliable. Specifically, the September 2000 SF133 IRS submitted to OMB misstated both the obligations incurred and recoveries to prior years’ obligations line items. IRS records an undelivered order when it orders a good or service for use in its operations. It then reduces the undelivered order balance and records an expense when the good or service is received. However, we found instances in which IRS did not reduce the balance in undelivered orders when the goods and services were received. As a result, the balance of undelivered orders and accrued expenses were misstated. We tested statistical samples of 83 and 78 transactions from fiscal year 2000 beginning and ending balances of undelivered orders, respectively. For both samples, we found instances in which IRS received goods and services during one fiscal year but did not reduce the undelivered orders balance reflected in its accounting system until the following fiscal year. This was caused, in part, by IRS personnel’s incorrectly recording into its accounting system the dates that the goods and services were received. This resulted in IRS’ overstating the beginning and the ending fiscal year 2000 undelivered order balances and understating accrued expenses. For example: In fiscal year 2000, IRS recorded an obligation and a corresponding undelivered order for computer equipment totaling $7.9 million. As of September 30, 2000, IRS had received equipment totaling $3.4 million. However, its records as of September 30, 2000, still showed that the entire undelivered order amount was still outstanding, i.e., $3.4 million was not yet removed from the undelivered order balance. Telephone support services for the month of September 1999 were entered into the receipt and acceptance system as being received on October 5, 1999. Consequently, the beginning fiscal year 2000 balance in undelivered orders was overstated. IRS failed to remove more than $4.1 million from the ending undelivered order balance for lockbox services received from July through September 2000. Consequently, the fiscal year 2000 ending undelivered order balance was overstated. The errors in the beginning undelivered orders balance totaled $2.9 million, while errors in the ending undelivered orders balance totaled $12.4 million. Based on our work, we estimate (1) the most likely overstatement of the fiscal year 2000 beginning undelivered orders balance as a result of these errors was $65 million, with an upper error limit of $111 million and (2) the most likely overstatement of the ending undelivered orders balance and corresponding understatement of accrued expenses was $47 million, with an upper error limit of $87 million. Because of the deficiencies in controls over the accurate recording of undelivered orders, IRS’ balances in undelivered orders and accrued expenses were misstated during fiscal year 2000. These deficiencies continued to affect IRS’ ability to report reliable, timely, and routine information critical for making sound day-to-day decisions and effectively managing its operations. To ensure effective management of available funding and accurate reporting of obligations, we recommend that IRS perform periodic reviews to monitor and ensure that obligations are promptly established in the accounting system. Such reviews would assist IRS in maintaining accurate and complete records of its obligations, and in reducing the risk of obligations exceeding available funding. To ensure that reported budget data are reliable on a routine basis, we recommend that IRS incorporate into its systems modernization blueprint the capability to differentiate prior-year adjustments between activities that are valid upward and downward adjustments to obligations and activities that are not valid adjustments to obligations. Such actions would help ensure that activities that are not valid adjustments to obligations are not recorded as adjustments to obligations. In fiscal year 2000, IRS revised the format of its statement of net cost and significantly expanded and enhanced the related disclosures in its financial statements to address an issue we had raised in our prior audit regarding the commingling of certain program costs in its financial statements. The resulting presentation appropriately classified the cost of IRS’ programs. However, in fiscal year 2000, as in prior years, IRS was unable to generate reliable financial information on a day-to-day basis to support decision- making. IRS lacked a financial management system that complies with the requirements of the Federal Financial Management Improvement Act of 1996 (FFMIA). In addition, IRS did not record transactions in a timely manner and perform routine reconciliations necessary to ensure the reliability of general ledger data. Finally, IRS lacked an effective system that can report on the full costs of its activities and on cost-based performance measures consistent with the Government Performance and Results Act (GPRA) of 1993. These weaknesses affected IRS’ ability to (1) routinely prepare reliable periodic financial reports, (2) generate routine and reliable cost-based information, (3) accurately determine the amount of revenue collected for specific tax types, and (4) certify excise taxes distributed to trust funds. Collectively, these issues are indications of serious internal control deficiencies and constitute a material weakness in controls over financial reporting. As noted earlier, in fiscal year 2000, due to monumental efforts and extensive workaround processes, IRS was able to produce for the first time combined financial statements that were fairly stated in all material respects. However, the information reported in the financial statements was reliable only for a single point in time. Financial data not subjected to these compensating procedures may not be reliable and cannot be used to effectively manage IRS’ day-to-day operations. Ultimately, Congress, IRS management, and the public do not routinely have timely and accurate information to evaluate IRS’ performance and make informed management and policy decisions. Table 8 summarizes the issues we identified in this area, together with their effects and IRS’ actions to address these issues. As the table above indicates, IRS does not have an adequate financial management system. As a result, IRS is hindered in its ability to produce reliable financial statements and to generate timely and accurate information needed to make management and operational decisions. An adequate financial management system is one that can provide complete, reliable, consistent, timely, and useful financial management information. Such a system comprises, among other elements, an integrated general ledger system using common data elements and transaction processing that is supported by transactional details and a system of internal controls to ensure that reliable data are obtained, maintained, and disclosed in reports. Such a system is also capable of capturing and reporting reliable performance information. However, IRS’ financial management system is made up of two independent general ledgers—custodial and administrative—that are not integrated with each other nor with their supporting records for material balances. Specifically, IRS’ custodial general ledger does not have adequate audit trails for federal taxes receivable, federal tax revenue, or federal tax refunds, while its administrative general ledger lacks audit trails for P&E and program costs. For example, as discussed earlier in this report, the lack of clear traceability between the general ledger and underlying financial transactions required IRS to use extensive ad hoc procedures and statistical methods to derive reliable balances for taxes receivable and other unpaid assessments. In addition, as discussed further below, because of weaknesses in internal controls, IRS could not demonstrate that reported performance indicators were reliable. Consequently, neither of IRS’ two general ledgers complies with the requirements of the U.S. Government Standard General Ledger (SGL) at the transaction level and cannot be used to support the preparation of financial statements without material financial reporting adjustments, nor do they comply with the requirements of FFMIA. One important requirement of an effective financial management system is that it can be relied upon to support the timely production of auditable financial statements. At IRS, this is not the case. Although IRS was able to produce financial statements that were fairly stated in all material respects for fiscal year 2000, these statements required monumental human efforts that extended well after the September 30, 2000, fiscal year-end. In addition, information produced by IRS’ financial management system required billions of dollars in adjustments to derive reliable financial statement balances. As mentioned earlier, substantial adjustments totaling billions of dollars had to be made to reliably report the balance for taxes receivable. These adjustments, as well as the balance in net taxes receivable, were not available until well after the fiscal year had ended. Similarly, fiscal year 2000 administrative activities totaling over $3.7 billion were either recorded in the wrong general ledger accounts or were not yet recorded in IRS’ general ledger as of September 30, 2000. For example, as of fiscal year-end, accrued payroll and depreciation expenses totaling $480 million had yet to be recorded in IRS’ general ledger, while P&E acquisitions that should have been capitalized were recorded as expenses. These activities had to be analyzed and recorded or reclassified, a time- consuming process that took several months to complete. Though IRS achieved an important milestone in receiving an unqualified opinion on its fiscal year 2000 financial statements, the approach used to achieve this goal did not address the underlying purpose of sound financial management as envisioned by the CFO Act—to produce reliable, useful, and timely financial and performance information on a routine basis for day-to-day decision-making. Furthermore, until lasting improvements are achieved, IRS will have to continue to rely on extensive efforts to produce reliable financial statements. During fiscal year 2000, IRS did not timely record transactions and perform the necessary reconciliations to ensure that the data contained in its general ledger systems were up-to-date and accurate. Consequently, IRS did not have reliable, timely, and routine financial information to effectively manage its operations. GAO’s Standards for Internal Control in the Federal Government requires that transactions and events be recorded accurately and timely and that ongoing monitoring occur in the course of normal operations to provide reasonable assurance that financial reporting is reliable. These internal control processes and procedures are crucial to ensuring that an agency’s financial management systems produce information that is reliable, timely, and useful. Without these processes and procedures, a modern and integrated financial management system by itself does not guarantee that an agency will be able to prepare financial statements that are fairly stated and generate financial data that can be relied upon for day-to-day decision- making. During fiscal year 2000, IRS’ internal controls over financial reporting were not consistent with these standards. Specifically, IRS did not record material transactions in the general ledger until months after they occurred. For example: Depreciation expenses totaling more than $350 million were not recorded throughout the year, but only at year-end. As a result, the balance in depreciation was inaccurate at interim periods during the year. Imputed financing costs totaling nearly $400 million were not recorded in the general ledger throughout the year but rather as a lump sum amount several months after the fiscal year-end. While IRS made the necessary adjustments to produce reliable year-end financial statements, the balance for imputed financing costs was incorrect throughout fiscal year 2000. In addition, IRS lacked adequate policies and procedures for ensuring that financial data would be adequately reviewed on an ongoing basis. Specifically, IRS management informed us that it did not have policies and procedures requiring systematic reviews and analyses of account balances at interim periods. Consequently, errors and omissions were allowed to arise without prompt detection and correction, and adjusting entries that should have been made throughout the year were allowed to build up until they became material and time-consuming to correct. IRS also did not have policies and procedures requiring reconciliation between its proprietary and budgetary accounts during fiscal year 2000. IRS had to make adjustments totaling more than $160 million several months after the fiscal year-end to bring the net cost of operations derived from the budgetary accounts and the net cost of operations derived from the proprietary accounts into agreement. The failure to maintain accurate and up-to-date financial data impeded IRS management in its ability to use the general ledger as a reliable source of financial data at interim periods to make managerial and operational decisions. IRS did not track the cost accounting information needed to prepare cost- based performance information consistent with GPRA. Deficiencies in IRS’ systems and internal controls discussed above mean that IRS cannot routinely generate reliable financial and performance data for cost-benefit analyses. This could adversely affect IRS management’s and Congress’ ability to make informed management decisions related to resource allocation and other aspects of IRS’ operations throughout the year. The Joint Financial Management Improvement Program’s (JFMIP) System Requirements for Managerial Cost Accounting requires that, at a minimum, agencies have cost accounting information to support the aggregation of financial information related to programs and projects, each of which could have several levels, such as subprograms. In order for IRS to aggregate cost information by program and project to conform to this standard, it must first capture costs at the detail level as they are incurred. However, IRS did not have a systematic process in place to capture costs at the project level during fiscal year 2000. Though IRS had a Project Cost Accounting Subsystem (PCAS) coding structure that can capture personnel costs at the detailed project and subproject level, IRS did not require that all of its employees use PCAS to itemize the time spent on specific projects on their time cards. Consequently, during fiscal year 2000, IRS staff did not use PCAS codes for time charged to either of IRS’ two largest appropriations, which collectively accounted for 74 percent of IRS’ budgetary resources. Similarly, except for information technology projects, PCAS did not collect nonpersonnel costs such as equipment depreciation, rent, and utilities by projects and subprojects. At year-end, IRS extracted data from its accounting system, imported the data into a database, and used a spreadsheet to allocate these nonpersonnel costs to the different projects and subprojects in an effort to derive reliable net operating cost data for the Statement of Net Cost. However, these data were not available until months after the fiscal year-end, were only reliable for a single point in time, and thus were not available on an ongoing basis for management purposes. The failure to fully and accurately capture cost at the project level affected IRS’ ability to produce reliable cost data. Specifically, IRS was unable to report on the costs associated with each of the 15 key performance indicators it reported in the “Management Discussion and Analysis” that accompanied its fiscal year 2000 financial statements. As a result, IRS cannot be consistent with GPRA in reporting cost-based performance measures related to its various programs. In addition, IRS was unable to provide evidence that supervisory review was performed to ensure that the performance indicators, and data used to derive these indicators, were complete, accurate, and reliable. For example, IRS did not have documentation demonstrating that a responsible official had reviewed the data to ensure that all data that should be collected for a specific performance indicator was collected, and that only pertinent data was included. This increases the risk that any errors or omissions affecting IRS’ key performance indicators will not be detected and corrected in a timely manner. Finally, IRS faces an additional challenge in the fact that its custodial and administrative general ledgers are independent of each other and are not integrated. Since cost data are primarily contained in the administrative general ledger while critical performance data comes from the custodial general ledger, IRS needs to be able to link these two general ledgers before it can calculate reliable, cost-based performance measures. IRS plans to implement a major portion of an integrated financial and taxpayer account management system by fiscal year 2005. Consequently, this link between the custodial and administrative general ledgers will not occur before then. IRS continues to be unable to determine the specific amount of revenue it actually collects for Social Security, Hospital Insurance, individual income taxes, and excise tax trust funds. These conditions exist primarily because (1) at the time of payment, taxpayers are not required to provide information on the specific taxes that they are paying and (2) IRS’ systems are not capable of capturing such information. Although the tax returns, which the taxpayers file months after the deposits are made, do contain a breakdown on the type of tax, this information pertains only to the amount of the tax liability and not to the amount of taxes paid to IRS. This condition restricts IRS’ ability to report actual collections of significant taxes, such as Social Security, that would be of interest to many parties, including Congress. IRS is developing a system to capture detailed collection information by type of tax and plans to initiate a study, in 3 to 4 years, to gauge taxpayers’ readiness to provide such detailed information. Because data are not available for the allocation of excise taxes to the appropriate trust funds when deposits are made, IRS uses a certification process that is complex, cumbersome, and prone to error in order to distribute excise tax receipts to the respective trust funds. In response to our previous reports, IRS implemented procedures to improve controls over the certification process. However, we continued to find weaknesses in the excise tax certification process. For example, due to delays in recording tax return information in its systems, the amount IRS certified to the Highway Trust Fund for the quarter ended September 30, 1999, included nearly $346 million in collections from previous quarters. These delays resulted in delays in transferring these amounts to the trust funds, thus reducing the amount of interest income the trust funds earn on these receipts. This reduction in interest income could adversely affect distributions of trust fund receipts to the states because the amounts distributed would be based on inaccurate data. To reduce the magnitude of year-end adjustments and assist IRS in improving the reliability of its financial data on a routine basis, we recommend that IRS develop, document, and implement policies and procedures to require monthly reconciliations between proprietary and budgetary accounts so that differences can be identified promptly and, if necessary, adjusted; routine reviews and analyses of general ledger account balances to promptly identify errors and omissions; and recording corrections and adjusting entries throughout the year to reduce the magnitude of year-end adjustments and improve the reliability of interim financial data. To improve IRS’ ability to collect and report on the full costs of its activities, we recommend that IRS implement policies and procedures to require that all employees itemize the time spent on specific projects on allocate nonpersonnel costs to programs and activities routinely throughout the year. To provide assurance on the reliability of performance data, we recommend that IRS document reviews performed to validate that performance data are complete, accurate, and reliable. Many of the issues presented throughout this report have existed for several years, and IRS has noted that the ultimate solution to many of these issues is modernization of its systems. As part of this modernization initiative, IRS plans to implement a new financial system that includes a cost accounting module as well as integrated administrative and custodial general ledgers that are supported by subsidiary ledgers containing the transactional details for key accounts such as taxes receivable and property and equipment. The modernized environment is expected to provide IRS with, among other things, the ability to (1) track and report on the status of each unpaid assessment category, amount, and taxpayer, (2) record P&E transactions in its general ledger accounts as they occur, and (3) prepare cost-benefit analyses and cost-based performance measures. However, these systems will take years to implement. IRS continues to make progress in addressing its financial management challenges. The strong commitment and dedication to financial management reform by IRS senior management has played a crucial role in the progress the agency has made to date and is critical for future improvements. IRS has developed many workaround processes that resulted in its ability to produce reliable financial statements for fiscal year 2000. However, these processes take considerable time, effort, and expense and do not fix many of the fundamental financial management issues that continue to plague the agency. Until these issues are addressed, IRS cannot achieve the overriding objective of the CFO Act and other reform legislation enacted during the last decade—to produce reliable, useful, and timely financial and performance information for day-to-day decision-making. In commenting on a draft of this report, IRS agreed that, in order to improve financial management, it must sustain a high level of effort to implement solutions that will address systems deficiencies and internal control weaknesses. IRS also provided information regarding past and current initiatives to address GAO’s audit recommendations. For example, during fiscal year 2000, IRS (1) routinely reconciled its fund balance, (2) reviewed and managed suspense items, (3) eliminated unneeded obligations, (4) installed and used live-scan fingerprint equipment, and (5) implemented procedures and processes to improve the reliability of P&E records. IRS also noted that it has undertaken additional initiatives to address remaining internal control deficiencies. For example, it noted that it implemented a new inventory system for its P&E and enforced standards to improve inventory practices, developed a standard checklist and conducted monthly security reviews in fiscal year 2001, and hired additional staff to support the master file extract process. We will follow up during our fiscal year 2001 audit to assess the effectiveness of these initiatives. While agreeing with the overall thrust of our report, IRS disagreed with some of the specific report findings and recommendations. Specifically, in the area of P&E, IRS disagreed that in the short term, property acquisitions should be recorded as capital assets as the transactions occur. IRS noted that, until an integrated property management system is acquired, it should continue the current practice of recording property acquisitions as expenses and then transferring these expenses to capital assets in the general ledger after a review process. We disagree. As our report states, IRS’ process for deriving a reliable P&E balance for its annual financial statements involves the use of extensive manual procedures by a contractor to extract and analyze IRS’ data on expenses to identify items that should be classified as assets. This process is time-consuming, occurs months after the acquisition of the assets, and only provides a reliable balance for P&E for a single point in time. This process does not provide IRS with reliable P&E data on an ongoing basis for use in operational decision-making. IRS also disagreed with our conclusions regarding the timeliness of IRS’ recording of obligations. IRS believed that the 2 instances we cited of IRS’ failure to timely record obligations were isolated and thus did not constitute a material weakness in controls over appropriated funds. The 2 instances cited in our report were illustrative examples of IRS’ failure to record obligations before goods and services were received, and did not represent the total number of errors found in our testing. In fact, we found 10 instances in which IRS failed to record obligations before goods and services were received. These exceptions were brought to the attention of IRS staff and management, in writing, throughout the audit. These 10 instances together represent more than isolated instances of IRS’ not recording obligations before goods and services are received. It is also important to note that we did not characterize in our report the issue of IRS not timely recording obligations in and of itself as a material weakness. However, taken collectively, this, plus other issues in the area of appropriated funds management, constitute a material weakness in IRS’ internal controls over its appropriated funds that preclude IRS from providing reasonable assurance that material misstatements would be prevented or detected on a timely basis. In addition, IRS disagreed that we should include its failure to properly record adjustments to obligations as a material weakness. IRS also requested that we reconsider our recommendation that it include in its systems modernization blueprint the capability to differentiate between valid and invalid adjustments to prior-year obligations. IRS stated that the issue stemmed from our and its different interpretations of the definition of upward and downward adjustments. IRS believed that it had successfully resolved this issue because it made audit adjustments we proposed prior to issuing its final fiscal year 2000 financial statements and stated that it would continue to make these adjustments in the future. While we agree that IRS made the audit adjustments we proposed to its financial statements, we disagree that this issue has been resolved and should be excluded from our report. As discussed above, our report does not characterize this issue in and of itself as a material weakness. As stated in our report, we requested that IRS make adjustments in instances involving changes in accounting codes and travel entries that do not meet the definition of upward and downward adjustments. IRS made these adjustments to its fiscal year 2000 financial statements. These adjustments eliminated the type of known errors found during our testing and reduced the dollar amounts of these accounts to levels not considered material for purposes of fairly presenting the financial statements as a whole. These adjustments do not, however, correct the underlying problems that gave rise to the errors in these accounts that required adjusting. Also, while IRS took exception to our recommendation, it noted that the CFO has included this issue in the functional requirements for IRS’ new financial management system, and that, in the short term, it will continue to make these adjustments manually. These corrective actions, if effectively implemented, should address our recommendation regarding this issue. We will evaluate the effectiveness of these actions during the fiscal year 2001 audit. IRS also contested our including an example in the report to illustrate its failure to record the liability for goods and services when received. IRS stated that it had entered into an agreement with us to exclude invoices received after November 30, 2000, from fiscal year 2000 audit procedures. As the invoice for this particular transaction was received on December 6, 2000, IRS believed that this transaction fell outside the agreed-to cutoff date and should thus not be cited. We disagree with IRS’ characterization of what was agreed to. The agreement between IRS and us related to our testing of subsequent disbursements. In previous years, we tested disbursements made within the 3 months following fiscal year-end to identify transactions that should have been, but were not, recorded as a transaction in the year under audit. In fiscal year 2000, we agreed to reduce the test period to 2 months following the fiscal year-end, that is, we would test only subsequent disbursements made from October 1 through November 30 after the fiscal year-end. However, the particular example in our report that IRS is taking issue with was identified during our testing of IRS’ ending undelivered orders balance—this was separate and apart from the testing of subsequent disbursements. Further, lockbox services are recurring transactions covered by 5-year contracts. Consequently, IRS had the capability to accrue for these services without waiting for the invoice. As our report states, the most likely misstatement of the ending undelivered orders balance resulting from the failure to timely record receipt of undelivered orders was $47 million, with an upper error limit of $87 million. The magnitude of these errors reinforces the need for IRS to act to ensure that goods and services are recorded when received. With respect to financial reporting, IRS took issue with our findings that material inaccuracies were found in the fiscal year 2000 financial statements and that these inaccuracies were not effectively detected in IRS’ review of these financial statements. IRS disagreed that these findings should be cited as a material reporting weakness. IRS further stated that it was aware of only two material adjustments we proposed that fell within the purview of financial reporting. Again, we disagree. Each of the internal control deficiencies over financial reporting cited in our report do not individually constitute a material weakness—it is the combination of these deficiencies that constitutes a material weakness. Further, as our report states, IRS’ draft financial statements contained material inaccuracies and the review procedures instituted by IRS were not effective in identifying and addressing errors and omissions material to the financial statements. For example, the first two draft financial statements prepared in January and early February 2001 omitted a material footnote comparing IRS’ Statement of Budgetary Resources with the President’s Budget as required by U.S. generally accepted accounting principles and OMB 97-01, despite the fact that we had indicated to IRS in October 2000 that the footnote was necessary. An effective review procedure would have identified this material omission. Further, we proposed not 2, but 14 audit adjustments, which IRS accepted and recorded. The aggregate absolute value impact of these adjustments was (1) $160 million to assets and liabilities, (2) $140 million to net cost, and (3) $227 million to the statements of financing and budgetary resources. In the area of refunds, IRS disagreed with our finding that IRS does not screen all EITC claims through EFDS. IRS stated that all EITC claims are run through the EFDS program, which prioritizes returns according to criteria that were based on the 1997 EITC Compliance study. We agree that all cases with EITC refund claims are run through the EFDS program by IRS’ Criminal Investigation Division and assigned a score to assist in prioritizing which cases to work. CI, in turn, refers cases above a certain score to the Examination Branch for examination. However, the Examination Branch only examines a subset of those cases referred for examination based upon its perceived level of available resources without collecting the data necessary to determine whether it is focusing the appropriate level of resources on this effort. Without such data, IRS is unable to determine the extent to which refunds associated with invalid EITC claims could be prevented or minimized had IRS devoted more resources to its examination efforts. We have modified our report to provide a more detailed explanation of the EITC examination selection process. IRS also disagreed with our recommendation that it implement policies and procedures requiring all employees to itemize their time on their time cards. IRS stated that it currently tracks itemized information for most employees through its functional tracking systems. We will follow up during our fiscal year 2001 audit to assess the adequacy of this approach. Again, we recognize that IRS achieved an important milestone in producing for the first time combined financial statements in fiscal year 2000 that were fairly stated in all material respects. However, as we state in our report, the tremendous efforts undertaken by IRS staff and management to produce reliable financial statements do not result in reliable, useful, and timely financial and performance information IRS needs for decision- making on an ongoing basis. This approach does not address the underlying financial management and operational issues that adversely affect IRS’ ability to effectively fulfill its responsibilities as the nation’s tax collector. As we have reported for several years, long-term and systematic improvements in IRS’ processes and systems are needed to address the management challenges we have identified. During fiscal year 2000, IRS demonstrated a strong commitment to address the operational and financial management issues raised by us in previous financial statement audits. It successfully implemented a number of initiatives to address outstanding financial-related recommendations and laid the groundwork for continued sustainable improvements in financial management. We will continue to work closely with IRS to build on the improvements made in fiscal year 2000 and to achieve sustained progress in these areas. The complete text of the IRS’ Deputy Commissioner for Operations’ response to this report is reprinted in appendix III. This report contains new recommendations to you. The head of a federal agency is required by 31 U.S.C. 720 to submit a written statement on actions taken on these recommendations. You should send your statement to the Senate Committee on Governmental Affairs and the House Committee on Government Reform within 60 days after the date of this report. A written statement also must be sent to the House and Senate Committees on Appropriations with the agency’s first request for appropriations made over 60 days after the date of this report. We are sending copies of this report to the Chairmen and Ranking Minority Members of the Senate Committee on Appropriations; Senate Committee on Finance; Senate Committee on Governmental Affairs; Senate Committee on the Budget; Subcommittee on Treasury, General Government, and Civil Service, Senate Committee on Appropriations; Subcommittee on Taxation and IRS Oversight, Senate Committee on Finance; Subcommittee on Oversight of Government Management, Restructuring, and the District of Columbia, Senate Committee on Governmental Affairs; House Committee on Appropriations; House Committee on Ways and Means; House Committee on Government Reform; House Committee on the Budget; Subcommittee on Government Efficiency, Financial Management, and Intergovernmental Relations, House Committee on Government Reform; and Subcommittee on Oversight, House Committee on Ways and Means. In addition, we are sending copies of this report to the Chairman and Vice- Chairman of the Joint Committee on Taxation, the Secretary of the Treasury, the Director of the Office of Management and Budget, the Chairman of the IRS Oversight Board, and other interested parties. Copies will be made available to others upon request. This report was prepared under the direction of Steven J. Sebastian, Acting Director, Financial Management and Assurance, who can be reached at (202) 512-3406. If I can be of further assistance, please call me at (202) 512- 2600. As part of our audit of IRS’ fiscal year 2000 financial statements, we evaluated IRS’ internal controls and its compliance with selected provisions of laws and regulations, and we followed up on the status of open recommendations from prior financial audits and related financial management reports. We designed our audit procedures to test relevant controls and included tests for proper authorization, execution, accounting, and reporting of transactions. Specifically, we Tested selected statistical samples of unpaid assessment, revenue, refund, accounts payable, accrued expense, payroll, nonpayroll and undelivered order transactions. These statistical samples were selected primarily to substantiate, and in some cases derive, balances and activities reported on IRS’ financial statements. Consequently, dollar errors or amounts can and have been statistically projected to the population of transactions from which they were selected. In testing these samples, certain attributes were identified that indicated significant deficiencies in the design or operation of internal control. These attributes can be and have been statistically projected to the appropriate populations. Conducted analytical testing procedures where appropriate. Evaluated relevant internal controls over financial reporting and reviewed the overall form and content of the financial statements. Reviewed the IRS contractor’s methodology and procedures for compiling the fiscal year 2000 P&E additions. Tested detailed purchasing transactions of P&E, major systems, capital leases, and leasehold improvements and a statistical sample of P&E items at several IRS locations. Compared EITC amounts from IRS and Treasury reports, and reviewed EITC audit cases. Tested transactions that represent the underlying basis of amounts distributed to various trust funds, primarily the Highway Trust Fund and Airport and Airway Trust Fund. Reviewed the IRS certifications of excise tax revenue distributed to the Highway Trust Fund and Airport and Airway Trust Fund. Reviewed IRS’ reconciliations and specific controls over refund processing and financial reporting. Observed physical safeguards over cash and checks received and processed at campuses, field offices, and lockbox banks. Interviewed and observed management and personnel at campuses, field offices, and lockbox banks. Reviewed relevant audit reports from the Office of the Treasury Inspector General for Tax Administration. Reviewed IRS’ fiscal year 2000 Federal Managers’ Financial Integrity Act Annual Assurance Statement, IRS’ January 2001 letter to Congress responding to Recommendations to Improve Financial and Operational Management (GAO-01-42), and IRS’ April 2001 Remediation Plan. We performed our work from April 2000 through February 2001 in accordance with U.S. generally accepted government auditing standards. We have also issued a management letter addressing additional matters that we identified during our fiscal year 2000 audit regarding accounting procedures and internal controls that could be improved, and we have issued separate reports on computer security issues. Appendix II consists of two tables. Table 9 lists our recommendations from prior financial statement audits and related financial management reports. Table 10 lists new recommendations resulting from our fiscal year 2000 audit. From our previous reports on IRS’ financial activities, 85 recommendations remained open as of the date of this report (1 through 85 in table 9). We are closing 24 of these recommendations primarily because IRS has addressed them or because they are being superseded by updated or more detailed recommendations. Thus, 61 of these prior recommendations remain open. The column “GAO status of recommendations” in table 9 lists the current status of these recommendations and indicates whether we believe that each open recommendation could be addressed in the short term (such as enforcing policies that are not being consistently followed) or whether each would require long-term changes for fundamentally deficient financial systems or other more extensive changes. We are also making 10 new recommendations in this report, numbered 86 through 95 in table 10, with short- or long-term changes also indicated. Consequently, 71 recommendations are open as of the date of this report. We have highlighted in bold the 9 recommendations we consider of highest priority for IRS to address. These are recommendations 6, 8, 17, 47, 48, 49, 53, 54, and 55. We will continue to monitor IRS’ progress toward addressing each of the recommendations in this appendix during our fiscal year 2001 audit. In addition to those named above, Tuyet-Quan Thai, Delores Lee, Richard Harada, George Jones, and William Cordrey made key contributions to this report. The General Accounting Office, the investigative arm of Congress, exists to support Congress in meeting its constitutional responsibilities and to help improve the performance and accountability of the federal government for the American people. 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Summary: This is a follow-on to GAO's report on its audit of the Internal Revenue Service's (IRS) fiscal year 2000 financial statements. Many of the issues raised in this report have persisted for years. IRS believes that the solution to many of these issues may lie in systems modernization. IRS plans to implement a new financial system that includes a cost accounting module as well as integrated administrative and custodial general ledgers that are supported by subsidiary ledgers containing the transactional details for key accounts, such as taxes receivable and property and equipment. IRS continues to make progress in addressing its financial management challenges. The strong commitment by IRS senior management to financial management reform has played a crucial role in the agency's progress so far and is critical for future improvements. IRS has developed many workaround processes that allowed it to produce reliable financial statements for fiscal year 2000. However, these processes take considerable time, effort, and expense and do not fix many of the fundamental financial management issues that continue to plague IRS.