IRS’s financial management has long been problematic. In fiscal year 2001, it continued to be plagued by many of the serious internal control and financial management issues that we have reported each year since we began auditing IRS’s financial statements in fiscal year 1992. Despite these issues, IRS was, for the second consecutive year, able to produce financial statements covering its tax custodial and administrative activities in fiscal years 2001 and 2000, that were fairly stated in all material respects. However, this was achieved only through extensive reliance on costly, time-consuming processes; statistical projections; external contractors; substantial adjustments; and monumental human efforts that extended nearly four months after the September 30, 2001, fiscal year-end. These costly efforts would not have been necessary if IRS’s systems and controls operated effectively. However, IRS still does not have a financial management system capable of producing the reliable and timely information its managers need to make day-to-day decisions on an ongoing basis, which is a goal of the CFO Act. Additionally, IRS’s current approach to developing its financial statements does not address the underlying financial management and operational issues that adversely affect IRS’s ability to effectively fulfill its responsibilities as the nation’s tax collector. Strong commitment and hard work by both IRS’s senior leadership and staff continued to be the key to its ability to overcome its fundamental systems and internal control deficiencies and achieve its goal of receiving an unqualified audit opinion on its fiscal years 2001 and 2000 financial statements. However, IRS found it extremely difficult to prepare its financial records for audit examination and issue its financial statements within the reporting timeline required by the Office of Management and Budget (OMB) for fiscal year 2001. OMB has announced the executive branch’s intention to significantly accelerate this timeline for future years and by fiscal year 2004, IRS will be required to issue its financial statements by November 15, or 6 weeks after fiscal year end. Also, the Department of the Treasury has established a goal of completing its fiscal year 2002 audit, including those of its component entities, and issuing its department wide accountability report by November 15, 2002. Without significant and systemic changes in how IRS processes transactions, maintains its records, and reports its financial results to accompany its extensive compensating processes, IRS’s ability to meet this accelerated reporting deadline while sustaining an unqualified opinion on its financial statements is questionable. We would now like to summarize the major financial management challenges confronting IRS. IRS did not have internal controls over its financial reporting process adequate to enable it to timely, routinely, and reliably generate and report the information needed to prepare financial statements and manage operations on an ongoing basis. Information produced by IRS’s financial management systems is neither current nor accurate, and must be supplemented by extensive, costly, time consuming manual procedures that take months to complete and typically result in billions of dollars in adjustments. The resulting financial statement balances are not available until months later and are only reliable at a single point in time. During fiscal year 2001, IRS continued to lack (1) an adequate general ledger system for financial reporting and management purposes, (2) adequate internal controls over material balances maintained in its general ledger system and recording of financial transactions, (3) a cost accounting system capable of providing timely and reliable cost information related to IRS’s activities and programs to assist management in making resource allocation decisions, and (4) the ability to separately report several of the federal government’s largest types of revenue collections. IRS’s pervasive financial reporting weaknesses prevented it from preparing timely and reliable financial statements or other financial information that Congress and senior IRS management could rely on to oversee and assist in managing operations during fiscal year 2001. Consequently, IRS was compelled to make certain business decisions affecting the disposition of tens of billions of dollars without current and reliable underlying financial information. For example, in each of the following cases involving taxpayer compliance issues, IRS indicated that resource limitations affected its ability to perform necessary follow-up. From 1996 to 1999, IRS only followed-up on 21 percent of the over 53 million underreported individual income tax cases it identified, which accounted for about 41 percent of the over $65 billion in underreported taxes IRS estimated on these cases; and As of September 30, 2001, IRS had either not started collection action or had stopped collection action in progress on unpaid tax assessment cases with outstanding balances totaling about $12 billion. In deciding the amount of resources to devote to follow-up on these cases, IRS should consider factors such as the effects on fairness to taxpayers and efforts to deter filing fraud. The relative costs and benefits involved in following up on questionable cases should also be an integral part of such decisions. However, in each of these circumstances, IRS could not readily determine or justify whether it would be cost-beneficial to devote additional resources for such follow-up because it was not able to readily determine (1) the cost of following up on cases or (2) how much it collected on those cases for which it did follow-up. Without this information, IRS cannot perform cost-benefit analysis to assist it in determining or justifying whether the amount of resources it has devoted to each of these programs is appropriate relative to costs and potential benefits involved. Consequently, IRS is hindered in its ability to justify its resource utilization decisions or provide justification for resource increases, which could result in potentially billions of dollars of revenue going uncollected, lead to further erosion in taxpayers’ confidence in the equity of the tax system, and adversely affect future compliance. Ongoing serious internal control deficiencies continued to render IRS unable to properly manage unpaid assessments and has led to increased taxpayer burden. IRS still lacks a subsidiary ledger that tracks and accumulates unpaid tax assessments on an ongoing basis. As a consequence, it must rely on specialized computer programs to extract unpaid tax assessment information from its master files—its only detailed databases of taxpayer account information—and then subject this information to statistical sampling procedures in order to prepare its financial statements. This process takes months to complete and typically requires tens of billions of dollars in adjustments to correct misclassifications and eliminate duplications in order to produce a reliable balance at a single point in time. Consequently, this information is not useful for ongoing management decisions. In addition, the lack of a subsidiary ledger renders IRS unable to timely develop reliable financial and management reports and promptly identify and focus collection efforts on accounts most likely to prove collectible. IRS’s management of unpaid assessments also continued to be hindered by significant errors and delays in recording taxpayer information and payments. As in prior years, the most prevalent errors we found involved IRS’s failure to record payments to all related taxpayers associated with unpaid payroll taxes. IRS’s current systems cannot automatically link each of the multiple assessments made for the one tax liability. Consequently, if the business or an officer pays some or all of the outstanding taxes, IRS’s systems are unable to automatically reflect the payment as a reduction in the related account or accounts. IRS also continued to experience problems in promptly releasing liens filed against the property of taxpayers who at one time owed the federal government for taxes but who had subsequently paid or otherwise satisfied these taxes. In one case we identified, IRS did not formally release a lien against a taxpayer’s property until 302 days after the tax liability had been fully paid. Based on the results of our work, we estimated that for over 8 percent of unpaid tax assessment cases where IRS had filed a tax lien that was resolved in fiscal year 2001, IRS did not release the lien within the 30 day period required under section 6325 of the Internal Revenue Code. The serious internal control issues IRS continues to experience with its unpaid assessments can lead, and have led, both to undue taxpayer burden and lost revenue to the government. These conditions can also further erode the confidence of the nation’s taxpayers in the integrity and fairness of the tax collection process. During fiscal year 2001, we found that IRS’s controls were not fully effective in maximizing the government’s ability to collect what is owed and in minimizing the risk of payment of improper refunds. Inherent in the voluntary nature of the nation’s tax collection system is the concept that IRS must, to a large degree, rely on taxpayers to report their tax liabilities. When taxpayers either intentionally or unintentionally fail to report to IRS the full amount of taxes they owe the federal government, IRS’s ability to independently identify the taxpayers and determine the amount they owe is inherently limited. IRS does not always follow up on potential unpaid taxes it is aware of, and does not always pursue collection of those taxes it determines are owed. In addition, IRS often does not initiate follow-up of those unpaid taxes it does pursue until months after the related tax return has been filed and any related refund has been paid. This delay significantly affects IRS’s prospects of collecting amounts due on these cases. The options available to IRS in its efforts to identify and pursue the correct amount of taxes owed and to ensure that only valid refunds are disbursed are currently limited. Additionally, while it processes hundreds of millions of tax returns each filing season, IRS must issue refunds within statutory time constraints or be subject to interest charges. Nonetheless, IRS does have some preventive controls that, if effectively implemented, could help to reduce the risks associated with not identifying underreported taxes owed or issuing improper refunds. For example, IRS’s Examination Branch is responsible for performing examinations on tax returns with potentially invalid EITC claims to determine the validity of the claim. When performed before refunds are disbursed, these examinations are an important control to prevent disbursement of improper refunds. However, these examinations are often performed after any related refunds are disbursed. Consequently, they are not an effective preventive control overall.