IRS does not have internal controls over its financial reporting process adequate to provide reasonable assurance that its principal financial statements are reliable. As a result, IRS (1) was unable to prepare reliable statements of net cost, changes in net position, budgetary resources, and financing and (2) could not support material amounts reported on its balance sheet, including fund balance with Treasury, accounts payable, and net position. In addition, we found that property and equipment is likely to be materially understated. We found that the custodial and administrative general ledger systems which support the principal financial statements are not in conformance with the U.S. Government Standard General Ledger (SGL) at the transaction level and do not provide a complete audit trail for recorded transactions, material balances reported on IRS’ principal financial statements are not supported by detailed subsidiary records, and IRS’ principal financial statements are not subject to management oversight adequate to provide reasonable assurance that significant errors and omissions are identified and corrected before the principal financial statements are issued. In an effort to overcome these deficiencies, IRS employs a costly, labor intensive, and time-consuming process involving extensive and complex analysis and ad hoc procedures to assist in preparing its principal financial statements. IRS continues to utilize specialized computer programs to extract information from databases underlying the administrative and custodial general ledgers to derive and/or support amounts to be reported in the principal financial statements. For example, IRS must use this process to identify the portion of its unpaid assessments that represent taxes receivable for financial reporting purposes. However, as in fiscal year 1997, the amounts produced by this approach needed material audit adjustments totaling tens of billions of dollars to produce reliable balances for custodial activities. With respect to IRS’ administrative activities, this approach was unsuccessful in producing reliable balances. In addition, IRS’ basic approach was designed specifically for the narrowly defined purpose of preparing auditable balances at year-end only. This mechanism is not capable of producing reliable agencywide principal financial statements or financial performance information to measure results throughout the year as a management tool, which is standard practice in private industry and some federal entities. We also found that IRS’ previously separate financial reporting processes for its custodial and administrative activities have not been integrated under unified supervision at the operational level. This unnecessarily complicates IRS’ year-end financial reporting process and hampers efforts to provide interim IRS-wide financial information as a management tool. IRS’ complex and often manual financial reporting process requires extensive technical computer and accounting expertise and is highly vulnerable to human error. It is therefore critical that this process be adequately staffed and supervised and be subject to adequate management oversight at each stage as balances and disclosures are developed. However, IRS’ financial reporting process often lacked these basic controls. For example, during fiscal year 1998, key personnel with responsibilities for financial systems and reporting on IRS’ administrative activities left IRS and had not been replaced by year-end. Consequently, IRS was compelled to attempt to prepare its financial statements without the necessary staff. This occurred at the same time as the implementation of new federal accounting and reporting requirements that required IRS to prepare four new financial statements. In addition, throughout the process, we found numerous errors and omissions in financial reporting documentation as well as in the draft financial statements themselves, which likely would have been caught and corrected had these records been appropriately reviewed by management. In our previous audit, we reported that IRS’ custodial financial management systems did not substantially comply with Federal Financial Management Systems Requirements (FFMSR), federal accounting standards, and the SGL at the transaction level, which are the core requirements of FFMIA. During fiscal year 1998, we found that this condition continued and that IRS’ administrative financial management systems also had significant problems. IRS (1) cannot reliably prepare four of the six principal financial statements required by the Office of Management and Budget, which prescribes the form and content of federal financial statements, (2) does not have a general ledger(s) that conforms to the SGL, (3) lacks a subsidiary ledger for its unpaid assessments, accounts payable, and undelivered orders, and (4) lacks an effective audit trail from its general ledgers back to subsidiary detailed records and transaction source documents. In addition, IRS does not consistently capture costs as required by federal accounting standards to permit it to (1) routinely prepare reliable cost-based performance measures for inclusion in the management discussion and analysis that accompanies its principal financial statements or (2) prepare the information to be included in its annual performance plan as required by the Government Performance and Results Act (GPRA) of 1993. This deficiency also renders IRS unable to include reliable cost-based performance information in its budget submission to Congress. As we have previously reported, IRS does not have a subsidiary ledger which tracks and accumulates unpaid assessments and their status on an ongoing basis, the absence of which adversely affects its ability to effectively manage and accurately report unpaid assessments. To compensate for this, IRS runs computer programs against its master files—the only detailed record of taxpayer information it maintains—to identify, extract, and classify the universe of unpaid assessments for financial reporting purposes. However, this approach is only designed for the limited purpose of allowing IRS to report auditable financial statement totals at year-end and is not an adequate substitute for a reliable subsidiary ledger which provides an accurate outstanding balance for each taxpayer on an ongoing basis. Additionally, this approach still resulted in the need for tens of billions of dollars of audit adjustments to IRS’ principal financial statements to correct duplicate or otherwise misstated unpaid assessment balances identified by our testing. Without the information an effective subsidiary ledger should provide, IRS cannot ensure that payments and assessments are promptly posted to the appropriate taxpayer accounts. We found in our statistical sample of unpaid assessments that this problem resulted in inaccurate taxpayer account balances and led IRS to pursue collection efforts against taxpayers who had already paid their taxes in full. In addition, in our sample we found that IRS inappropriately issued refunds to taxpayers with outstanding tax assessment balances. We previously reported that IRS had significant problems locating supporting documentation for unpaid assessment transactions. To address this issue, we worked closely with IRS and identified various forms of documentation to support these items, and we requested these documents in performing our fiscal year 1998 testing. While we did note some improvement, we continued to find that IRS experienced difficulties in providing supporting documentation. The lack of adequate supporting documentation made it difficult to assess the classification and collectibility of unpaid assessments reported in the principal financial statements as federal taxes receivable and may make it difficult for IRS to readily identify and focus collection efforts. As in prior years, we continued to find that IRS does not have sufficient preventive controls over refunds to reduce to an acceptable level the risk that inappropriate payments for tax refunds will be disbursed. Inappropriate refund payments continued to be issued in fiscal year 1998 due to (1) IRS comparing the information on tax returns and third party data such as W-2s (Wage and Tax Statement) too late to identify and correct discrepancies between these documents, (2) significant levels of invalid Earned Income Tax Credit (EITC) claims, and (3) deficiencies in controls that allowed duplicate refunds to be issued. We also found instances of erroneous refunds being issued as a result of errors or delays in posting assessments to taxpayer accounts. Errors and posting delays such as these impair IRS’ ability to effectively offset refunds due taxpayers against amounts owed by the same taxpayers on another account. Although IRS has detective (post-refund) controls in place, the lack of sufficient preventive controls exposes the government to potentially significant losses due to inappropriate disbursements for refunds. According to IRS’ records, IRS investigators identified over $17 million in alleged fraudulent refunds that had been disbursed during the first 9 months of calendar year 1998 and prevented the disbursement of an additional $65 million in alleged fraudulent refund claims. During calendar year 1997, IRS’ records indicate that intervention by IRS investigators prevented the disbursement of additional alleged fraudulent refund claims totaling over $1.5 billion. However, the full magnitude of invalid refunds disbursed by IRS is unknown. In addition, rates of invalid EITC claims have historically been high. During fiscal year 1998, IRS reported that it processed EITC claims totaling over $29 billion, including over $23 billion (79 percent) in refunds. In an effort to minimize losses due to invalid EITC claims, IRS electronically screens tax returns claiming EITC to identify those exhibiting characteristics considered indicative of potentially questionable claims based on past experience and then selects those claims considered most likely to be invalid for detailed examination. During fiscal year 1998, IRS examiners reviewed over 290,000 tax returns claiming $662 million in EITC of which $448 million (68 percent) was found to be invalid. These examinations are an important control mechanism for detecting questionable claims and providing a deterrent to future invalid claims. However, because examinations are often performed after any related refunds are disbursed, they cannot substitute for effective preventive controls designed to identify invalid claims before refunds are disbursed. In fiscal year 1998, IRS began implementing a 5-year EITC compliance initiative intended to expand customer service to increase taxpayers’ awareness of their rights and responsibilities related to EITC, strengthen enforcement of EITC requirements, and enhance research into the sources of EITC noncompliance. However, most of IRS’ efforts under that initiative had not progressed far enough at the time we completed our audit for us to make any judgment about their effectiveness. While we were able to substantiate the amounts of refunds disbursed as reported on IRS’ fiscal year 1998 principal financial statements, IRS nevertheless lacks effective preventive controls to minimize its vulnerability to payment of inappropriate refunds. Once an inappropriate refund has been disbursed, IRS is compelled to expend both the time and expense to attempt to recover it, with dubious prospects of success.