Management Letter: Suggested Improvements in IRS' Accounting Procedures
and Internal Controls (Correspondence, 06/14/2000, GAO/AIMD-00-162R).

Pursuant to a legislative requirement, GAO provided information on the
results of the Internal Revenue Service's (IRS) financial statements and
on the effectiveness of its internal controls for fiscal year (FY)
ending September 30, 1999.

GAO noted that: (1) GAO found weaknesses in IRS' accounting procedures
for certain assets purchased in one year but used for a multi year
period; (2) IRS corrected this problem for its FY 1999 balance sheet;
(3) IRS does not consistently follow procedures for reimbursements that
it expects to receive when it provides goods and services to other
federal agencies, state and foreign governments, and private
organizations; (4) based on a statistical sample of September 30, 1999,
reimbursement receivables, GAO determined that the gross amount of
reimbursable receivables was not fairly stated, although due to the
allowance for bad debts accounts, GAO did not take exception to the net
amount; (5) some problems were also noted with respect to IRS' use of
its allowance for bad debts account; (6) GAO found that existing review
procedures at IRS' national office were inadequate to prevent errors in
transactions posted to the general ledger and in financial information
reported to Treasury; (7) the self-assessments IRS performs under the
Federal Managers' Financial Integrity Act (FMFIA) can be a better tool
for disclosing and correcting its internal weaknesses; (8) GAO found
that IRS' FY 1999 FMFIA process ended too early to provide reasonable
assurance that all material weaknesses that existed during the reporting
year were adequately disclosed; (9) specifically, although IRS did not
submit its FY 1999 FMFIA assurance statement to Treasury until February
2000, IRS concluded its internal self-assessment process for FY 1999 on
September 30, 1999; (10) IRS officials informed GAO that any material
weaknesses that came to their attention during this intervening period
would be considered in the succeeding reporting period, rather than FY
1999; and (11) as a result, to the extent material weaknesses that
existed in FY 1999 were identified during this period, IRS' FY 1999
FMFIA assurance statement would ordinarily exclude them and potentially
present an incomplete list of material weaknesses and a misleading
assessment of the effectiveness of IRS' internal controls in meeting the
objectives of FMFIA.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  AIMD-00-162R
     TITLE:  Management Letter: Suggested Improvements in IRS'
	     Accounting Procedures and Internal Controls
      DATE:  06/14/2000
   SUBJECT:  Financial statement audits
	     Auditing standards
	     Internal controls
	     Financial records
	     Auditing procedures
	     Financial management
	     Accounting procedures
	     Tax administration systems
	     Reporting requirements

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GAO/AIMD-00-162R

   * B-285297 DOCPROPERTY B-number

   * June 14, 2000
   *
   * The Honorable Charles O. Rossotti
   * Commissioner of Internal Revenue
   *

Subject: Management Letter: Suggested Improvements in IRS' Accounting

Procedures and Internal Controls

   *
   * Dear Mr. Rossotti:
   *
   * In February 2000, we issued our report on the results of our audit of
     the Internal Revenue Service's (IRS) financial statements and on the
     effectiveness of its internal controls for the fiscal year ending
     September 30, 1999. We also reported our conclusions on IRS' compliance
     with significant provisions of selected laws and regulations and on
     whether IRS' systems substantially comply with requirements of the
     Federal Financial Management Improvement Act of 1996.
   *
   * The purpose of this letter is to report additional matters identified
     during our fiscal year 1999 audit regarding accounting procedures and
     internal controls that could be improved. These matters are not
     considered material in relation to the financial statements; however,
     they warrant management's consideration. These additional internal
     control matters concern policies and procedures over (1) property and
     equipment purchased through Treasury's working capital fund (WCF), (2)
     reimbursable receivable transactions, (3) supervisory reviews at IRS'
     National Office, and (4) IRS' Federal Managers' Financial Integrity Act
     of 1982 (FMFIA) process. At the end of our discussion on each of these
     matters, we offer suggestions for improving IRS' internal controls. We
     conducted our audit in accordance with generally accepted government
     auditing standards and Office of Management and Budget (OMB) Bulletin
     98-08.

In its response to a draft of this letter, IRS agreed with the issues
regarding recording reimbursable transactions and review procedures at the
IRS national office. However, IRS disagreed in whole or in part with our
conclusions regarding Treasury's WCF and IRS' FMFIA process. At the end of
our discussion of each of the issues in this letter, we have summarized IRS'
related comments and provided our evaluation. The complete text of IRS'
response is included in enclosure I to this letter.

Procedures Needed to Properly

Account for Prepaid Expenses and

Treasury Working Capital Fund Assets

We found weaknesses in IRS' accounting procedures for certain assets
purchased in one year but used for a multiyear period. Federal accounting
standards require that prepayments be recorded as assets. These include cash
outlays for the cost of goods and services that will benefit an entity in
future years. Recording assets in this way and expensing the cost
systematically over their useful life is necessary in order to match the
expense with the period in which the benefit is received. Doing so gives
management reliable information on the cost of federal programsâan
important part of assessing operating performance.

During fiscal year 1999, we found that in some instances, IRS is billed for
goods and services that benefit the agency for more than 1 year and thus
should be recorded as prepaid expenses. However, IRS records the entire
amount as an expense at the time of purchase. For example, IRS purchases a
significant portion of its telecommunications services through Treasury's
WCF. WCF purchases capital items such as routers, and bills IRS for the full
cost of these items in the year of purchase. Although IRS benefits from
these purchases for a number of years, it had been recognizing the full
expense of these items in the year of purchase.

IRS corrected this problem for its fiscal year 1999 balance sheet. After we
brought this problem to IRS' attention, IRS used a contractor to estimate
its prepaid expenses by statistically projecting the net book value of WCF
assets in order to properly reflect prepaid expenses on its balance sheet at
September 30, 1999. As a result of this projection, IRS subsequently made a
$21.7 million adjustment to reflect this amount as a prepaid expense on its
September 30, 1999, balance sheet. However, IRS still does not have
processes or controls in place to properly record its WCF prepaid expenses
for fiscal year 2000 and beyond.

While observing the IRS contractor's development of the estimated prepaid
expense, we also identified two control issues relating to the
accountability over IRS and WCF property and equipment. First, many
telecommunication equipment items located at IRS facilities have both IRS
and WCF inventory tags. This is problematic because the same types of
telecommunications assets that are owned by WCF but benefit IRS are also
purchased directly by IRS. Thus, IRS has difficulty determining whether
property and equipment should be recorded on IRS or WCF records.

Second, the property records themselves do not reconcile. IRS keeps records
of WCF assets in its own detailed property and equipment records. Items are
tracked for control purposes but are recorded at no cost. During fiscal year
1999, we attempted to reconcile IRS' physical records of WCF assets to WCF's
records. However, we found that WCF's records of purchases for IRS contained
over 43,000 items while IRS' records contained only 24,000 items. IRS and
Treasury's WCF had not reconciled the two databases.

   * Suggestions

We suggest that IRS develop procedures to require that prepayments be
recorded as assets in accordance with federal accounting standards. Services
that are provided to IRS that will benefit IRS for more than 1 year should
be established as prepaid expenses and amortized over the period of benefit.

We suggest that IRS establish clear policies and procedures to ensure that
telecommunications equipment is appropriately tagged based on whether it was
purchased by IRS or WCF. No property and equipment should have multiple
inventory tags.

We suggest that IRS develop a policy to require reconciliation of IRS and
WCF property records on a routine basis.

IRS' Comments and Our Evaluation

Concerning the prepaid expense amount related to WCF equipment, IRS
indicated that although it agrees that payments made to WCF for services
that span more than 1 year should be recorded as prepaid expenses, IRS
depends on the Treasury Department to inform it when this occurs. As we
noted, IRS did record a prepaid expense for the amount prepaid through
fiscal year 1999, based on a consultant's estimate of WCF equipment at IRS.
According to IRS, it will amortize this prepaid amount over a 5-year period.
For future charges, IRS indicated that it will rely on Treasury, which has
informed IRS that it will be providing only services to IRS, hence,
prepayments should not be much of an issue. We found that in the past, as
supported by the prepaid expense recorded for WCF equipment by IRS in fiscal
year 1999, WCF has charged IRS for equipment it purchases before the benefit
had been fully received. To determine whether this will cease to be an issue
in the future, as IRS states, we will evaluate this issue as part of our
fiscal year 2000 audit.

IRS disagreed with our suggestion that it develop a policy requiring
reconciliation of IRS and WCF property records on a routine basis, and
indicated that it believes this suggestion would be more appropriately
directed to Treasury/WCF since it owns the assets concerned. However, IRS
also stated that all WCF assets were removed from its inventory system in
April 2000. This would eliminate the need for the reconciliation we
suggested. We will verify this during our fiscal year 2000 audit.

IRS also agreed to properly tag telecommunications equipment and to remove
multiple tags. We also will verify this during our fiscal year 2000 audit.

Reimbursable Receivable Transactions
Were Not Properly Recorded

   *
   * IRS does not consistently follow procedures for accounting for
     reimbursements that it expects to receive when it provides goods and
     services to other federal agencies, state and foreign governments, and
     private organizations. According to IRS procedures, once the goods have
     been delivered or the services performed, IRS is to record revenue and
     post an unbilled receivable to the accounting system. When the customer
     is billed for the goods or services, IRS' procedure is to liquidate the
     unbilled account receivable and establish a billed account receivable.
     The billing document must reference the initial entry that recorded the
     revenue in order to liquidate the unbilled receivable. Once the
     receivable is paid, a receipt entry should be posted to liquidate the
     billed receivable balance.
   *
   * Based on a statistical sample of September 30, 1999, reimbursable
     receivables, we determined that the gross amount of reimbursable
     receivables was not fairly stated, although due to the allowance for
     bad debts accounts, we did not take exception to the net amount. Of 13
     reimbursable receivable cases tested, we found 7 cases (54 percent)
     where the receivable was no longer valid. In some cases, these
     receivables were on the books from as far back as fiscal year 1995. For
     example, a fiscal year 1995 receivable of $363,000 remained on the
     books as unbilled even though the receivable had been billed and
     subsequently collected. This occurred because at the point the billed
     receivable was recorded, it did not properly reference the unbilled
     receivable. Thus, the unbilled receivable was not liquidated and
     remained on the books. In other cases, the funds received were simply
     not recorded against the receivables in a timely manner. For example, a
     $2.4 million receivable recorded in fiscal year 1999 remained on the
     books at fiscal year-end even though it had been fully collected.
     According to IRS officials, this error resulted from inadequate
     staffing resources for posting the collections as of fiscal year-end.
   *
   * Some problems were also noted with respect to IRS' use of its allowance
     for bad debts account. Many of the exceptions in our sample were
     receivables from several years prior and an offsetting amount was
     included in the allowance for bad debts. However, in one case, IRS
     inappropriately included a $3.6 million receivable from Treasury's WCF
     as a component of the allowance account. This receivable related to
     telecommunications services provided by IRS to WCF in fiscal year 1996.
     According to IRS officials, discrepancies exist between IRS and
     Treasury Department records on the amount owed for the services. These
     IRS officials stated that IRS is working with Treasury to resolve this
     issue, and believe that the receivable is collectible and thus should
     not have been included in the allowance account. Setting up bad debt
     allowances for valid receivables distorts both the allowance account
     and the net accounts receivable balance.

   * Suggestions
   *
   * We suggest that IRS analyze its listing of reimbursable receivables to
     determine which outstanding receivables are still valid. If no longer
     valid, the receivables and corresponding allowance amounts should be
     written off.

We suggest that IRS ensure compliance with its procedure manual's
requirements for recording reimbursable receivables and subsequent
collections. For example, when entered into the accounting system, documents
should reference the unbilled receivable, and cash receipt documents should
reference the billing document that created the account receivable. Also,
supervisors should review entries to ensure that procedures are being
followed.

   *
   * We also suggest that IRS reconcile its reimbursable receivable records
     to Treasury's in order to substantiate the amount owed by WCF. After
     this is done, IRS should promptly collect the appropriate amount due
     from Treasury.

IRS' Comments and Our Evaluation

IRS agreed that the validity of the receivables is important, and indicated
that it is currently reviewing them to assess their collectibility. IRS also
agreed with the need for a link between billed and unbilled receivables and
indicated it has already added such a link. In addition, IRS indicated that
it is contact with Treasury concerning the amounts owed by WCF, believes
that these amounts are at least partially collectible, and is aggressively
pursuing collection of these amounts. We will follow-up during our fiscal
year 2000 audit to assess the effectiveness of IRS' actions.

   * Review Procedures at IRS' National Office
     Were Insufficient to Identify Errors

   * Errors in various IRS financial reports can be reduced by stronger
     review procedures. Our Standards for Internal Controls in the Federal
     Government require that supervisory personnel perform sufficient review
     to detect and eliminate errors, and thus to ensure that transactions
     are properly recorded and adequately supported and that reports are
     properly prepared.
   *
   * We found that existing review procedures at IRS' national office were
     inadequate to prevent errors in transactions posted to the general
     ledger and in financial information reported to Treasury. Specifically,
     we found the following.

   * A disbursement for $95 million was improperly recorded as a receipt and
     a receipt for $94.9 million was improperly recorded as a disbursement
     in the general ledger. We also determined that a $125,000 receipt was
     incorrectly reported. These errors were not discovered and corrected
     until we reviewed the underlying documents supporting the transactions
     and apprised IRS of the errors.

   * The IRS national office's Statement of Transactions for September 1999
     reported a $1.5 million receipt in an appropriation suspense account.
     However, we found the transaction's supporting documentation inadequate
     for determining whether the transaction was actually a receipt or a
     disbursement.

   * An IRS-prepared analysis of refunds disbursed during the first 9 months
     of fiscal year 1999 contained an earned income tax credit refund
     adjustment that was understated by $11.8 million. We determined that
     IRS' national office had incorrectly recorded the May 1999 debtor
     master file offset in its general ledger, and this error had not
     previously been detected due to ineffective supervisory reviews.

   * These problems might have been identified earlier by IRS had adequate
     supervisory reviews been performed. While IRS' Internal Revenue Manual
     specifies that management should be accountable for reported amounts,
     it does not specifically require detailed supervisory review.

   * Suggestion
   *
   * We suggest that IRS revise its policies and procedures to require
     documented and sufficiently detailed supervisory reviews of
     transactions to ensure that transactions are correct and adequately
     supported and that reports are properly prepared before information is
     summarized and reported externally.

IRS' Comments and Our Evaluation

IRS agreed that stronger review procedures were needed for custodial
reporting, and has implemented additional review procedures to address this
issue. In addition, IRS indicated that its Interim Revenue Accounting and
Control System, which accounts for its custodial activities, has been
reprogrammed to distinguish between Online Payment and Collections
Processing receipt and disbursement transactions. We will follow up during
our fiscal year 2000 audit to assess the effectiveness of IRS' actions.

IRS' FMFIA Process Ends Prematurely

   *
   * The self-assessments IRS performs under FMFIA (31 U.S.C. 3512) can be a
     better tool for disclosing and correcting its internal control
     weaknesses. FMFIA requires executive agencies, including the Department
     of the Treasury, to report annually to the President and the Congress
     whether their internal accounting controls comply with the objectives
     specified in the act. As a major component of Treasury, IRS annually
     provides Treasury an FMFIA assurance statement attesting to the
     conformance of IRS' internal controls with the objectives specified in
     the act, which forms the basis for a major segment of Treasury's
     required annual FMFIA report. IRS' annual FMFIA assurance statement
     should include all known control weaknesses that existed during the
     fiscal year ended September 30, 1999, (the reporting year) that could
     materially affect IRS', and therefore Treasury's, operations. It should
     also disclose sufficient information about the reported weaknesses to
     clearly describe the problems and specify planned corrective actions.
   *
   * However, we found that IRS' fiscal year 1999 FMFIA process ended too
     early to provide reasonable assurance that all material weaknesses that
     existed during the reporting year were adequately disclosed.
     Specifically, although IRS did not submit its fiscal year 1999 FMFIA
     assurance statement to Treasury until February 2000, IRS concluded its
     internal self-assessment process for fiscal year 1999 on September 30,
     1999. IRS officials informed us that any material weaknesses that came
     to their attention during this intervening period would be considered
     in the succeeding reporting period (fiscal year 2000), rather than
     fiscal year 1999. As a result, to the extent material weaknesses that
     existed in fiscal year 1999 were identified during this period, IRS'
     fiscal year 1999 FMFIA assurance statement would ordinarily exclude
     them and potentially present an incomplete list of material weaknesses
     and a misleading assessment of the effectiveness of IRS' internal
     controls in meeting the objectives of FMFIA.

Suggestion

In order to ensure that IRS' FMFIA assurance statement to Treasury
appropriately discloses all material weaknesses IRS is aware of that existed
during the reporting period covered by the statement, we suggest that IRS
extend its self-assessment process for each reporting year until such time
as the related FMFIA assurance statement is submitted to Treasury.

IRS' Comments and Our Evaluation

IRS did not specifically address the closing date of its annual FMFIA
process but indicated that it does not believe that it ends prematurely. IRS
indicated that in preparing its assurance statement, it includes all issues
known up to the date the Commissioner signs IRS' FMFIA statement. However,
as we noted, IRS concludes its FMFIA process for the year on September 30
although its FMFIA assurance statement to Treasury is not finalized until
several months later. IRS does not determine if its managers or TIGTA
subsequently became aware of any additional weaknesses in the interim period
that existed as of September 30. Consequently, IRS' practice of concluding
its FMFIA process several months before the results are provided to Treasury
increases the risk that IRS' FMFIA assurance statement to Treasury may not
include all material internal control weaknesses that existed during the
reporting period.

IRS also urged us to provide our findings earlier in the process so
management can fully consider them as part of the annual assessment process.
We believe we already do so, to the extent practicable. We note that under
the current audit process, IRS receives notification of our detailed
findings on an ongoing basis throughout the audit in the form of matters for
further consideration and periodic briefings with senior IRS management.

- - - - -

   * This letter is intended for use by the management of IRS. We are
     sending copies to Senator Robert C. Byrd, Senator Joseph I. Lieberman,
     Senator Daniel Patrick Moynihan, Senator William V. Roth, Senator Ted
     Stevens, and Senator Fred Thompson, and to Representative Bill Archer,
     Representative Dan Burton, Representative Stephen Horn, Representative
     David R. Obey, Representative Charles Rangel, Representative Jim
     Turner, Representative Henry A. Waxman, and Representative C.W. Bill
     Young, in their capacities as Chairmen or Ranking Minority Members of
     Senate and House Committees and Subcommittees. We are also sending
     copies to the Honorable Lawrence H. Summers, Secretary of the Treasury;
     the Honorable Jacob J. Lew, Director, Office of Management and Budget;
     and other interested parties. This letter is a matter of public record
     and its distribution is not limited. Consequently, copies are available
     to others on request.
   *
   * We acknowledge and appreciate the cooperation and assistance provided
     by IRS officials and staff during our audit of IRS' fiscal year 1999
     financial statements. If you have any questions or need assistance in
     addressing these matters, please contact me at (202) 512-3406 or
     Charles R. Fox, Assistant Director, at (202) 512-5261.

   * Sincerely yours,

   * Gregory D. Kutz
   * Associate Director, Governmentwide Accounting and Financial Management
     Issues EnclosuresComments From the Internal Revenue Service   
*** End of document. ***