We are unable to give an opinion on the Statement of Financial Position as of September 30, 1996, because IRS could not provide adequate documentation to support the classification of its inventory of unpaid assessments as federal tax receivables and compliance assessments. Because we were unable to determine the appropriateness of IRS’ classifications of its inventory of unpaid assessments, we were unable to determine whether the amounts reported for net federal tax receivables and the related allowance for doubtful accounts as reflected on the Statement of Financial Position as of September 30, 1996, were fairly stated. Also, because of this limitation, which affects over 95 percent of the custodial assets on the Statement of Financial Position and which prevented us from being able to give an opinion, we did not perform testing of other line items on the Statement of Financial Position, such as Frozen Tax Refunds and Credits, Tax Refunds Payable, Advances, and Commitments and Contingencies. As we have reported in the past and as discussed in a later section of this report, IRS lacks an accounts receivable subsidiary ledger or other similar mechanism which routinely tracks receivables individually from period to period. This condition requires that IRS use alternative methods to identify the amounts to be recorded as federal tax receivables on its financial statements. However, these methods thus far have not provided IRS with the capability to report accurate and supportable amounts for federal tax receivables. Further, these methods have not provided the means necessary for IRS to effectively manage and routinely monitor the status of amounts owed by taxpayers. This makes it difficult to determine a reasonable estimate of amounts deemed collectible and could minimize the amounts IRS may ultimately be able to collect on its federal tax receivables. Because IRS could not provide sufficient evidence to support the classification of certain itemized taxes collected and refunded, we could not determine if the classifications of collection and refund amounts by tax type—for example, payroll versus corporate taxes—as reflected on the Statement of Custodial Activity were reliable. Otherwise, in our opinion, the Statement of Custodial Activity presents fairly, in all material respects, in conformity with a comprehensive basis of accounting other than generally accepted accounting principles as described in note 1, IRS’ custodial activities for taxes collected, refunded, and distributed. We evaluated management’s assertion about the effectiveness of its internal controls designed to safeguard assets against loss from unauthorized acquisition, use, or assure the execution of transactions in accordance with laws and regulations that have a direct and material effect on the Custodial Financial Statements or are listed in Office of Management and Budget (OMB) audit guidance and could have a material effect on the Custodial Financial Statements; and properly record, process, and summarize transactions to permit the preparation of reliable financial statements and to maintain accountability for assets. IRS management stated that, except for the material weaknesses in internal controls presented in the agency’s fiscal year 1996 FMFIA report on compliance with the internal control and accounting standards, internal controls provide reasonable assurance that the following would be prevented or detected for amounts material in relation to the financial statements: unauthorized acquisition, use, or disposition of assets, that could lead to noncompliance with laws and regulations; and misstatements in amounts reported in the financial statements. Management made this assertion based upon criteria established under FMFIA and the OMB Circular A-123, Management Accountability and Control. For financial statement reporting, a material weakness is a condition that precludes the entity’s internal control from providing reasonable assurance that losses, noncompliance, or misstatements material in relation to the financial statements will be prevented or detected in a timely basis. The following material weaknesses, which we also found in our prior audits of IRS, were reported in IRS’ FMFIA report for fiscal year 1996, with the exception of the computer security issues discussed below. These deficiencies in internal controls may adversely affect any decision by management that is based, in whole or in part, on information that is inaccurate because of the deficiencies. Our internal control work would not necessarily disclose material weaknesses not reported by IRS. Unaudited financial information reported by IRS may also contain misstatements resulting from these deficiencies. The nature of these weaknesses was such that they affected our ability to (1) render an opinion on IRS’ fiscal year 1996 financial statements taken as a whole and (2) conclude on IRS’ compliance with laws and regulations we tested as discussed in a later section of this report. Consequently, we believe that the internal controls were not effective in satisfying the objectives discussed above during fiscal year 1996. As discussed above, IRS does not maintain an accounts receivable subsidiary ledger or other similar mechanism that routinely tracks receivables and their related activity on an ongoing basis. Consequently, IRS does not have readily available the information on receivables it needs to prepare its financial statements. To compensate for this, IRS runs computer programs against its masterfiles—the only detailed record of taxpayer information it maintains—to identify taxpayer accounts for which assessments or other debits exceed receipts received or other credits made to taxpayers’ accounts. After these accounts—unpaid assessments—have been identified, IRS runs computer programs that utilize transaction and other codes within the masterfiles to separately classify these accounts as financial receivables or compliance assessments. Those accounts that are classified as financial receivables are then evaluated on a statistical basis by IRS to estimate what amount IRS ultimately believes it will collect on its receivables. The total amount deemed collectible by IRS, based on a projection of its statistical sample, is reported as federal tax receivables on its custodial Statement of Financial Position. The difference between the amount estimated to be collectible and the total amount identified as financial receivables is reported on the custodial Statement of Financial Position as an allowance for doubtful accounts. In our audit of IRS’ fiscal year 1995 financial statements, we reported that IRS was unsuccessful in deriving reliable receivables information for use in preparing the financial statements. We reported that errors we identified in the transaction and other coding of assessments within the masterfiles, coupled with mistakes IRS made in performing the statistical procedures, resulted in IRS’ sampling results being unreliable for purposes of projecting both the gross and net receivable amounts for financial reporting. For our fiscal year 1996 audit, we again reviewed IRS’ process for extracting and classifying taxpayer assessments into financial receivables and compliance assessments. We also tested samples of assessments classified by IRS as both financial receivables and compliance assessments to determine whether IRS’ classifications were appropriate. To test for proper classification, we attempted to review supporting documents in taxpayer files, such as tax returns, receipt deposits, correspondence between the taxpayer and IRS, and other pertinent information. We found that IRS could not locate sufficient supporting documentation (such as tax returns and installment agreements) for us to determine whether IRS had properly classified its inventory of unpaid assessments as either federal tax receivables or compliance assessments. Thus, we were unable to determine whether IRS had appropriately recognized federal tax receivables on the Statement of Financial Position. IRS officials stated that the missing documents had either been destroyed based on the agency’s record retention policies or simply could not be located. The lack of a detailed listing, or subsidiary ledger, for receivables, coupled with IRS not readily maintaining supporting documents on outstanding accounts receivable, increases the risk that material amounts may be inappropriately included or excluded from the financial statements. Additionally, IRS’ not maintaining adequate documentation, in many cases, to support the underlying assessments, could affect IRS’ ability to pursue collection from taxpayers on amounts owed, resulting in lost tax revenue, including interest and penalties, to the government. In an effort to address some of the concerns noted above, IRS is continuing to review all individual assessments in excess of $10 million identified through its computer programs as financial receivables and compliance assessments to ensure their proper classification. Additionally, IRS is continuing to refine its efforts to more accurately classify its unpaid assessments inventory through various enhancements to the computer programs it uses to classify these assessments. As part of a larger and long-term effort to modernize its systems, IRS is also identifying and refining the business and system requirements necessary to assess the status of its unpaid assessments and manage its receivables. IRS’ efforts are consistent with our recommendations from prior years’ audits that IRS take steps to ensure that (1) in the long-term, tax system modernization efforts provide for a mechanism to enable IRS to readily identify and routinely track and report on the status of federal tax receivables and (2) in the short-term, continue to identify ways to improve the accuracy of receivables reporting through further enhancements to its computer programs and detailed reviews of taxpayer accounts. (See appendix I.) As we have reported in our prior financial audits, IRS’ custodial financial management system was not designed to readily support the preparation of financial statements. Specifically, IRS’ Revenue Accounting Control System—its general ledger—is unable to sufficiently identify detailed tax revenues collected and related refunds paid to permit the preparation of its Custodial Financial Statements. For fiscal year 1995, we reported that IRS had attempted to extract taxpayer information from its masterfiles to support the amounts it reported as revenues on the fiscal year 1995 Custodial Financial Statements. We reported that, while IRS extracted taxpayer information from its masterfiles, it could not adequately reconcile this information to its general ledger and the Department of Treasury’s Financial Management Service’s (FMS) records. For fiscal year 1996, IRS again extracted detailed taxpayer information from its masterfiles to derive the reported amounts for revenue collections and refunds by tax types on the Custodial Financial Statements. IRS then performed reconciliations between the information used to derive the financial statements and (1) summary amounts recorded in its general ledger and (2) amounts reported for tax revenues collected and refunds paid by FMS.