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.