As I mentioned earlier, as has been the case for the previous 6 fiscal years, the federal government continues to have a significant number of material weaknesses related to financial systems, fundamental recordkeeping and financial reporting, and incomplete documentation. Several of these material weaknesses (referred to hereafter as material deficiencies) resulted in conditions that continued to prevent us from forming and expressing an opinion on the U.S. government’s consolidated financial statements for the fiscal years ended September 30, 2003 and 2002. There may also be additional issues that could affect the consolidated financial statements that have not been identified. Major challenges include the federal government’s inability to properly account for and report property, plant, and equipment and inventories and related property, primarily at the Department of Defense (DOD); reasonably estimate or adequately support amounts reported for certain liabilities, such as environmental and disposal liabilities and related costs at DOD, and ensure complete and proper reporting for commitments and contingencies; support major portions of the total net cost of government operations, most notably related to DOD, and ensure that all disbursements are properly recorded; fully account for and reconcile intragovernmental activity and balances; demonstrate how net outlay amounts reported in the consolidated financial statements were related to net outlay amounts reported in the underlying federal agencies’ financial statements; and effectively prepare the federal government’s financial statements, including ensuring that the consolidated financial statements are consistent with the underlying audited agency financial statements, balanced, and in conformity with GAAP. In addition to these material deficiencies, we identified four other material weaknesses in internal control related to loans receivable and loan guarantee liabilities, improper payments, information security, and tax collection activities. The material weaknesses identified by our work are discussed in more detail in appendix III. The ability to produce the data needed to efficiently and effectively manage the day-to-day operations of the federal government and provide accountability to taxpayers and the Congress has been a long-standing challenge at most federal agencies. The results of the fiscal year 2003 assessments performed by agency inspectors general or their contract auditors under FFMIA show that these problems continue to plague the financial management systems used by most of the CFO Act agencies. While the problems are much more severe at some agencies than at others, their nature and severity indicate that overall, management at most CFO Act agencies lacks the full range of information needed for accountability, performance reporting, and decision making. These problems include nonintegrated financial systems, lack of accurate and timely recording of data, inadequate reconciliation procedures, and noncompliance with accounting standards and the U.S. Government Standard General Ledger (SGL). Agencies’ inability to meet the federal financial management systems requirements continues to be the major barrier to achieving compliance with FFMIA. Under FFMIA, CFO Act agency auditors are required to report, as part of the agencies’ financial statement audits, whether agencies’ financial management systems substantially comply with (1) federal financial management systems requirements, (2) applicable federal accounting standards, and (3) the SGL at the transaction level. As shown in figure 2, auditors most frequently reported instances of noncompliance with federal financial management systems requirements. These instances of noncompliance involved not only core financial systems, but also administrative and programmatic systems. For fiscal year 2003, auditors for 17 of the 23 CFO Act agencies reported that the agencies’ financial management systems did not comply substantially with one or more of FFMIA’s three requirements. For the remaining 6 CFO Act agencies, auditors provided negative assurance, meaning that nothing came to their attention indicating that the agencies’ financial management systems did not substantially meet FFMIA requirements. The auditors for these 6 agencies did not definitively state whether the agencies’ systems substantially complied with FFMIA requirements, as is required under the statute. DHS is not subject to the requirements of the CFO Act and, consequently, is not required to comply with FFMIA. Accordingly, DHS’s auditors did not report on DHS’s compliance with FFMIA. However, the auditors identified and reported deficiencies that related to the aforementioned three requirements of FFMIA. Federal agencies have recognized the seriousness of their financial systems weaknesses and have efforts under way to implement or upgrade their financial systems to alleviate long-standing problems. We recognize that it will take time, investment, and sustained emphasis to improve agencies’ underlying financial management systems. As I mentioned earlier, for the past 7 fiscal years, the federal government has been required to prepare, and have audited, consolidated financial statements. Successfully meeting this requirement is tightly linked to the requirements for the CFO Act agencies to also have audited financial statements. This has stimulated extensive cooperative efforts and considerable attention by agency chief financial officers, inspectors general, Treasury and OMB officials, and GAO. With the benefit of the past 7 years’ experience by the federal government in having the required financial statements subjected to audit, more intensified attention will be needed on the most serious obstacles to achieving an opinion on the U.S. government’s consolidated financial statements. Three major impediments to an opinion on the consolidated financial statements are (1) serious financial management problems at DOD, (2) the federal government’s inability to fully account for and reconcile transactions between federal government entities, and (3) the federal government’s ineffective process for preparing the consolidated financial statements. Essential to achieving an opinion on the consolidated financial statements is resolution of the serious financial management problems at DOD, which we have designated as high risk since 1995. In accordance with section 1008 of the National Defense Authorization Act for Fiscal Year 2002, DOD reported that for fiscal year 2003, it was not able to provide adequate evidence supporting material amounts in its financial statements. DOD stated that it is unable to comply with applicable financial reporting requirements for (1) property, plant, and equipment (PP&E); (2) inventory and operating materials and supplies; (3) environmental liabilities; (4) intragovernmental eliminations and related accounting adjustments; (5) disbursement activity; and (6) cost accounting by responsibility segment. Although DOD represented that the military retirement health care liability data had improved for fiscal year 2003, the cost of direct health care provided by DOD-managed military treatment facilities was a significant amount of DOD’s total recorded health care liability and was based on estimates for which adequate support was not available. Overhauling DOD’s financial management operations represents a challenge that goes far beyond financial accounting to the very fiber of DOD’s range of business operations, management information systems, and culture. As I have reported in past years, DOD’s financial management problems are pervasive, complex, long-standing, and deeply rooted in virtually all business operations throughout the department. To date, none of the military services or major DOD components has passed the test of an independent financial audit because of pervasive weaknesses in financial management systems, operations, and controls. DOD has been up front about the seriousness of these problems and the need to transform the way it does business. To address these problems, DOD has taken several positive steps in many key areas. For example, the Secretary of Defense has included improving DOD’s financial management as one of his top 10 priorities, and the department has taken a number of actions under its Business Management Modernization Program, including development in April 2003 of an initial business enterprise architecture to guide operational and technological changes. DOD is currently working to refine and implement that architecture and expects to issue new versions of it during 2004. DOD reports that it is also developing detailed financial improvement plans intended to provide disciplined leadership, identify corrective actions, implement solutions, and result in a favorable audit opinion on the fiscal year 2007 DOD-wide financial statements. But DOD still has a long way to go, and top leadership must continue to stress the importance of achieving lasting improvement that truly transforms the department’s business systems and operations. Only through major transformation, which will take time and sustained leadership from top management, will DOD be able to meet the mandate of the CFO Act and achieve the President’s Management Agenda goal of improved financial performance. OMB and Treasury require the CFOs of 35 executive departments and agencies, including the 23 CFO Act agencies, to reconcile selected intragovernmental activity and balances with their “trading partners” and to report to Treasury, the agency’s inspector general, and GAO on the extent and results of intragovernmental activity and balances reconciliation efforts. A substantial number of the agencies continue to be unable to fully perform reconciliations of intragovernmental activity and balances with their trading partners, citing reasons such as (1) trading partners not providing needed data; (2) limitations and incompatibility of agency and trading partner information systems; and (3) lack of human resources. Amounts reported for federal agency trading partners for certain intragovernmental accounts were significantly out of balance in the aggregate for both fiscal years 2003 and 2002. We reported in previous years that the heart of the intragovernmental transactions issue was that the federal government lacked clearly articulated business rules for these transactions so that they would be handled consistently by agencies. In this regard, at the start of fiscal year 2003, OMB issued business rules to transform and standardize intragovernmental ordering and billing. To address long-standing problems with intragovernmental exchange transactions between federal agencies, Treasury provided federal agencies with quarterly detailed trading partner information during fiscal year 2003 to help them better perform their trading partner reconciliations. In addition, the federal government began a three-phase Intragovernmental Transactions e-gov project to define a governmentwide data architecture and provide a single source of detailed trading partner data. Resolving the intragovernmental transactions problem, though, still remains a difficult challenge and will require a commitment by the CFO Act agencies and continued strong leadership by OMB. The federal government did not have adequate systems, controls, and procedures to ensure that the consolidated financial statements are consistent with the underlying audited agency financial statements, balanced, and in conformity with GAAP. In this regard, Treasury is developing a new system and procedures to prepare the consolidated financial statements beginning with the statements for fiscal year 2004. Treasury officials have stated that these actions are intended to, among other things, directly link information from federal agencies’ audited financial statements to amounts reported in the consolidated financial statements and resolve many of the issues we identified in the process for preparing the consolidated financial statements. Resolving issues surrounding preparing the consolidated financial statements will require continued strong leadership by Treasury management. Our nation’s large and growing long-term fiscal imbalance, which is driven largely by known demographic trends and rising health care costs— coupled with new homeland security and defense commitments—serves to sharpen the need to fundamentally review and re-examine basic federal entitlements, as well as other mandatory and discretionary spending, and tax policies. As we look ahead, our nation faces an unprecedented demographic challenge with significant implications, among them budgetary and economic. Between now and 2035, the number of people who are 65 years old or over will double, driving federal spending on the elderly to a larger and ultimately unsustainable share of the federal budget. As a result, tough choices will be required to address the resulting structural imbalance. GAO prepares long-term budget simulations that seek to illustrate the likely fiscal consequences of the coming demographics and rising health care costs. Our latest long-term budget simulations reinforce the need for change in the major cost drivers—Social Security and health care programs. As shown in figure 3, by 2040, absent reform of these entitlement programs, projected federal revenues may be adequate to pay little beyond interest on the debt. Current financial reporting does not clearly and transparently show the wide range of responsibilities, programs, and activities that may either obligate the federal government to future spending or create an expectation for such spending and provides an unrealistic and even misleading picture of the federal government’s overall performance and financial condition. Few agencies adequately show the results they are getting with the taxpayer dollars they spend. In addition, too many significant federal government commitments and obligations, such as Social Security and Medicare, are not fully and consistently disclosed in the federal government’s consolidated financial statements and budget, and current federal financial reporting standards do not require such disclosure. Figure 4 shows some selected fiscal exposures. The spectrum of these exposures ranges from covering only the explicit liabilities that are shown on the consolidated financial statements to implicit promises embedded in current policy or public expectations. These liabilities, commitments, and promises have created a fiscal imbalance that will put unprecedented strains on the nation’s spending and tax policies. Although economic growth can help, the projected fiscal gap is now so large that the federal government will not be able to simply grow its way out of the problem. Tough choices are inevitable. Particularly troubling are the many big-ticket items that taxpayers will eventually have to deal with. The federal government has pledged its support to a long list of programs and activities, including pension and health care benefits for senior citizens, medical care for veterans, and contingencies associated with various government-sponsored entities, whose claims on future spending total trillions of dollars. Despite their serious implications for future budgets, tax burdens, and spending flexibilities, these unfunded commitments get short shrift in the federal government’s current financial statements and in budgetary deliberations. The federal government’s gross debt as of September 2003 was about $7 trillion, or about $24,000 for every man, woman, and child in this country today. But that number excludes items such as the gap between promised and funded Social Security and Medicare commitments and veterans health care benefit commitments provided through the Department of Veterans Affairs. If these items are factored in, the burden for every American rises to well over $100,000. In addition, the new Medicare prescription drug benefit will add thousands more to that tab. The new drug benefit is one of the largest unfunded commitments ever undertaken by the federal government. The Trustees of the Social Security and Medicare trust funds will include an official estimate of the discounted present value cost of this new benefit over the next 75 years in their annual report, which is scheduled for issuance later this month. Preliminary estimates of its long-term cost range up to $7 trillion in discounted present value terms over a 75-year period. To put that number into perspective, it is as much as the total amount of the federal government’s gross debt outstanding as of September 30, 2003. Even before the prescription drug benefit was enacted, our long-term budget simulations showed that by 2040, the federal government may have to cut federal spending in half or double taxes to pay for the mounting cost of the government’s current unfunded commitments. Either would be devastating. Proper accounting and reporting practices are essential in the public sector. After all, the U.S. government is the largest, most diverse, most complex, and arguably the most important entity on earth today. Its services—homeland security, national defense, Social Security, mail delivery, and food inspection, to name a few—directly affect the well- being of almost every American. But sound decisions on the future direction of vital federal government programs and policies are made more difficult without timely, accurate, and useful financial and performance information. Fortunately, we are starting to see efforts to address the shortcomings in federal financial reporting. The President’s Management Agenda, which closely reflects GAO’s list of high-risk government programs, is bringing attention to troubled areas across the federal government and is taking steps to better assess the results that programs are getting with the resources they are given. The Federal Accounting Standards Advisory Board is also making progress on many key financial reporting issues. In addition to these efforts, we have published a framework for analyzing various Social Security reform proposals and will soon publish a framework for analyzing health care reform proposals. We have also helped to create a consortium of “good government” organizations to stimulate the development of a set of key national indicators to assess the United States’ overall position and progress over time and in comparison to those of other industrialized nations. Budget experts at the Congressional Budget Office (CBO) and GAO continue to encourage reforms to the federal budget process to better reflect the federal government’s commitments and signal emerging problems. Among other things, we have recommended that the federal government issue an annual report on major fiscal exposures. The President’s fiscal year 2005 budget also proposes that future President’s budgets report on any enacted legislation in the past year that worsens the unfunded obligations of programs with long-term actuarial projections, with CBO to make a similar report. Such reporting could be a good starting point. Although these are positive initial steps, much more must be done given the magnitude of the federal government’s fiscal challenge. A top-to- bottom review of government activities to ensure their relevance and fit for the 21st century and their relative priority is long overdue. As I have spoken about in the past, the federal government needs a three-pronged approach to (1) restructure existing entitlement programs, (2) reexamine the base of discretionary and other spending, and (3) review and revise the federal government’s tax policy and enforcement programs. New accounting and reporting approaches, budget control mechanisms, and metrics are needed for considering and measuring the impact of spending and tax policies and decisions over the long term. Our report on the U.S. government’s consolidated financial statements for fiscal years 2003 and 2002 highlights the need to continue addressing the federal government’s serious financial management weaknesses. With the significantly accelerated financial reporting time frame for fiscal year 2004 and beyond, it is essential that the federal government move away from the extraordinary efforts many federal agencies continue to make to prepare financial statements and toward giving prominence to strengthening the federal government’s financial systems, reporting, and controls. This is the only way the federal government can meet the end goal of making timely, accurate, and useful financial and performance information routinely available to the Congress, other policymakers, and the American public. The requirement for timely, accurate, and useful financial and performance management information is greater than ever as our nation faces major long-term fiscal challenges that will require tough choices in setting priorities and linking resources to results. The Congress and the President face the challenge of sorting out the many claims on the federal budget without the budget enforcement mechanisms or fiscal benchmarks that guided the federal government through the previous years of deficit reduction into the brief period of surplus. While a number of steps will be necessary to address this challenge, truth and transparency in federal government reporting are essential elements of any attempt to address the nation’s long-term fiscal challenges. The fiscal risks I mentioned earlier can be managed only if they are properly accounted for and publicly disclosed. A crucial first step will be to face facts and identify the significant commitments facing the federal government. If citizens and federal government officials come to understand various fiscal exposures and their potential claims on future budgets, they are more likely to insist on prudent policy choices today and sensible levels of fiscal risk in the future. In addition, new budget control mechanisms will be required, along with effective approaches to successfully engage in a fundamental review, reassessment, and reprioritization of the base of federal government programs and policies that I have recommended previously. Public officials will have more incentive to make difficult but necessary choices if the public has the facts and comes to support serious and sustained action to address the nation’s fiscal challenges. Without meaningful public debate, however, real and lasting change is unlikely. Clearly, the sooner action is taken, the easier it will be to turn things around. I believe a national education campaign and outreach effort is needed to help the public understand the nature and magnitude of the long-term financial challenge facing this nation. An informed electorate is essential for a sound democracy. Members of Generation X and Y especially need to become active in this discussion because they and their children will bear the heaviest burden if policymakers fail to act in a timely and responsible manner. We at GAO are committed to doing our part, but others also need to step up to the plate. By working together, I believe we can make a meaningful difference for our nation, fellow citizens, and future generations of Americans. In closing Mr. Chairman, I want to reiterate the value of sustained congressional interest in these issues, as demonstrated by this subcommittee’s hearings and those the former Subcommittee on Government Efficiency, Financial Management, and Intergovernmental Relations held over the past several years to oversee financial management reform. It will also be key that the appropriations, budget, authorizing, and oversight committees hold agency top leadership accountable for resolving these problems and that they support improvement efforts. For further information regarding this testimony, please contact Jeffrey C. Steinhoff, Managing Director, and Gary T. Engel, Director, Financial Management and Assurance, at (202) 512-2600. R. Navarro & Associates, Inc. R. Navarro & Associates, Inc. Primary Effects on the Fiscal Years 2003 and 2002 Consolidated Financial Statements and the Management of Government Operations Without accurate asset information, the federal government does not fully know the assets it owns and their location and condition and cannot effectively (1) safeguard assets from physical deterioration, theft, or loss, (2) account for acquisitions and disposals of such assets, (3) ensure the assets are available for use when needed, (4) prevent unnecessary storage and maintenance costs or purchase of assets already on hand, and (5) determine the full costs of programs that use these assets. Problems in accounting for liabilities affect the determination of the full cost of the federal government’s current operations and the extent of its liabilities. Also, improperly stated environmental and disposal liabilities and weak internal control supporting the process for their estimation affect the federal government’s ability to determine priorities for cleanup and disposal activities and to allow for appropriate consideration of future budgetary resources needed to carry out these activities. In addition, when disclosures of commitments and contingencies are incomplete or incorrect, reliable information is not available about the extent of the federal government’s obligations. Inaccurate cost information affects the federal government’s ability to control and reduce costs, assess performance, evaluate programs, and set fees to recover costs where required. Improperly recorded disbursements could result in misstatements in the financial statements and in certain data provided by federal agencies for inclusion in the President’s budget concerning obligations and outlays. Problems in accounting for and reconciling intragovernmental activity and balances impair the government’s ability to account for billions of dollars of transactions between governmental entities. Until the differences between the total net outlays reported in federal agencies’ Statements of Budgetary Resources and the records used by the Department of the Treasury to prepare the Statement of Changes in Cash Balance from Unified Budget and Other Activities are reconciled, the effect that these differences may have on the U.S. government’s consolidated financial statements will be unknown. Because the federal government did not have adequate systems, controls, and procedures to prepare its consolidated financial statements, the federal government’s ability to ensure that the consolidated financial statements are consistent with the underlying audited agency financial statements, balanced, and in conformity with U.S. generally accepted accounting principles was impaired. Without a systematic measurement of the extent of improper payments, federal agency management cannot determine (1) if improper payment problems exist that require corrective action, (2) mitigation strategies and the appropriate amount of investments to reduce them, and (3) the success of efforts implemented to reduce improper payments. Weaknesses in the processes and procedures for estimating credit program costs affect the government’s ability to support annual budget requests for these programs, make future budgetary decisions, manage program costs, and measure the performance of lending activities. Information security weaknesses over computerized operations are placing enormous amounts of federal assets at risk of inadvertent or deliberate misuse, financial information at risk of unauthorized modification or destruction, sensitive information at risk of inappropriate disclosure, and critical operations at risk of disruption. Primary Effects on the Fiscal Years 2003 and 2002 Consolidated Financial Statements and the Management of Government Operations Weaknesses in controls over tax collection activities continue to affect the federal government’s ability to efficiently and effectively account for and collect revenue. Additionally, weaknesses in financial reporting affect the federal government’s ability to make informed decisions about collection efforts. As a result, the federal government is vulnerable to loss of tax revenue and exposed to potentially billions of dollars in losses due to inappropriate refund disbursements. The federal government did not maintain adequate systems or have sufficient, reliable evidence to support information reported in the consolidated financial statements of the U.S. government, as described below. These material deficiencies contributed to our disclaimer of opinion on the consolidated financial statements and also constitute material weaknesses in internal control. The federal government could not satisfactorily determine that all PP&E and inventories and related property were included in the consolidated financial statements, verify that certain reported assets actually exist, or substantiate the amounts at which they were valued. Most of the PP&E and inventories and related property are the responsibility of DOD. As in past years, DOD did not maintain adequate systems or have sufficient records to provide reliable information on these assets. Other agencies, most notably the National Aeronautics and Space Administration, reported continued weaknesses in internal control procedures and processes related to PP&E. The federal government could not reasonably estimate or adequately support amounts reported for certain liabilities. For example, DOD was not able to estimate with assurance key components of its environmental and disposal liabilities. In addition, DOD could not support a significant amount of its estimated military postretirement health benefits liabilities included in federal employee and veteran benefits payable. These unsupported amounts related to the cost of direct health care provided by DOD-managed military treatment facilities. Further, the federal government could not determine whether commitments and contingencies, including those related to treaties and other international agreements entered into to further the U.S. government’s interests, were complete and properly reported. The previously discussed material deficiencies in reporting assets and liabilities, material deficiencies in financial statement preparation, as discussed below, and the lack of adequate disbursement reconciliations at certain federal agencies affect reported net costs. As a result, the federal government was unable to support significant portions of the total net cost of operations, most notably related to DOD. With respect to disbursements, DOD and certain other federal agencies did not adequately reconcile disbursement activity. For fiscal years 2003 and 2002 there were unsupported adjustments to federal agencies’ records and unreconciled disbursement activity, including unreconciled differences between federal agencies’ and Treasury’s records of disbursements, totaling billions of dollars, which could also affect the balance sheet. OMB and Treasury require the CFOs of 35 executive departments and agencies, including the 23 CFO Act agencies, to reconcile selected intragovernmental activity and balances with their “trading partners” and to report to Treasury, the agency’s inspector general, and GAO on the extent and results of intragovernmental activity and balances reconciliation efforts. A substantial number of the agencies did not fully perform the required reconciliations for fiscal years 2003 and 2002, citing reasons such as (1) trading partners not providing needed data, (2) limitations and incompatibility of agency and trading partner information systems, and (3) lack of human resources. For both of these years, amounts reported for federal agency trading partners for certain intragovernmental accounts were significantly out of balance. Treasury’s ability to eliminate certain intragovernmental activity and balances is impaired by these federal agencies’ problems in handling their intragovernmental transactions. OMB Bulletin 01-09, Form and Content of Agency Financial Statements, states that outlays in federal agencies’ Statements of Budgetary Resources (SBR) should agree with the respective agency’s net outlays reported in the budget of the U.S. government. In addition, SFFAS No. 7, Accounting for Revenue and Other Financing Sources and Concepts for Reconciling Budgetary and Financial Accounting, requires explanation of any material differences between the information required to be disclosed (including net outlays) and the amounts described as “actual” in the budget of the U.S. government. We found material differences between the total net outlays reported in selected federal agencies’ audited SBRs and the records used to prepare the Statement of Changes in Cash Balance from Unified Budget and Other Activities (Statement of Changes in Cash Balance), totaling about $140 billion and $186 billion for fiscal years 2003 and 2002, respectively. Two agencies (Treasury and the Department of Health and Human Services (HHS)) accounted for about 83 percent and 75 percent of the differences identified in fiscal years 2003 and 2002, respectively. We found that the major cause of the differences for the two agencies was the treatment of offsetting receipts. Some offsetting receipts for these two agencies had not been included in the agencies’ SBRs, which would have reduced the agencies’ net outlays and made the amounts more consistent with the records used to prepare the Statement of Changes in Cash Balance. For example, we found that HHS reported net outlays for fiscal year 2003 as $596 billion on its audited SBR, while the records that Treasury uses to prepare the Statement of Changes in Cash Balance showed $505 billion for fiscal year 2003 for this agency. Until these differences between the total net outlays reported in the federal agencies’ SBRs and the records used to prepare the Statement of Changes in Cash Balance are reconciled, the effect that these differences may have on the U.S. government’s consolidated financial statements will be unknown. OMB has stated that it plans to work with the agencies to address this issue. The federal government did not have adequate systems, controls, and procedures to ensure that the consolidated financial statements are consistent with the underlying audited agency financial statements, balanced, and in conformity with generally accepted accounting principles (GAAP). During our fiscal year 2003 audit, we found the following: The process for compiling the consolidated financial statements does not directly link information from federal agencies’ audited financial statements to amounts reported in the consolidated financial statements, and therefore does not ensure that the information in the consolidated financial statements is consistent with the underlying information in federal agencies’ audited financial statements and other financial data. Internal control weaknesses exist in Treasury’s process for preparing the consolidated financial statements, such as a lack of (1) segregation of duties and (2) appropriate documentation of certain policies and procedures for preparing the consolidated financial statements. The net position reported in the consolidated financial statements is derived by subtracting liabilities from assets, rather than through balanced accounting entries. To make the fiscal years 2003 and 2002 consolidated financial statements balance, Treasury recorded a net $24.5 billion and a net $17.1 billion decrease, respectively, to net operating cost on the Statements of Operations and Changes in Net Position, which it labeled “Unreconciled Transactions Affecting the Change in Net Position.” An additional net $11.3 billion and $12.5 billion of unreconciled transactions were recorded in the Statements of Net Cost for fiscal years 2003 and 2002, respectively. Treasury does not identify and quantify all components of these unreconciled activities, nor does Treasury perform reconciliation procedures, which would aid in understanding and controlling the net position balance as well as eliminating the unreconciled transactions associated with compiling the consolidated financial statements. Significant differences in other intragovernmental accounts, primarily related to appropriations, still remain unresolved. Intragovernmental activity and balances are “dropped” or “offset” in the preparation of the consolidated financial statements rather than eliminated through balanced accounting entries. This contributes to the federal government’s inability to determine the impact of these differences on amounts reported in the consolidated financial statements. The federal government did not have an adequate process to identify and report items needed to reconcile the operating results, which for fiscal year 2003 showed a net operating cost of $665 billion, to the budget results, which for the same period showed a unified budget deficit of $374.8 billion. The consolidated financial statements include certain financial information for the executive, legislative, and judicial branches, to the extent that federal agencies within those branches have provided Treasury such information. However, there are undetermined amounts of assets, liabilities, costs, and revenues that are not included, and the federal government did not provide evidence or disclose in the consolidated financial statements that such excluded financial information was immaterial. Treasury lacks an adequate process to ensure that the financial statements, related notes, Stewardship Information, and Supplemental Information are presented in conformity with GAAP. We found that certain financial information required by GAAP was not disclosed in the consolidated financial statements. Treasury did not provide us with documentation of its rationale for excluding this information. As a result of this and certain material deficiencies noted above, we were unable to determine if the missing information was material to the consolidated financial statements. In addition to the material deficiencies noted above, we found four other material weaknesses in internal control as of September 30, 2003: (1) several federal agencies continue to have deficiencies in the processes and procedures used to estimate the costs of their lending programs and value their related loans receivable; (2) most federal agencies have not reported the magnitude of improper payments in their programs and activities; (3) federal agencies have not yet fully institutionalized comprehensive security management programs; and (4) material internal control weaknesses and systems deficiencies continue to affect the federal government’s ability to effectively manage its tax collection activities. In general, federal agencies continue to make progress in reducing the number of material weaknesses and reportable conditions related to their lending activities. However, significant deficiencies in the processes and procedures used to estimate the costs of certain lending programs and value the related loans receivable still remain. The most notable deficiencies existed at the Small Business Administration (SBA), which, while improved from last year, continues to have a material weakness related to this area. For example, SBA did not adequately document its estimation methodologies, lacked the management controls necessary to ensure that appropriate estimates were prepared and reported based on complete and accurate data, and could not fully support the reasonableness of the costs of its lending programs and valuations of its loan portfolio. SBA’s material weakness plus deficiencies at other federal credit agencies relating to the processes and procedures for estimating credit program costs continue to adversely affect the government’s ability to support annual budget requests for these programs, make future budgetary decisions, manage program costs, and measure the performance of lending activities. Across the federal government, improper payments occur in a variety of programs and activities, including those related to health care, contract management, federal financial assistance, and tax refunds. While complete information on the magnitude of improper payments is not yet available, based on available data, OMB has estimated that improper payments exceed $35 billion annually. Many improper payments occur in federal programs that are administered by entities other than the federal government, such as states. Improper payments often result from a lack of or an inadequate system of internal controls. Although the President’s Management Agenda includes an initiative to reduce improper payments, most federal agencies have not reported the magnitude of improper payments in their programs and activities. The Improper Payments Information Act of 2002 provides for federal agencies to estimate and report on their improper payments. It requires federal agencies to (1) annually review programs and activities that they administer to identify those that may be susceptible to significant improper payments, (2) estimate improper payments in susceptible programs and activities, and (3) provide reports to the Congress that discuss the causes of improper payments identified and the status of actions to reduce them. In accordance with the legislation, OMB issued guidance for federal agencies’ use in implementing the act. Among other things, the guidance requires federal agencies to report on their improper payment-related activities in the Management Discussion and Analysis section of their annual Performance and Accountability Reports (PAR). While the act does not require such reporting by all federal agencies until fiscal year 2004, OMB required 44 programs and 14 CFO Act agencies to report improper payment information in their fiscal year 2003 PARs. Our preliminary review of the PARs found that 12 of the 14 agencies reported improper payment amounts for 27 of the 44 programs identified in the guidance. We also found that, for the programs where improper payments were identified, the reports often contained information on the causes of the payments but little information that addressed the other reporting requirements cited in the legislation. Although progress has been made, serious and widespread information security weaknesses continue to place federal assets at risk of inadvertent or deliberate misuse, financial information at risk of unauthorized modification or destruction, sensitive information at risk of inappropriate disclosure, and critical operations at risk of disruption. GAO has reported information security as a high-risk area across government since February 1997. Such information security weaknesses could result in compromising the reliability and availability of data that are recorded in or transmitted by federal financial management systems. A primary reason for these weaknesses is that federal agencies have not yet fully institutionalized comprehensive security management programs, which are critical to identifying information security weaknesses, resolving information security problems, and managing information security risks on an ongoing basis. The Congress has shown continuing interest in addressing these risks, as evidenced by recent hearings on information security and enactment of the Federal Information Security Management Act of 2002 and the Cyber Security Research and Development Act. In addition, the administration has taken important actions to improve information security, such as integrating information security into the Executive Branch Management Scorecard. Material internal control weaknesses and systems deficiencies continue to affect the federal government’s ability to effectively manage its tax collection activities. Due to errors and delays in recording activity in taxpayer accounts, taxpayers were not always credited for payments made on their taxes owed, which could result in undue taxpayer burden. In addition, the federal government did not always follow up on potential unreported or underreported taxes and did not always pursue collection efforts against taxpayers owing taxes to the federal government. 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Summary: GAO is required to audit the consolidated financial statements of the U.S. government. Proper accounting and reporting practices are essential in the public sector. The U.S. government is the largest, most diverse, most complex, and arguably the most important entity on earth today. Its services--homeland security, national defense, Social Security, mail delivery, and food inspection, to name a few--directly affect the well-being of almost every American. But sound decisions on the future direction of vital federal government programs and policies are made more difficult without timely, accurate, and useful financial and performance information. Until the problems discussed in GAO's audit report on the U.S. government's consolidated financial statements are adequately addressed, they will continue to (1) hamper the federal government's ability to accurately report a significant portion of its assets, liabilities, and costs; (2) affect the federal government's ability to accurately measure the full cost as well as the financial and nonfinancial performance of certain programs while effectively managing related operations; and (3) significantly impair the federal government's ability to adequately safeguard certain significant assets and properly record various transactions. As in the 6 previous fiscal years, certain material weaknesses in internal control and in selected accounting and reporting practices resulted in conditions that continued to prevent GAO from being able to provide the Congress and American citizens an opinion as to whether the consolidated financial statements of the U.S. government are fairly stated in conformity with U.S. generally accepted accounting principles. Three major impediments to an opinion on the consolidated financial statements continue to be (1) serious financial management problems at DOD, (2) the federal government's inability to fully account for and reconcile transactions between federal government entities, and (3) the federal government's ineffective process for preparing the consolidated financial statements. For fiscal year 2003, 20 of 23 Chief Financial Officers (CFO) Act agencies received unqualified opinions, the same number received by these agencies for fiscal year 2002, up from 6 for fiscal year 1996. However, only 3 of the CFO Act agencies had neither a material weakness in internal control, an issue involving compliance with applicable laws and regulations, nor an instance of lack of substantial compliance with Federal Financial Management Improvement Act requirements. The requirement for timely, accurate, and useful financial and performance management information is greater than ever as the nation faces major long-term fiscal challenges that will require tough choices in setting priorities and linking resources to results. Given the nation's large and growing long-term fiscal imbalance, which is driven largely by known demographic trends and health care costs, coupled with new homeland security and defense commitments, the status quo is unsustainable. Current financial reporting does not clearly and transparently show the wide range of responsibilities, programs, and activities that may either obligate the federal government to future spending or create an expectation for such spending and provides an unrealistic and even misleading picture of the federal government's overall performance and financial condition. In addition, too many significant federal government commitments and obligations, such as Social Security and Medicare, are not fully and consistently disclosed in the federal government's financial statements and budget, and current federal financial reporting standards do not require such disclosure. A top-to-bottom review of government activities to ensure their relevance and fit for the 21st century and their relative priority is long overdue. The federal government needs a three-pronged approach to (1) restructure existing entitlement programs, (2) reexamine the base of discretionary and other spending, and (3) review and revise the federal government's tax policy and enforcement programs. New accounting and reporting approaches, budget control mechanisms, and metrics are needed for considering and measuring the impact of spending and tax policies and decisions over the long term.