The Federal Reserve System was created by the Federal Reserve Act in 1913 as the central bank of the United States to provide a safe and flexible banking and monetary system. The System is composed primarily of 12 FRBs with 25 branches (organized into 12 districts), the Federal Open Market Committee, and the Federal Reserve Board, which exercises broad supervisory powers over the FRBs. The primary functions of the Federal Reserve System are to (1) conduct the nation’s monetary policy by influencing bank reserves and interest rates, (2) administer the nation’s currency in circulation, (3) buy or sell foreign currencies to maintain stability in international currency markets, (4) provide financial services such as check clearing and electronic funds transfer to the public, financial institutions, and foreign official institutions, (5) regulate the foreign activities of all U.S. banks and the domestic activities of foreign banks, and (6) supervise bank holding companies and state chartered banks that are members of the System. The FRBs also provide various financial services to the U.S. government, including the administration of Treasury securities. The FRBs’ assets are comprised primarily of investments in U.S. Treasury and agency securities. As of December 31, 1994, the FRBs reported a securities portfolio balance of $379 billion (87 percent of total assets). These securities primarily consist of Treasury bills, Treasury notes, and Treasury bonds that the FRBs buy and sell when conducting monetary policy. The FRBs act as Treasury’s fiscal agent by creating Treasury securities in electronic (book-entry) form upon authorization by the U.S. Treasury and administering ongoing principal and interest payments on these securities. Treasury securities are maintained on electronic recordkeeping systems operated and controlled by the FRBs. The U.S. Treasury maintains an independent record of total Treasury securities outstanding but not individual ownership records. The FRBs maintain records of securities held by depository institutions, by the central banks of other countries, and which they hold for their own account. These records do not indicate whether securities held by the depository institutions are for their own accounts or on behalf of their customers. The portion of these securities owned by the FRBs is maintained on recordkeeping systems that the New York FRB operates. A security’s historical cost is comprised of the security’s face value (par) and any difference between this face value and the security’s purchase price. These differences are referred to as premiums when the purchase price is higher than the face value and as discounts when the price is less than the face value. These amounts are reduced over the life of the security to adjust interest income. Federal Reserve notes are the primary paper currency of the United States in circulation and the FRBs’ largest liability. As of December 31, 1994, the FRBs reported a Federal Reserve note balance of $382 billion (89 percent of total liabilities). Notes are printed by the U.S. Treasury’s Bureau of Engraving and Printing and shipped to the FRBs, who store them in their vaults until they are withdrawn by financial institutions. Notes do not mature or expire and are liabilities of the FRBs until they are returned to the FRBs. The amount the FRBs report as their liabilities for outstanding notes is actually a running balance of all notes issued from inception that have not been returned to the FRBs. The Federal Reserve Act designates certain assets of each FRB as eligible collateral for the reported Federal Reserve note liability. The majority of the assets pledged as collateral are each FRB’s Treasury securities. In addition, the FRBs have entered into cross-collateralization agreements under whose terms the assets pledged as collateral to secure each FRB’s notes are also pledged to secure the notes of all the FRBs. Therefore, as long as total collateral assets held by the FRBs equal or exceed the FRBs’ total liabilities for notes, the note liability of each individual FRB is fully secured. To conduct our work, we (1) gained an understanding of relevant accounting and reporting policies and procedures by reviewing and analyzing documentation and interviewing key FRB and Board personnel, (2) reviewed documentation supporting selected significant balance sheet amounts originating at the Dallas FRB, and (3) tested the effectiveness of certain internal controls in place at the Dallas FRB and the Federal Reserve Automation Services (FRAS) in Richmond, Virginia, and Dallas, Texas. We conducted our work primarily at the Federal Reserve Banks of Dallas and New York; the Dallas FRB’s branches in Houston, San Antonio, and El Paso; the two FRAS sites mentioned above; and the Board of Governors of the Federal Reserve System in Washington, D.C., between July 1994 and November 1995 in accordance with generally accepted government auditing standards. We requested written comments on a draft of this report from the Chairman, Board of Governors of the Federal Reserve System. The Secretary of the Board provided us with written comments. These comments are discussed in the “Agency Comments and Our Evaluation” section and are reprinted in appendix I. Our work at the Dallas FRB, its three branches, and the Federal Reserve Automation Services identified internal control issues that we considered to be significant enough to warrant management’s attention. Our findings were detailed in separate reports to officials of the Dallas FRB and FRAS, as applicable. In these reports, we provided suggestions for improvements and documented the many corrective actions either taken, underway, or planned by Dallas FRB and FRAS officials. The issues we identified at the Dallas FRB include weaknesses in controls over financial reporting, those aspects of automated systems that were controlled in Dallas, check processing, and Federal Reserve note inventories. For example, (1) reconciliations of general ledger accounts and activity were not always based on independent records, (2) the automated systems did not prohibit access by all terminated employees, (3) accounting adjustments related to check processing activity were not appropriately reviewed, and (4) inventory counts of Federal Reserve notes at some branches were not always properly conducted and documented. The management of the Dallas FRB has already taken action on some of our suggestions to resolve these issues. We also identified weaknesses in general controls over the automated systems maintained and operated by FRAS and used by the Dallas FRB. These weaknesses involved controls over access to sensitive information and the computer center, changes to system software, testing the disaster recovery plan, and the use of special privileges on automated tasks. For example, (1) access to job management software was not restricted to authorized individuals, (2) access to the FRAS computer center was inappropriately granted to contractor personnel, (3) FRAS lacked policies and procedures for testing and certifying software changes prior to implementation, and (4) FRAS had not tested the communication network linking the Federal Reserve System. FRAS officials agreed with our suggestions for improvement and, in most cases, initiated corrective actions prior to the conclusion of our work. The FRBs used different practices to track new note issuances than they used to track the notes they held in their vaults, resulting in inconsistent note accounting and reporting. Furthermore, various changes to the Federal Reserve Act, the notes’ interchangeable nature, and the way in which the FRBs meet their note collateral requirements appear to have made the tracking of note issuances by identifier unnecessary. When new notes are issued, the FRB whose identifying marking appears on the note records a liability for the note amount. Notes that are held in each FRB’s vault, regardless of identifier, reduce this liability to arrive at the reported amount of notes outstanding. Consequently, for each FRB, the reported amount of notes outstanding does not accurately reflect the actual amount of outstanding notes bearing that FRB’s identifier. Various changes to the act have also diminished the importance of these FRB identifiers. Originally, the act required an identifier on each note to help ensure that each FRB satisfied statutory gold reserve requirements for its notes in circulation. However, these gold reserve requirements have since been repealed. Additionally, in response to changes in the act, notes in the vault are no longer sorted and recorded by identifier. Historically, the identifiers facilitated the FRBs’ sorting of notes to comply with other note-related provisions. For example, the act originally prohibited the FRBs from paying out notes with other FRBs’ identifiers to customers. To comply with the act, each FRB sorted notes received from customers and returned notes to the other FRBs, as appropriate. The Congress eliminated these provisions to reduce costs and inefficiencies in the FRBs’ note-related operations. Additionally, under the act’s original provisions, the FRBs were required to return all excessively worn notes to the Comptroller of the Currency for destruction. Each FRB was credited with the amount of its notes to be destroyed. To further reduce costs, the Congress amended the act to modify these requirements. As a result, unfit notes may be destroyed at any FRB and the Board of Governors then apportions the note destructions among the FRBs. The act allows the Board to determine the method by which note destructions will be apportioned. Other factors affecting notes further diminish the importance of using identifiers to associate each note with a specific FRB for accounting and reporting purposes. As the nation’s currency, all notes are accepted at any FRB and are used interchangeably, regardless of their identifiers. In addition, the FRBs comply with the act’s collateral requirements by pledging each FRB’s eligible assets as collateral to secure the notes of all the FRBs. Individual FRB note liabilities are less meaningful than the combined note liability because of the notes’ cross-collateralization. Thus, continuing to use specific note identifiers to record note liabilities appears to be unnecessary. The FRBs have responded to the inefficiencies involved in using identifiers to track notes by automating the note accounting and reporting process. This has eliminated much of the effort involved in tracking notes manually. However, the inconsistency between how the issuances of new notes and the contents of the vault are accounted for and reported has continued. In November 1994, the Board contracted with an independent accounting firm to audit the asset accounts allocated among the FRBs for calendar years 1994 through 1999. The contract also requires audits of the combined financial statements of the FRBs as of December 31 for each of the years from 1995 through 1999. During these years, the financial statements of each individual FRB will also be audited once based on the schedule shown in table 1. Under this contract, the combined financial statements will be audited more frequently than the individual statements. This audit approach is appropriate in light of the needs of users of the combined financial statements. The FRBs operate under agreements which specify that assets pledged as collateral by each FRB for its outstanding notes are available to secure the notes of all the FRBs. Accordingly, the combined assets of the FRBs are used to determine whether the notes are adequately collateralized, thus making this combined presentation the most meaningful. These audits of the FRBs’ combined financial statements will give the Federal Reserve the opportunity to make audited financial statements publicly available. These annual audits enhance the credibility of reported information and conforms to the practices of the central banks of many other major industrialized nations. Although the Federal Reserve’s past annual reports have included the FRBs’ financial statements, these statements were not audited and lacked adequate disclosure of key information, such as significant accounting policies followed by the FRBs. In contrast, the central banks of France, Germany, the United Kingdom, and Canada issue publicly available annual reports that include audited financial statements and the independent auditors’ reports. Presently, there is no requirement that the combined financial statements of the FRBs be audited in accordance with generally accepted government auditing standards (GAGAS). Audits conducted under the contract will be performed in accordance with generally accepted auditing standards (GAAS). We believe that performing these audits under GAGAS would enhance the value of these audits. GAGAS audits incorporate the GAAS requirements, but go further by requiring additional tests of internal controls and compliance with laws and regulations and reports on these matters. The unique role of the FRBs and the nature of records underlying reported balances of Treasury securities and notes preclude full reliance on traditional auditing procedures. For example, confirming account balances with independent parties is an effective audit procedure to substantiate reported balances. However, this procedure cannot be performed for the FRBs’ Treasury security investments and Federal Reserve note liabilities. As part of functions it performs on behalf of Treasury, the New York FRB maintains the ownership records for Treasury securities, including those in the FRBs’ portfolio. However, the New York FRB also maintains the related accounting records for these securities. In contrast, Federal Reserve notes are held by parties independent of the FRBs. However, records of specific note holders cannot be maintained because notes continuously circulate throughout the country and the world. Consequently, the FRBs’ ownership of Treasury securities and the amount of notes outstanding cannot be independently confirmed. The FRBs retain supporting documentation for the cost of securities transactions for about 2 years. As a result, verifying the entire historical cost of securities that have been in the FRBs’ portfolio for extended periods is difficult. However, by retaining support and detailed records for the price paid for new security purchases, the FRBs could eventually support the entire cost of the securities portfolio when the current holdings either are sold or mature. The portion of recorded cost that cannot be readily supported relates to security premiums and discounts. The recorded amounts of premiums and discounts were not significant to the FRBs’ total Treasury security account balance as of December 31, 1994. However, auditing the completeness of these recorded amounts is complicated by the lack of supporting documentation and records. Certain Federal Reserve note characteristics affect related accounting and further complicate audit efforts. For example, notes do not mature or expire. In some countries, such as the United Kingdom and France, after a new currency issue is placed in circulation, the old issue is no longer valid for trade, and the liability for the old currency is removed after an appropriate period. However, the United States does not invalidate old note issues when a new note issue is placed in circulation. All notes issued are recorded as liabilities until returned to the FRBs. Additionally, many notes are held by collectors or are held in foreign countries and may never be returned to the FRBs. Destructibility, another note characteristic, also affects the note balance and complicates the FRB audits. Since notes were first issued, they have been destroyed by fires, wars, and other accidents and natural disasters beyond the FRBs’ control. The value of notes destroyed in this manner in a single year is unlikely to be large relative to the balance. However, the cumulative effect of these destructions and of other notes that may not be returned to the FRBs is unknown. The existence of these factors is not disclosed in the FRBs’ financial statements. We commend the Board for taking the step to contract for external, independent financial statement audits over the next 5 years. We believe that the Board’s current commitment to auditing the FRBs’ combined financial statements should be sustained and become a permanent part of the Board’s operating practices. Presenting audited, combined FRB financial statements that contain appropriate disclosures will enhance the credibility of the Federal Reserve’s annual report and will help meet the needs of financial statement users, including the Congress and the public. Institutionalizing such annual, external independent audits will also place the Federal Reserve System on a par with the central banks of other major industrialized nations with respect to financial reporting practices. In conducting these audits, the FRBs’ external auditors will need to address the audit challenges posed by the FRBs’ unique roles. Recording note liabilities based on bank identifiers is an inefficient use of FRB resources, and reporting this liability under the current approach does not serve a meaningful purpose. Discontinuing the practice of tracking and recording each FRB’s note liability based on note identifiers would increase efficiency and provide a consistent basis for the note liabilities reported by the FRBs. To bring about consistency and improve the efficiency of Federal Reserve note accounting and reporting procedures, we recommend that in conjunction with planning and implementing future changes to the automated systems used to account for and report notes, the Board of Governors of the Federal Reserve System consider incorporating changes in the function of these systems to allow FRBs to account for and report notes without regard to the identifiers printed on the notes; directing the FRBs to discontinue using specific FRB identifiers printed on notes as the basis for recording each FRB’s liability for Federal Reserve notes; stopping the tracking of shipments by FRB identifiers; directing each FRB to record its note liability based on the Federal Reserve notes it actually receives and holds without regard to FRB identifiers; and apportioning note destructions among FRBs on an appropriate basis without regard to FRB identifiers. To enhance the combined financial statements as a vehicle for informing Federal Reserve management, the Congress, and the public about the operations of Federal Reserve Banks, we recommend that the Board of Governors of the Federal Reserve System do the following: Adopt a policy to institutionalize annual, external independent audits of the FRBs’ combined financial statements as a routine operating procedure. These audits should be performed in accordance with GAGAS. Make the FRBs’ audited combined financial statements and independent auditor’s report publicly available upon issuance. For example, these documents could be included in the Federal Reserve System’s annual report. Include disclosures in the financial statements that (1) appropriately describe the significant accounting policies followed, such as the basis for the reported note liability and the treatment of the notes held in the vault, and (2) provide the information typically included in financial statements of other central banks and private sector financial institutions. Regarding our recommendations to bring about consistency and improve the efficiency of Federal Reserve note accounting and reporting procedures, the Board acknowledged in a letter dated January 11, 1996, that changes to the Federal Reserve Act and Federal Reserve policies have blurred the distinction among Federal Reserve notes with different unique identifiers. The Board acknowledged that the accounting process for note destructions offers an opportunity for further efficiencies to be gained in this area. The Board stated it will give consideration to the accounting method used for Federal Reserve notes as the accounting and tracking systems associated with the notes are reviewed for possible redesign. Our other recommendations were intended to enhance the Federal Reserve Banks’ combined financial statements as a vehicle for informing Federal Reserve management, the Congress, and the public about the operations of the Federal Reserve Banks, and we believe implementing them would enhance management’s accountability. The Board stated it will give careful consideration to our recommendations concerning the use of external auditors, presentation of financial statements, and the application of auditing standards. We are sending copies of this report to the Chairman of the Board of Governors of the Federal Reserve System; the Secretary of the Treasury; the Chairman of the House Committee on Banking and Financial Services; the Chairman and Ranking Minority Member of the Senate Committee on Banking, Housing, and Urban Affairs; and the Director of the Office of Management and Budget. Copies will be made available to others upon request. Please contact me at (202) 512-9406 if you or your staff have any questions. Major contributors to this report are listed in appendix II. Helen T. Desaulniers, Attorney The first copy of each GAO report and testimony is free. Additional copies are $2 each. Orders should be sent to the following address, accompanied by a check or money order made out to the Superintendent of Documents, when necessary. VISA and MasterCard credit cards are accepted, also. Orders for 100 or more copies to be mailed to a single address are discounted 25 percent. 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Summary: Pursuant to a congressional request, GAO reviewed several internal control issues at the Federal Reserve Bank (FRB) of Dallas and the Federal Reserve Automation Services' (FRAS) accounting procedures, focusing on: (1) Dallas FRB financial accounting and reporting and electronic data processing (EDP) control weaknesses; (2) the efficiency and consistency of Federal Reserve note accounting; and (3) auditing issues that need the attention of the Federal Reserve System's Board of Governors and its auditor. GAO found that: (1) at the Dallas FRB, its 3 branches, and FRAS, weaknesses exist in accounting records, asset accountability, and the use of automated systems; (2) Dallas FRB control weaknesses include failure to use independent records to verify and reconcile general ledger accounts and activity, limit access to FRB automated systems, review accounting adjustments related to check processing activity, and properly conduct and document Federal Reserve note inventories; (3) FRAS and Dallas FRB general EDP weaknesses include inadequate control over access to sensitive information, system software changes, disaster recovery plan testing, and the use of special privileges on automated tasks; (4) the Federal Reserve could improve the consistency and efficiency of its note accounting procedures by eliminating the use of the FRB identifier on each note for recording liabilities for notes in circulation; (5) the Board of Governors has contracted for annual independent external audits of the combined FRB asset accounts and financial statements over the next 5 years and one audit of each FRB during the same period to enhance the credibility of reported information; and (6) the auditor will face challenges identifying the ownership and original cost of U.S. Treasury securities, confirming amounts held by note holders, and the notes' unique characteristics of nonmaturity and destructibility.