Several factors constrain CNMI’s economic potential, including the lack of diversification, scarce natural resources, small domestic markets, limited infrastructure, and shortages of skilled labor. The United States exercises sovereignty over CNMI, and, in general, federal laws apply to CNMI. However, federal minimum wage provisions and federal immigration laws do not apply. CNMI immigration policies and the demands for labor by the garment manufacturing industry and tourism sector have resulted in rapid population growth since 1980 such that the majority of the population are non-U.S. citizens. (See fig. 1.) According to U.S. Census Bureau data for 2000, the most recent census data available, about 56 percent of the CNMI population of 69,221 were not U.S. citizens. According to U.S. Census Bureau data for 2000, the median household income in CNMI was $22,898, a little more than half of the U.S. median household income of almost $42,000 for 2000. The percentage of individuals in poverty in 2000 was 46 percent, nearly four times the continental U.S. rate of 12 percent in that same year. CNMI’s economy depends on two industries, garment manufacturing and tourism, for its employment, production, and exports. These two industries rely heavily on a noncitizen workforce. This workforce represents more than three quarters of the labor pool that are subject to the CNMI minimum wage, which is lower than the U.S. minimum wage. The garment industry, for example, uses textiles and labor imported mostly from China. A 1999 study found that garment manufacturing and tourism accounted for about 85 percent of CNMI’s total economic activity and 96 percent of its exports. A 2005 estimate of CNMI’s gross domestic product (GDP) suggest that, in 2002, the garment industry contributed to roughly 40 percent of CNMI’s GDP and 47 percent of payroll. However, recent changes in trade laws have increased foreign competition for CNMI’s garment industry, while other external events have negatively impacted its tourism sector. Recent developments in international trade laws have reduced CNMI’s trade advantages, and the garment industry has declined in recent years. Historically, while garment exporters from other countries faced quotas and duties in shipping to the U.S. market, CNMI’s garment industry benefited from quota-free and duty-free access to U.S. markets for shipments of goods in which 50 percent of the value was added in CNMI. In recent years, however, U.S. agreements with other textile-producing countries have liberalized the textile and apparel trade. For example, in January 2005, in accordance with one of the 1994 World Trade Organization (WTO) Uruguay Round agreements, the United States eliminated quotas on textile and apparel imports from other textile- producing countries, leaving CNMI’s apparel industry to operate under stiffer competition, especially from low-wage countries such as China. According to a DOI official, more than 3,800 garment jobs were lost between April 2004 and the end of July 2006, with 10 out of 27 garment factories closing. U.S. Department of Commerce data show that the value of CNMI shipments of garments to the United States dropped by more than 16 percent between 2004 and 2005, from about $807 million to $677 million, and down from a peak of $1 billion in 1998--2000. In 2006, reported garment exports to the United States fell further, by an estimated 25 percent compared to 2005, with exports declining to an estimated $497 million. The reported level of shipments to the United States in 2006 was comparable to levels of sales in 1995--1996, prior to the significant build-up of the industry. (See fig. 2.) In December 2006, the largest and oldest garment factory closed. Given that the garment industry is significant to CNMI’s economy, these developments will likely have a negative financial effect on government revenue. For example, reported fees collected by the government on garment exports fell 37 percent from $38.6 million in 2000 to $24.4 million in 2005. CNMI’s tourism sector experienced a sharp decline in the late 1990s, and a series of external events have further hampered the sector. Tourism became a significant sector of economic activity in CNMI by the mid-1980s and continued to grow into the 1990s. Due to its proximity to Asia, Asian economic trends and other events have a direct effect on CNMI’s economy. For example, tourism in CNMI experienced a sharp decline in the late 1990s with the Asian financial crisis and due to the cancellation of Korean Air service to CNMI following an airplane crash on Guam in August 1997. (See fig. 3.) Visitors from Korea, the second largest source of tourists, decreased by 85 percent from 1996 to 1998. After a modest recovery in 2000, tourism faltered again with the September 11, 2001, terrorist attacks on the United States. In 2003, according to CNMI officials, tourism slowed—with a double-digit decline in arrivals for several months—in reaction to the SARS epidemic and to the war in Iraq. Tourism in CNMI is also subject to changes in airline practices. For example, Japan Airlines (JAL) withdrew its direct flights between Tokyo and Saipan in October 2005, raising concerns because roughly 30 percent of all tourists and 40 percent of Japanese tourists arrive in CNMI on JAL flights, according to CNMI and DOI officials. The Marianas Visitors Authority’s June 2006 data show that the downward trend in Japanese arrivals is not being offset by the growth in arrivals from other markets such as China and South Korea, with the total number of foreign visitors dropping from 43,115 in June 2005 to 38,510 a year later. At the same time, CNMI has experienced increased Chinese tourists in recent years, which offer the potential to reenergize the industry. The fiscal condition of CNMI’s government has steadily weakened from fiscal year 2001 through fiscal year 2005, the most recent year for which audited financial statements for CNMI were available. In addition, several indicators point to a severe financial crisis in fiscal year 2006. As shown in figure 4, CNMI’s reported governmental fund balance declined from a positive $3.5 million at the beginning of fiscal year 2001 to a deficit of $84.1 million by the end of fiscal year 2005, as CNMI’s expenditures for its governmental activities consistently exceeded revenues in each year since fiscal year 2002. Most of CNMI’s governmental activities, which include basic services such as public safety, health care, general administration, streets and parks, and security and safety, are reported in its governmental activities, or government funds. The fund balance (or deficit) for these activities reflects the amount of funds available at the end of the year for spending. A significant contributing factor to the gap between expenditures and revenues is that actual expenditures have exceeded budgeted expenditures each fiscal year during the period 2001 through 2005. Another measure of fiscal health is the measure of net assets for governmental activities, which represents total assets minus total liabilities. As shown in table 1, CNMI has experienced a negative trend in its balance of net assets for governmental activities, going from a reported positive $40.6 million balance at the end of fiscal year 2001 to a negative $38 million balance at the end of fiscal year 2005. The primary difference between the fund balance measure and net assets is that the net assets include capital assets and long-term liabilities, whereas the fund balance figure focuses on assets available for current period expenditures and liabilities that are due and payable in the current period. In order to finance its government activities in an environment where expenditures have exceeded revenues, CNMI has increased its debt and has not made the required contributions to its retirement fund. CNMI’s reported balance of notes and bonds payable has increased from $83 million in fiscal year 2002 to $113 million in fiscal year 2005, representing an increase of 36 percent. CNMI’s balance owed to its pension fund has increased from $72 million in 2002 to $120 million in 2005, representing an increase of 67 percent. CNMI has also been incurring penalties on the unpaid liabilities to the pension fund. The total amount of assessed penalties was $24 million as of September 30, 2005. As shown in figure 5, CNMI’s reported debt to assets ratio has increased significantly, from 89.8 percent in fiscal year 2002 to 113.5 percent in 2005. In other words, at the end of fiscal year 2005, CNMI owed $1.14 for every $1.00 in assets that it held. Although CNMI’s audited fiscal year 2006 financial statements are not yet available, indicators point to a severe fiscal crisis during fiscal year 2006. In a May 5, 2006 letter to the CNMI Legislative leaders, Governor Benigno R. Fitial stated that “the Commonwealth is facing an unsustainable economic emergency. . . . I regret to say that the nature and extent of these financial problems are such that there is no simple or painless solution.” CNMI has implemented several significant cost-cutting and restructuring measures during fiscal year 2006. For instance, in August 2006, CNMI enacted its Public Law No. 15-24 to implement “austerity holidays” consisting of bi-weekly furloughs, during which government employees are not paid and many government operations are closed. This measure was taken to help alleviate the financial crisis by saving millions of dollars in both personnel and operational costs. The measure declared unpaid holidays once per pay period for the remainder of fiscal years 2006 and 2007, reducing the government’s normal pay period to 72 hours every 2 weeks. In June of 2006, CNMI enacted Public Law No. 15-15 to authorize the CNMI government to suspend the government’s employer contributions to the retirement fund for the remainder of fiscal years 2006 and 2007. In addition, CNMI has passed laws to restructure loans among its component units, reform the rate of compensation for members of boards and commissions, increase the governor’s authority to reprogram funds, extend the date for full funding of the retirement fund’s defined benefit plan, and create a defined contribution retirement plan for government employees hired on or after January 1, 2007. These measures are immediate and dramatic, and are indicative of severe financial problems that will likely call for long-term solutions. CNMI has had long-standing financial accountability problems, including the late issuance of its single audit reports, the inability to achieve unqualified (“clean”) audit opinions on its financial statements, and numerous material weaknesses in internal controls over financial operations and compliance with laws and regulations governing federal grant awards. CNMI received a reported $65.6 million in federal grants in fiscal year 2005 from a number of federal agencies. The five largest federal grantors in 2005 for CNMI included the Departments of Agriculture, Health and Human Services, Interior, Homeland Security, and Labor. As a nonfederal entity expending more than $500,000 a year in federal awards, CNMI is required to submit a single audit report each year to comply with the Single Audit Act, as amended. Single audits are audits of the recipient organization—the government in the case of CNMI—that focus on the recipient’s financial statements, internal controls, and compliance with laws and regulations governing federal grants. One of the objectives of the act is to promote sound financial management, including effective internal controls, with respect to federal expenditures of the recipient organization. Single audits also provide key information about the federal grantee’s financial management and reporting and are an important control used by federal agencies for overseeing and monitoring the use of federal grants. For fiscal years 1997 through 2005, CNMI did not submit its single audit reports by the due date, which is generally no later than 9 months after the fiscal year end. CNMI’s late submission of single audit reports means that the federal agencies overseeing federal grants to CNMI did not have current audited information about CNMI’s use of federal grant funds. As shown in table 2, CNMI’s single audit submissions were significantly late for fiscal years 1997 through 2004. However, CNMI has made significant progress in 2005 by submitting its fiscal year 2005 single audit report less than 1 month late. Auditors are required by OMB Circular No. A-133 to provide opinions (or disclaimers of opinion, as appropriate) as to whether the (1) financial statements are presented fairly in all material respects in conformity with generally accepted accounting principles (GAAP) and (2) auditee complied with laws, regulations, and the provisions of contracts or grant agreements that could have a direct and material effect on each major federal program. The CNMI government has been unable to achieve unqualified (“clean”) audit opinions on its financial statements, receiving qualified opinions on the financial statements issued for fiscal years 1997 through 2005. Auditors render a qualified opinion when they identify one or more specific matters that affect the fair presentation of the financial statements. The effect of the auditors’ qualified opinion can be significant enough to reduce the usefulness and reliability of CNMI’s financial statements. CNMI has made some progress in addressing the matters that resulted in the qualified opinions on its financial statements for fiscal years 2001 through 2003. However, some of the issues continued to exist in 2004 and 2005. The auditors identified the following issues in fiscal year 2005 that resulted in the most recent qualified audit opinion: (1) inadequacies in the accounting records regarding taxes receivable, advances, accounts payable, tax rebates payable, other liabilities and accruals, and the reserve for continuing appropriations, (2) inadequacies in accounting records and internal controls regarding the capital assets of the Northern Marianas College, and (3) the lack of audited financial statements for the Commonwealth Utilities Corporation, which represents a significant component unit of CNMI. Auditors for CNMI also rendered qualified opinions on CNMI’s compliance with the requirements for major federal award programs from 1997 through 2005. In fiscal year 2005, the auditors cited noncompliance in the areas of allowable costs, cash management, eligibility, property management, procurement, and other requirements. CNMI has long-standing and significant internal control weaknesses over financial reporting and compliance with requirements for federal grants. Table 3 shows the number of material weaknesses and reportable conditions for CNMI for fiscal years 2001 through 2005. The large number and the significance of reported internal control weaknesses raise serious questions about the integrity and reliability of CNMI’s financial statements and its compliance with requirements of major federal programs. Furthermore, the lack of reliable financial information hampers CNMI’s ability to monitor programs and financial information such as revenues and expenses and to make timely, informed decisions. CNMI’s 13 internal control reportable conditions for fiscal year 2005, 9 of which were material weaknesses, indicate a lack of sound internal control over financial reporting needed to provide adequate assurance that transactions are properly recorded, assets are properly safeguarded, and controls are adequate to prevent or detect fraud, waste, abuse, and mismanagement. For example, one of the material internal control weaknesses that the auditors reported for CNMI’s government for fiscal year 2005 was the lack of audited fiscal year 2005 financial statements of the Commonwealth Utilities Corporation (Corporation), a significant component unit of CNMI. Because the Corporation’s financial statements were unaudited, the auditors could not determine the propriety of account balances presented in the financial statements that would affect CNMI’s basic financial statements. CNMI’s auditors also reported other significant material internal control weaknesses that have continued from previous years, such as improper tracking and lack of support for advances to vendors, travel advances to employees, liabilities recorded in the General Fund, and tax rebates payable. Due to the lack of detailed subsidiary ledgers and other supporting evidence, the auditors could not determine the propriety of these account balances. According to the auditors, the effect of these weaknesses is a possible misstatement of expenditures and related advances and liabilities, which also resulted in a qualification of the opinion on the fiscal year 2005 CNMI financial statements. Consequently, CNMI’s financial statements may not be reliable. As shown in table 3, auditors also reported 38 reportable conditions in CNMI’s compliance with requirements for major federal programs and the internal controls intended to ensure compliance with these requirements. Two of these reportable conditions were considered material weaknesses. One of the two material internal control weaknesses affecting compliance with federal programs reported for CNMI’s government for fiscal year 2005 included the failure to record expenditures for the Medical Assistance Program when they were incurred. Specifically, the auditors identified expenditures in fiscal year 2005 for billings from service providers for services rendered in previous years. The effect of this weakness is that expenditures reported to the grantor agency, the U.S. Department of Health and Human Services, are based on the paid date and not, as required, the service date. In addition, actual expenditures incurred during the year are not properly recorded and, therefore, current year expenditures and unrecorded liabilities are understated. The other material weakness affecting compliance related to the lack of adherence to established policies and procedures for managing and tracking property and equipment purchased with federal grant funds. As a result, CNMI’s government was not in compliance with federal property standards and its own property management policies and procedures. The other 36 reportable conditions concerned compliance with requirements regarding allowable costs; cash management; eligibility; equipment and property management; matching, level of effort, and earmarking; procurement and suspensions and debarment; reporting; subrecipient monitoring; and special tests and provisions that are applicable to CNMI’s major federal programs. In CNMI’s corrective action plan for fiscal year 2005, CNMI officials agreed with almost all of the auditors’ findings. According to its fiscal year 2005 corrective action plan, CNMI is working to get a current audit of its component unit, the Commonwealth Utilities Corporation. Other planned actions include properly reconciling advances to vendors; reviewing travel advance balances and making adjustments as needed, including making payroll deductions if expense vouchers are not filed timely; implementing procurement receiving procedures for prepaid items; making necessary corrections to its automated tax system to enable auditors to better review tax returns; determining the correct balances for construction projects; implementing controls over verifying eligibility for Medicaid and restricting access to the related data; and ensuring proper completion of inventories. The plan provides that most of the findings will be addressed by the end of fiscal year 2007. It is important to note however, that many of the auditors’ findings, particularly those categorized as material weaknesses, are longstanding findings going back in some cases to 1987. OIA has ongoing efforts to support economic development in CNMI and assist CNMI in addressing its accountability issues. OIA has in the last 3 years sponsored conferences in the United States and business- opportunity missions in the insular areas to attract American businesses to the insular areas. The main goal of these efforts is to facilitate interaction and the exchange of information between U.S. firms and government and business officials from the insular areas to spur new investment in a variety of industries. Innovative projects such as setting up a production and mass mailing facility in CNMI aimed at the Japanese market are reported to be underway. OIA’s efforts in helping to create links between the business communities in the United States and CNMI are key to helping meet some of the economic challenges. In our recent report, we concluded that the insular areas would benefit from formal periodic OIA evaluation of its conferences and business-opportunity missions, including assessments of the cost and benefit of its activities and the extent to which these efforts are creating partnerships with businesses in other nations. In our December 2006 report, we recommended that OIA conduct such formal periodic evaluations to assess the effect of these activities on creating private sector jobs and increasing insular area income. OIA agreed with our recommendation. DOI’s OIA and IG, other federal inspectors general, and local auditing authorities assist or oversee CNMI’s efforts to improve its financial accountability. OIA monitors the progress of completion and issuance of the single audit reports as well as providing general technical assistance funds to provide training for insular area employees and funds to enhance financial management systems and processes. DOI’s IG has audit oversight responsibilities for federal funds in the insular area. To promote sound financial management processes in the insular area government, OIA has increased its focus on bringing the CNMI government into compliance with the Single Audit Act. For example, OIA created an incentive for CNMI to comply with the act by stating that an insular area cannot receive capital funding unless its government is in compliance with the act or has presented a plan, approved by OIA, that is designed to bring the government into compliance by a certain date. In addition, OIA provides general technical assistance funds for training and other direct assistance, such as grants, to help the insular area governments comply with the act and to improve their financial management systems and environments. The Graduate School of the U.S. Department of Agriculture (USDA) has been working with OIA for over a decade through its Pacific Islands and Virgin Islands Training Initiatives (PITI and VITI) to provide training and technical assistance. OIA staff members make site visits to CNMI as part of its oversight activities. In our December 2006 report, we recommended that OIA develop a standardized framework for its site visits to improve the effectiveness of its monitoring. We also recommended that OIA develop and implement procedures for formal evaluation of progress made by the insular areas to resolve accountability findings and set a time frame for achieving clean audit opinions. OIA agreed with our recommendations and noted that it had already made some progress during fiscal year 2006. Establishing a routine procedure of documenting the results of site visits in a standard framework would help ensure that (1) all staff members making site visits are consistent in their focus on overall accountability objectives and (2) OIA staff has a mechanism for recording and following up on the unique situations facing CNMI. CNMI faces daunting economic, fiscal, and financial accountability challenges. CNMI’s economic and fiscal conditions are affected by its economy’s general dependence on two key industries. In addition, although progress has been made in improving financial accountability, CNMI continues to have serious internal control and accountability problems that increase its risk of fraud, waste, abuse, and mismanagement. Efforts to meet formidable fiscal challenges in CNMI are exacerbated by delayed and incomplete financial reporting that does not provide officials with the timely and complete information they need for effective decision making. Timely and reliable financial information is especially important as CNMI continues to take actions to deal with its fiscal crisis. OIA has ongoing efforts to assist CNMI in addressing its accountability issues and to support economic development in CNMI. OIA officials monitor CNMI’s progress in submitting single audit reports, and OIA provides funding to improve financial management. Yet, progress has been slow and inconsistent. The benefit to CNMI of past and current assistance is unclear. Federal agencies and CNMI have sponsored and participated in conferences, training sessions, and other programs to improve accountability, but knowing what has and has not been effective and drawing the right lessons from this experience is hampered by a lack of formal evaluation and data collection. Strong leadership is needed for CNMI to weather its current crisis and establish a sustainable and prosperous path for the future. During 2006, the CNMI government took dramatic steps to reverse prior patterns of deficit spending. The CNMI government will need to continue to work toward long-term sustainable solutions. A focused effort is called for in which direct and targeted attention is concentrated on the challenges facing CNMI, with feedback mechanisms for continuing improvement to help CNMI achieve economic, fiscal, and financial stability. OIA plays a key role in this effort. In its comments on our December 2006 report, OIA pointed out that it provides “a crucial leadership role and can provide important technical assistance” to help CNMI and the other insular areas improve their business climates, identify areas of potential for private sector investment, and market insular areas to potential investors. It also noted that improving accountability for federal financial assistance for CNMI and other insular areas is a major priority. OIA has stated its commitment to continuing its comprehensive approach and to implementing other innovative ideas to assist CNMI and the other insular areas in continuing to improve financial management and accountability. Leadership on the part of the CNMI government and OIA is critical to addressing the challenges CNMI faces and to providing long-term stability and prosperity for this insular area. Mr. Chairman and Members of the Committee, this concludes my statement. I would be pleased to answer any questions that you and other Members of the Committee may have at this time. For further information about this testimony, please contact Jeanette Franzel, Director, Financial Management and Assurance at (202) 512-9471 or franzelj@gao.gov, or David Gootnick, Director, International Affairs and Trade at (202) 512-4128 or gootnickd@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this testimony. The following individuals made important contributions to this report: Norma Samuel, Cheryl Clark, Anh Dang, Meg Mills, Maxine Hattery, and Emil Friberg, Jr. This is a work of the U.S. government and is not subject to copyright protection in the United States. It may be reproduced and distributed in its entirety without further permission from GAO. 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Summary: The U.S. insular area of the Commonwealth of the Northern Mariana Islands (CNMI) is a self-governing commonwealth of the United States that comprises 14 islands in the North Pacific. In a December 2006 report--U.S. Insular Areas: Economic, Fiscal, and Financial Accountability Challenges (GAO-07-119)--regarding four insular areas including CNMI, GAO identified and reported the following: (1) economic challenges, including the effect of changing tax and trade laws on their economies; (2) fiscal condition; and (3) financial accountability, including compliance with the Single Audit Act. The Chairman of the Senate Committee on Energy and Natural Resources, which requested the December 2006 report, asked GAO to present and discuss the results as they pertain to CNMI. Our summary and conclusions are based on our work performed for our December 2006 report on U.S. insular areas. For this testimony we also had available CNMI's fiscal year 2005 audited financial statements, which we have included in our review, along with some recent developments in fiscal year 2006. The Commonwealth of the Northern Mariana Islands (CNMI) faces serious economic, fiscal, and financial accountability challenges. CNMI's economy depends heavily on two industries, garment manufacturing and tourism. However, recent changes in U.S. trade law have increased foreign competition for CNMI's garment industry, while other external events have negatively affected its tourism sector. CNMI's garment industry has declined in recent years with factory closings and reduced production. The value of garment shipments to the United States dropped by more than 16 percent between 2004 and 2005 and by an estimated 25 percent in 2006. Tourism in CNMI declined sharply in the late 1990s as a result of a series of external events, including the Asian financial crisis; cancellation of Korean Air service; and fears of international crises such as the SARS epidemic, terrorism, and the Iraq war. In 2005, Japan Airlines withdrew direct flights to the capital. The fiscal condition of CNMI's government has steadily weakened from fiscal year 2001 through fiscal year 2005, as government spending has exceeded revenues each year since 2002. CNMI ended fiscal year 2005 with a deficit of $84.1 million in its governmental fund balance. CNMI's liabilities also exceed its assets for its primary government. Indicators point to a severe financial crisis in fiscal year 2006. In response, the CNMI government has implemented cost-cutting and restructuring measures, including "austerity holidays," consisting of biweekly furloughs during which government workers are not paid and many government operations are closed to reduce personnel and operating costs. CNMI's long-standing financial accountability problems include the late submission of financial audit reports, inability to achieve "clean" opinions in its financial statements by the independent financial auditors, and reports showing serious internal control weaknesses over financial reporting. Many of the auditors' findings are longstanding, going back in some cases to 1987. Federal agencies and CNMI have sponsored and participated in conferences, training sessions, technical assistance, and other programs to improve CNMI's economy, fiscal condition, and accountability. During 2006, the CNMI government took steps to reverse its prior patterns of deficit spending. It will need to continue to work toward long-term sustainable solutions, with concentrated attention on the challenges facing the islands and feedback mechanisms for continuing improvement. Leadership on the part of the CNMI government and the Department of the Interior's Office of Insular Affairs is critical to providing long-term stability and prosperity for this U.S. insular area.