    Financial Audit: IRS' Fiscal Year 1998 Financial Statements (Letter
    Report, 03/01/99, GAO/AIMD-99-75).

    Pursuant to a legislative requirement, GAO examined the Internal Revenue
    Service's (IRS) financial statements for the fiscal year (FY) ending
    September 30, 1998.

    GAO noted that: (1) pervasive weaknesses in the design and operation of
    IRS' financial management systems, accounting procedures, documentation,
    recordkeeping, and internal controls, including computer security
    controls, prevented IRS from reliably reporting on the results of its
    administrative activities; (2) IRS was able to reliably report on the
    results of its custodial activities for Fy 1998, including tax revenue
    received, tax refunds disbursed, and taxes receivable due from the
    public; (3) however, this achievement required extensive, costly, and
    time-consuming ad hoc procedures to overcome pervasive and long-standing
    internal control and systems weaknesses; (4) IRS' major accounting,
    reporting, and internal control deficiencies include: (a) an inadequate
    financial reporting process that resulted in IRS' inability to reliably
    prepare several of the required principal financial statements; (b) the
    lack of a subsidiary ledger to properly manage unpaid assessments, which
    has resulted in both taxpayer burden and lost revenue to the government;
    (c) deficiencies in preventive controls over tax refunds that have
    permitted the disbursement of millions of dollars of fraudulent refunds;
    (d) a failure to reconcile its fund balance to Treasury records during
    Fy 1998; (e) the inability to properly safeguard or reliably report its
    property and equipment; (f) vulnerabilities in computer security that
    may allow unauthorized individuals to access, alter, or abuse
    proprietary IRS programs and data, and taxpayer information; (g)
    vulnerabilities in controls over tax receipts and taxpayer data that
    increase the government's and the taxpayers' risk of loss or
    inappropriate disclosure of sensitive taxpayer data; and (h) an
    inability to provide assurance that its budgetary resources are being
    properly accounted for, reported, and controlled; (5) these weaknesses,
    as they relate to IRS' administrative activities, prevented GAO from
    rendering an unqualified opinion on five of IRS' six principal financial
    statements; and (6) with respect to IRS' custodial activities, GAO was
    able to verify that the reported balances were reliable.

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

     REPORTNUM:  AIMD-99-75
         TITLE:  Financial Audit: IRS' Fiscal Year 1998 Financial Statements
          DATE:  03/01/99
       SUBJECT:  Reporting requirements
                 Financial management systems
                 Accounting procedures
                 Tax administration
                 Internal controls
                 Financial records
                 Federal agency accounting systems
                 Financial statement audits

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    Cover
    ================================================================ COVER

    Report to the Secretary of the Treasury

    March 1999

    FINANCIAL AUDIT - IRS' FISCAL YEAR
    1998 FINANCIAL STATEMENTS

    GAO/AIMD-99-75

    IRS Fiscal Year 1998 Financial Statements

    (919205)

    Abbreviations
    =============================================================== ABBREV

      BPD - Bureau of the Public Debt
      CFO - Chief Financial Officer
      EITC - Earned Income Tax Credit
      FASAB - Federal Accounting Standards Advisory Board
      FFMIA - Federal Financial Management Improvement Act of 1996
      FFMSR - Federal Financial Management Systems Requirements
      FIA - Financial Integrity Act
      FMS - Financial Management Service
      GPRA - Government Performance and Results Act
      HI - Hospital Insurance Trust Fund
      IRS - Internal Revenue Service
      JFMIP - Joint Financial Management Improvement Program
      MD&A - management discussion and analysis
      OMB - Office of Management and Budget
      OTA - Office of Tax Analysis
      P&E - property and equipment
      SFFAS - Statement of Federal Financial Accounting Standards
      SGL - U.S.  Government Standard General Ledger
      SMI - Supplemental Medical Insurance Trust Fund
      SSA - Social Security Administration

    Letter
    =============================================================== LETTER

    B-281967

    March 1, 1999

    The Honorable Robert E.  Rubin
    The Secretary of the Treasury

    Dear Mr.  Secretary:

    This report presents the results of our audit of the principal
    financial statements of the Internal Revenue Service (IRS) for the
    fiscal year ending September 30, 1998, which we performed in
    accordance with the Chief Financial Officer's Act of 1990, as
    expanded by the Government Management Reform Act of 1994.  It
    contains our (1) opinions on IRS' balance sheet and statement of
    custodial activity, (2) disclaimers of opinion on IRS' statement of
    net cost, statement of changes in net position, statement of
    budgetary resources, and statement of financing, (3) opinion on IRS
    management's assertion about the effectiveness of its internal
    controls, and (4) conclusions on IRS' compliance with significant
    provisions of laws and regulations we tested and on whether its
    financial management systems comply with the requirements of the
    Federal Financial Management Improvement Act of 1996.

    This report also discusses significant matters that we considered in
    performing our audit and in forming our conclusions, including
    identified weaknesses in IRS' internal controls, noncompliance with
    laws and regulations and the requirements of the Federal Financial
    Management Improvement Act of 1996, and other matters that should be
    brought to the attention of IRS management and users of IRS'
    principal financial statements and other reported IRS financial
    information.  We will be separately reporting in more detail and
    recommending corrective actions to address the weaknesses in IRS'
    internal controls and compliance with laws and regulations issues
    discussed in this report.

    We are sending copies of this report to the Chairmen and Ranking
    Minority Members of the Senate Committee on Appropriations; Senate
    Committee on Finance; Senate Committee on Governmental Affairs;
    Senate Committee on the Budget; Subcommittee on Treasury, General
    Government, and Civil Service, Senate Committee on Appropriations;
    Subcommittee on Taxation and IRS Oversight, Senate Committee on
    Finance; Subcommittee on Oversight of Government Management,
    Restructuring, and the District of Columbia, Senate Committee on
    Governmental Affairs; House Committee on Appropriations; House
    Committee on Ways and Means; House Committee on Government Reform;
    House Committee on the Budget; Subcommittee on Government Management,
    Information, and Technology, House Committee on Government Reform;
    Subcommittee on Oversight, House Committee on Ways and Means; and
    Subcommittee on Treasury, Postal Service, and General Government,
    House Committee on Appropriations.  We are also sending copies of
    this report to the Chairmen and Vice Chairmen of the Special
    Committee on the Year 2000 Technology Problem and Joint Committee on
    Taxation, the Commissioner of the Internal Revenue Service, the
    Director of the Office of Management and Budget, and other interested
    parties.  Copies will be made available to others upon request.

    If I can be of further assistance, please call me at (202) 512-5500.
    This report was prepared under the direction of Gregory D.  Kutz,
    Associate Director, Governmentwide Accounting and Financial
    Management Issues, Accounting and Information Management Division,
    who can be reached at (202) 512-3406.

    Sincerely yours,

    David M.  Walker
    Comptroller General
    of the United States

    Letter
    =============================================================== LETTER

    B-281967

    To the Commissioner of Internal Revenue

    In accordance with the Chief Financial Officers' Act of 1990, as
    expanded by the Government Management Reform Act of 1994, this report
    presents the results of our audit of the principal financial
    statements of the Internal Revenue Service (IRS) for fiscal year
    1998.  The principal financial statements report the assets,
    liabilities, net position, net costs, changes in net position,
    budgetary resources, reconciliation of net costs to budgetary
    obligations, and custodial activity related to IRS' administration of
    its responsibilities for implementing federal tax legislation, which
    include collecting federal tax revenues, refunding overpayments of
    taxes, and pursuing collection of amounts owed.

    During fiscal year 1998, IRS combined the financial reporting of its
    administrative\1 and custodial activities, which had previously been
    reported and audited separately, into a single set of principal
    financial statements.\2 This required IRS to include both
    administrative and custodial activities on its balance sheet.  Also,
    IRS has presented four principal financial statements which were
    required for the first time for fiscal year 1998:  the (1) statement
    of net cost, (2) statement of changes in net position, (3) statement
    of budgetary resources, and (4) statement of financing.  As a result
    of these changes, comparison of IRS' fiscal year 1998 principal
    financial statements with the fiscal year 1997 financial statements
    would not be meaningful.  Accordingly, these financial statements
    reflect financial information as of and for the fiscal year ended
    September 30, 1998, only.

    IRS continues to face significant financial and other management
    challenges and risks.  Although focusing primarily on financial
    management and federal taxes receivable and other unpaid assessments,
    this report alerts readers to other significant issues facing IRS
    including tax systems modernization, filing fraud, information
    systems security, and the Year 2000 computer problem.\3 We reported
    on these issues in January 1999 in our high-risk series update and a
    report on major management challenges and program risks facing the
    Department of the Treasury.\4 We realize that IRS' ability to
    successfully meet the financial management challenges it faces must
    be balanced with the competing demands placed on its resources by its
    customer service and tax law compliance responsibilities.  However,
    it is critical that IRS rise to the challenges posed by these
    financial management issues, because IRS' success in achieving all
    aspects of its strategic objectives depends in part upon reliable
    financial management information and effective internal controls.  It
    is also important to recognize that several of the financial
    management issues raised in this report directly or indirectly affect
    IRS' ability to meet its customer service and tax law
    responsibilities.

    In summary, pervasive weaknesses in the design and operation of IRS'
    financial management systems, accounting procedures, documentation,
    recordkeeping, and internal controls, including computer security
    controls, prevented IRS from reliably reporting on the results of its
    administrative activities.  IRS was able to reliably report on the
    results of its custodial activities for fiscal year 1998, including
    tax revenue received, tax refunds disbursed, and taxes receivable due
    from the public.  However, this achievement required extensive,
    costly, and time-consuming ad hoc procedures to overcome pervasive
    and long-standing internal control and systems weaknesses.  IRS'
    major accounting, reporting, and internal control deficiencies
    include:

      -- an inadequate financial reporting process that resulted in IRS'
         inability to reliably prepare several of the required principal
         financial statements,

      -- the lack of a subsidiary ledger to properly manage unpaid
         assessments, which has resulted in both taxpayer burden and lost
         revenue to the government,

      -- deficiencies in preventive controls over tax refunds that have
         permitted the disbursement of millions of dollars of fraudulent
         refunds,

      -- a failure to reconcile its fund balance to Treasury records
         during fiscal year 1998,

      -- the inability to properly safeguard or reliably report its
         property and equipment,

      -- vulnerabilities in computer security that may allow unauthorized
         individuals to access, alter, or abuse proprietary IRS programs
         and data, and taxpayer information,

      -- vulnerabilities in controls over tax receipts and taxpayer data
         that increase the government's and the taxpayers' risk of loss
         or inappropriate disclosure of sensitive taxpayer data, and

      -- an inability to provide assurance that its budgetary resources
         are being properly accounted for, reported, and controlled.

    These weaknesses, as they relate to IRS' administrative activities,
    prevented us from rendering an unqualified opinion on five of IRS'
    six principal financial statements.  With respect to IRS' custodial
    activities, we were able, through extensive audit procedures, to
    verify that the reported balances were reliable.  However, the
    substantial deficiencies we identified in our audit represent serious
    agencywide financial and other management challenges that will
    require a substantial commitment of resources, time, effort, and
    expertise to correct.  IRS has acknowledged these weaknesses and has
    plans in place or under development to address these challenges.  We
    will follow up in future audits to assess the effectiveness of these
    plans in resolving these issues.

    --------------------
    \1 IRS' administrative activities include managing costs funded by
    appropriations and reimbursements from other federal agencies, state
    and local governments, and the public.

    \2 The fiscal year 1997 results of IRS' administrative activities
    were audited by the Department of the Treasury Office of Inspector
    General.  See Internal Revenue Service Accountability Report, Fiscal
    Year 1997, Department of the Treasury (March 1998).

    \3 The Year 2000 problem is rooted in the way dates are recorded and
    computed in automated information systems.  For the past several
    decades, systems have used two digits to represent the year, such as
    "99" representing 1999, to conserve on electronic data storage and
    reduce costs.  With this two digit format, however, the Year 2000 is
    indistinguishable from 1900, or 2001, from 1901, etc.  As a result,
    system or application programs that use dates to perform
    calculations, comparisons, or sorting may generate incorrect results
    or, worse, not function at all.

    \4 See High-Risk Series:  An Update (GAO/HR-99-1, January 1999) and
    Major Management Challenges and Program Risks:  Department of the
    Treasury (GAO/OCG-99-14, January 1999).

       OPINIONS ON PRINCIPAL FINANCIAL
       STATEMENTS
    ------------------------------------------------------------ Letter :1

    Our opinion on the statement of custodial activity is unqualified.
    The statement of custodial activity and accompanying notes present
    fairly, in all material respects, in conformity with federal
    accounting standards as described in note 1, IRS' fiscal year 1998
    custodial activities.  The basis of accounting described in note 1 is
    a comprehensive basis of accounting other than generally accepted
    accounting principles.

    Our opinion on the balance sheet is qualified.  Except for (1) the
    limitations on the scope of our work resulting from insufficient
    evidence about the reliability of the fund balance with Treasury and
    accounts payable, and the resulting effect on net position, and (2)
    evidence that leads us to conclude that property and equipment is
    likely to be materially understated, the balance sheet and
    accompanying notes present fairly, in all material respects, in
    conformity with federal accounting standards as described in note 1,
    IRS' assets and liabilities as of September 30, 1998.

    We are unable to render an opinion on the statement of net cost,
    statement of changes in net position, statement of budgetary
    resources, or statement of financing because of limitations on the
    scope of our work resulting from the balance sheet issues described
    in the previous paragraph, and insufficient evidence about nonpayroll
    expenses and budgetary balances.

       OPINION ON MANAGEMENT'S
       ASSERTION ABOUT THE
       EFFECTIVENESS OF INTERNAL
       CONTROLS
    ------------------------------------------------------------ Letter :2

    We evaluated IRS management's assertion about the effectiveness of
    its internal controls designed to provide reasonable assurance that
    the following objectives are met:

      -- Reliability of financial reporting - transactions are properly
         recorded, processed, and summarized to permit the preparation of
         principal financial statements in accordance with federal
         accounting standards and safeguarding of assets against loss
         from unauthorized acquisition, use, and disposition.

      -- Compliance with applicable laws and regulations - transactions
         are executed in accordance with laws governing the use of budget
         authority and with other laws and regulations that could have a
         direct and material effect on the principal financial statements
         and any other applicable laws, regulations, and governmentwide
         policies identified by the Office of Management and Budget (OMB)
         in Bulletin 98-08,\5 Appendix C, as applicable.

    IRS management asserted that, due to the material weaknesses in
    internal controls presented in the agency's fiscal year 1998 Federal
    Managers' Financial Integrity Act (FIA) annual assurance statements
    to Treasury on compliance with relevant internal control and
    accounting standards, internal controls provided qualified assurance
    that misstatements, losses, or noncompliance material in relation to
    the principal financial statements would be prevented or detected on
    a timely basis.

    Management made this assertion based on criteria under FIA and the
    OMB Circular A-123, Management Accountability and Control.  Our
    internal control work would not necessarily disclose material
    weaknesses not reported by IRS.  However, due to material weaknesses
    in its financial accounting, reporting, and safeguarding controls,
    which were also cited by IRS in its fiscal year 1998 FIA assurance
    statements to Treasury, IRS cannot provide reasonable assurance that
    (1) government assets, taxpayer funds, and confidential taxpayer
    information are appropriately safeguarded, (2) laws and regulations
    material to the principal financial statements are complied with, and
    (3) financial or budgetary information reported by IRS is accurate,
    timely, and meaningful to users.  Consequently, we found that IRS'
    internal controls were not effective in satisfying the above
    objectives.

    --------------------
    \5 Audit Requirements for Federal Financial Statements, August 24,
    1998.

       COMPLIANCE WITH LAWS AND
       REGULATIONS AND THE
       REQUIREMENTS OF FFMIA
    ------------------------------------------------------------ Letter :3

    Our tests of compliance with selected provisions of laws and
    regulations disclosed one instance of noncompliance with laws and
    regulations which we consider to be reportable under generally
    accepted government auditing standards and OMB Bulletin 98-08.  This
    concerns IRS' noncompliance with a provision of the Internal Revenue
    Code concerning the use of installment agreements to collect
    delinquent taxes.  Also, due to the limitations on the scope of our
    work discussed above, we were unable to test compliance with the
    Anti-Deficiency Act, as amended.\6 We also concluded that IRS'
    financial management systems do not substantially comply with the
    following requirements of the Federal Financial Management
    Improvement Act of 1996 (FFMIA), which is reportable under OMB
    Bulletin 98-08:

      -- Federal Financial Management Systems Requirements;

      -- applicable federal accounting standards; and

      -- the U.S.  Government Standard General Ledger at the transaction
         level.

    In its fiscal year 1998 FIA assurance statement to the Treasury, IRS
    also concluded that its financial management systems do not comply
    with FFMIA.  The objective of our audit was not to provide an opinion
    on overall compliance with laws, regulations, and requirements
    tested.  Accordingly, we do not express such an opinion.

    --------------------
    \6 The Anti-Deficiency Act, as amended (31 U.S.C.   1341), prohibits
    officers and employees of the Federal government from (1) making or
    authorizing an expenditure or obligation exceeding an amount in an
    appropriation or fund for the expenditure or obligation, or (2)
    involving the Federal government in a contract or obligation for the
    payment of money before an appropriation is made unless authorized by
    law.

       MATERIAL WEAKNESSES
    ------------------------------------------------------------ Letter :4

    During our audit of IRS' fiscal year 1998 principal financial
    statements, we identified six material weaknesses\7 in internal
    controls that may adversely affect any decision by IRS' management
    which is based, in whole or in part, on information that is
    inaccurate because of these deficiencies.  We were unable to obtain,
    through substantive audit procedures, reasonable assurance that IRS'
    fund balance with Treasury, accounts payable, net position,
    nonpayroll expenses and budgetary balances were reliable.  In
    addition, we found evidence that leads us to conclude that property
    and equipment is likely materially understated.  Unaudited financial
    information reported by IRS, including budget and performance
    information, may also contain misstatements resulting from these
    deficiencies.  In addition, some of these material weaknesses have
    allowed inappropriate refund payments and errors in taxpayer
    accounts, resulting in increased taxpayer burden.  These material
    weaknesses relate to IRS'

      -- financial reporting process,

      -- supporting subsidiary ledger and documentation for unpaid
         assessments,

      -- controls over refunds,

      -- controls over fund balance with Treasury,

      -- controls over property and equipment, and

      -- computer security.

    In our report on IRS' fiscal year 1997 custodial financial
    statements,\8 we reported a material weakness in IRS' revenue
    accounting and reporting because of its inability to (1) separately
    report Social Security, Hospital Insurance,\9 and individual income
    taxes collected on its statement of custodial activity for fiscal
    year 1997 as required by OMB's form and content of governmentwide
    financial statements,\10 and (2) determine the amount of excise tax
    revenue it collected for the relevant trust funds.  We also noted
    that effective for fiscal year 1998, federal accounting standards
    would require IRS to separately report Social Security, Hospital
    Insurance, and individual income taxes.  However, during fiscal year
    1998, the Federal Accounting Standards Advisory Board (FASAB)\11
    provided clarification on the federal accounting standards
    requirement and OMB provided clarification noting that agencies are
    allowed flexibility in the classification of tax revenues on the
    statement of custodial activity.  IRS' presentation of federal tax
    revenues on its fiscal year 1998 statement of custodial activity is
    consistent with federal accounting standards and OMB reporting
    requirements.  Accordingly, we no longer consider this issue to be a
    material weakness since it does not materially affect IRS' principal
    financial statements.  However, we still consider this limitation to
    be a reportable condition as discussed later in this report.

    --------------------
    \7 A material weakness is a reportable condition in which the design
    or operation of the internal control elements does not reduce to a
    relatively low level the risk that errors, fraud, or noncompliance in
    amounts that would be material in relation to the principal financial
    statements being audited may occur and not be detected within a
    timely period by employees in the normal course of performing their
    assigned functions.  Reportable conditions are matters coming to our
    attention that, in our judgment, should be communicated because they
    represent significant deficiencies in the design or operation of
    internal control that could adversely affect IRS' ability to meet the
    objectives described in this report.

    \8 See Financial Audit:  Examination of IRS' Fiscal Year 1997
    Custodial Financial Statements (GAO/AIMD-98-77, February 26, 1998).

    \9 The Hospital Insurance Trust Fund (HI) is one of two trust funds
    comprising the accumulated funds of the Medicare program.  The other
    Medicare trust fund is the Supplemental Medical Insurance Trust Fund
    (SMI).  Of these trust funds, only HI receives distributions from the
    Treasury's general revenue fund.

    \10 OMB's Formats and Instructions for the Form and Content of the
    Financial Statements of the U.S.  Government (September 2, 1997).

    \11 FASAB considers and recommends accounting standards and
    principles for the Federal government considering the financial and
    budgetary information needs of congressional oversight groups,
    executive agencies, and the needs of other users of federal financial
    information.

          IRS' FINANCIAL REPORTING
          CONTROLS ARE INADEQUATE
    ---------------------------------------------------------- Letter :4.1

    IRS does not have internal controls over its financial reporting
    process adequate to provide reasonable assurance that its principal
    financial statements are fairly presented.  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 evidence that leads us to conclude that property
    and equipment is likely materially understated.  These weaknesses
    also left IRS reliant on extensive and labor intensive compensating
    ad hoc procedures to enable it to report reliable revenue and refund
    balances on its statement of custodial activities, and reliable tax
    refunds payable, taxes receivable and the corresponding liability to
    Treasury amounts on its balance sheet.  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)\12 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 they are issued.

    During our audit of IRS' fiscal year 1997 custodial financial
    statements,\13 we reported that IRS' general ledger system for its
    custodial activities was not able to routinely generate the
    information on custodial assets and liabilities needed to prepare
    principal financial statements, and did not use the standard federal
    accounting classification structure or provide a complete audit
    trail.  During fiscal year 1998, these problems continued.  IRS was
    again unable to rely on its custodial general ledger to support
    related amounts on the principal financial statements.

    We also found problems that affected IRS' administrative general
    ledger.  IRS' general ledger for its administrative activities does
    utilize the SGL account structure.  However, it does not conform to
    the SGL at the transaction level since it does not provide an
    adequate audit trail for significant administrative activities
    including property and equipment, accounts payable, nonpayroll
    expenses, and undelivered orders.  For example, IRS' property and
    equipment system does not interface with its general ledger system.
    Also, IRS initially records property and equipment purchases in its
    operating expense account, and at year-end posts entries to record
    the purchases in the property and equipment general ledger account.
    Our testing of nonpayroll operating expenses revealed that property
    and equipment purchases were inappropriately included as operating
    expenses.

    Implementation of the SGL is required by the Core Financial System
    Requirements of the Joint Financial Management Improvement
    Program,\14 and OMB Circular A-127.  FFMIA also requires financial
    systems that implement the SGL at the transaction level.  Because of
    the problems discussed above, IRS' general ledgers do not comply with
    these requirements.  In addition, IRS does not consistently capture
    costs to permit it to routinely prepare reliable cost-based
    performance measures for inclusion in its management discussion and
    analysis which accompanies its principal financial statements, or to
    prepare the information to be included in its annual performance plan
    as required by the Government Performance and Results Act (GPRA) of
    1993.

    Also, IRS does not have a detailed subsidiary ledger for undelivered
    orders, taxes receivable or accounts payable.  For example, IRS
    relies upon a detailed transaction history to support its balance for
    accounts payable.  However, this transaction history includes all
    transactions which have been recorded in accounts payable, including
    amounts that have since been paid and are therefore no longer
    payables.  As a result, IRS cannot readily determine the basis for
    the reported total nor determine the basis for the total amount owed
    to each of its creditors.  In addition, the detailed history for
    nonpayroll expenses included transactions which were not valid
    current year expenses, such as property and equipment and prior year
    expenses.  As a result, we were unable to verify that total
    nonpayroll expenses were reliable.

    In an effort to overcome these pervasive 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
    data bases 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, similar to fiscal year 1997, the amounts produced by this
    approach needed material audit adjustments to produce reliable
    financial statement balances.  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.
    Also, for custodial activities, even the successful application of
    this approach at year-end requires extensive technical knowledge of
    IRS' master files--its data base of taxpayer information--which is
    possessed by only a limited number of key individuals.  Should these
    individuals become unavailable for any reason, this approach could
    cease to be a viable option, and IRS will be forced to rely on a
    financial reporting process which, in the absence of such specialized
    expertise, cannot generate reliable custodial balances.  Also, IRS'
    previously separate financial reporting processes for its custodial
    and administrative activities, respectively, 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.  Similarly, the final financial statements
    should be carefully reviewed by senior IRS management prior to public
    issuance to ensure they are in accordance with all applicable
    standards and meet the objectives of management.

    However, we found that 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.  These problems
    were compounded by the implementation of new federal accounting and
    reporting requirements which 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 draft financial statements themselves, which likely would
    have been caught and corrected had these records been appropriately
    reviewed by management.

    --------------------
    \12 The SGL establishes the general ledger account structure for
    federal agencies as well as the rules for agencies to follow in
    recording financial events.

    \13 See GAO/AIMD-98-77, February 26, 1998.

    \14 The Joint Financial Management Improvement Program (JFMIP) is a
    cooperative undertaking of the Office of Management and Budget, the
    Department of the Treasury, the Office of Personnel Management, and
    GAO, working in cooperation with each other and with operating
    agencies to improve financial management practices.

          IRS CONTINUES TO LACK A
          SUBSIDIARY LEDGER AND
          ADEQUATE SUPPORTING
          DOCUMENTATION FOR UNPAID
          ASSESSMENTS
    ---------------------------------------------------------- Letter :4.2

    As we have previously reported,\15 IRS does not have a detailed
    listing, or subsidiary ledger, which tracks and accumulates unpaid
    assessments and their status\16 on an ongoing basis.  This condition
    adversely affects IRS' ability to effectively manage and accurately
    report unpaid assessments.  As a result, IRS is unable to readily
    identify and focus collection efforts on those accounts most likely
    to prove collectible,\17 and cannot readily prevent or detect and
    correct errors in taxpayer accounts.  This condition has resulted in
    instances of unnecessary taxpayer burden.  In addition, IRS continues
    to experience difficulty locating and providing adequate supporting
    documentation for individual unpaid assessment balances.

    To compensate for the lack of a subsidiary ledger, IRS runs computer
    programs against its master files 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.  Without this information, IRS cannot
    ensure that payments and assessments are promptly posted to the
    appropriate taxpayer accounts.  We found in our sample of fiscal year
    1998 unpaid assessments that this problem resulted in inaccurate
    taxpayer account balances, and led to IRS pursuing collection efforts
    against taxpayers that 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.

    For example, when a company does not pay IRS the taxes that have been
    withheld from employee's wages, such as Social Security or individual
    income tax withholdings, IRS has the authority to assess the
    responsible officers individually for the amount withheld from
    employees.  Thus, IRS may record assessments against several
    individuals (officers) each for the employee withholding component of
    the payroll tax liability in an effort to collect the total tax
    liability of the business.  While these assessments--known as trust
    fund recovery penalties--are a necessary enforcement tool, IRS'
    current systems cannot automatically link each of the multiple
    assessments made to one tax liability.  This is due to the fact that
    the corporation's tax liability is maintained in IRS' business master
    files, while the trust fund recovery penalties assessed against the
    corporation's officers are maintained in the individual master files.
    These are two separate databases, each of which is independent of the
    other.  In fact, in numerous unpaid payroll tax cases we reviewed
    involving multiple assessments, we found that payments were not
    accurately recorded to reflect each responsible party's reduction in
    tax liability.  Also, we found that IRS' failure to quickly identify
    and assess responsible officers resulted in refunds being sent to
    those officers that could have been offset by IRS against amounts
    due.

    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.  We did note
    some improvement in the documentation.  For example, estate case
    files we reviewed generally contained an independent appraisal of the
    estate's assets.  However, we continued to find that IRS experienced
    difficulties in providing other supporting documentation.  For
    example, bankruptcy case files frequently did not include the
    information necessary to verify the IRS' creditor status.  In
    addition, nonestate installment agreement cases rarely contained
    documentation sufficient to validate all of the installment
    agreements.

    The lack of adequate supporting documentation may make it difficult
    for IRS to readily identify and focus collection efforts.  The lack
    of documentation also made it difficult to assess the classification
    and collectibility of unpaid assessments reported in the principal
    financial statements as federal tax receivables.  Through our audit
    procedures, we were able to verify the existence and proper
    classification of unpaid assessments and obtain reasonable assurance
    that reported balances were reliable.  However, this required tens of
    billions of dollars of audit adjustments to IRS' principal financial
    statements to correct misstated and duplicate unpaid assessment
    balances identified by our testing.

    --------------------
    \15 See GAO/AIMD-98-77, February 26, 1998.

    \16 Unpaid assessments consist of (1) taxes due from taxpayers for
    which IRS can support the existence of a receivable through taxpayer
    agreement or a favorable court ruling (federal taxes receivable), (2)
    compliance assessments where neither the taxpayer nor the court has
    affirmed that the amounts are owed, and (3) write-offs, which
    represent unpaid assessments for which IRS does not expect further
    collections due to factors such as the taxpayer's death, bankruptcy,
    or insolvency.  Of these three classifications of unpaid assessments,
    only federal taxes receivable are reported on the principal financial
    statements.  As of September 30, 1998, IRS reported $26 billion (net
    of an allowance for doubtful accounts of $55 billion), $22 billion,
    and $119 billion in these three categories, respectively.

    \17 It should be noted that, despite the fact that certain taxpayer
    accounts have little likelihood of collection, IRS would generally
    continue some efforts to collect, to reinforce continued compliance
    by those taxpayers who appropriately report and pay their tax
    obligations and to increase compliance by taxpayers who are not
    compliant with respect to reporting and paying their tax obligations.

          CONTINUED WEAKNESSES IN
          CONTROLS OVER REFUNDS
    ---------------------------------------------------------- Letter :4.3

    We previously reported\18 that IRS did not have sufficient preventive
    controls over refunds to reduce to an acceptable level the risk that
    inappropriate payments for tax refunds will be disbursed.  We found
    that in fiscal year 1998, inappropriate refund payments continued to
    be issued 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.  Although IRS has detective (post-refund) controls in
    place, the lack of sufficient preventative 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.

    As we have previously reported, IRS does not compare tax returns to
    accompanying W-2s until months after the tax return has been
    processed.  As a result, we found differences between these documents
    that were not detected by IRS.  These differences could indicate an
    invalid refund claim filing that is not being detected in time to
    prevent the disbursement of incorrect refund amounts.  We also found
    instances where inappropriate refunds were issued as a result of
    errors or delays in posting tax assessments to taxpayers accounts.
    For example, we identified a case where a taxpayer who owed taxes was
    erroneously issued a refund because the tax assessment had not yet
    been posted to the taxpayer's account.  Errors and posting delays
    such as these also impair IRS' ability to effectively offset refunds
    due taxpayers against amounts owed by the same taxpayers on another
    account.  For example, IRS does not always properly offset refunds
    against other amounts owed by individuals.  Most frequently, we noted
    this was a problem where multiple payees were responsible for the
    same unpaid assessment.  In some cases we reviewed involving unpaid
    payroll taxes, individuals received a refund even though amounts were
    owed by their businesses.

    As we previously reported, EITC have historically been vulnerable to
    high rates of invalid claims.\19 During fiscal year 1998, IRS
    reported that it processed EITC claims totaling over $29 billion,
    including over $23 billion (79 percent) in refunds.\20 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 preventative controls
    designed to identify invalid claims before refund disbursement.  In
    fiscal year 1998, IRS began implementing a 5-year EITC compliance
    initiative intended to expand customer service to increase taxpayer
    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 work for us to make any judgment about
    their effectiveness.

    As we have previously reported, IRS is also vulnerable to issuance of
    duplicate refunds allowed by gaps in its internal controls.  IRS'
    manual and automated systems are not properly coordinated to prevent
    identical refunds from being processed through both systems.  For
    example, we identified three refunds which were paid twice.  In each
    case, IRS processed one manually, and the other through automated
    procedures.  Since IRS systems were not coordinated to compare the
    two, both were paid.  IRS reported this condition as a material
    weakness in its fiscal year 1998 FIA assurance statement to Treasury.
    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
    prospect of success.

    --------------------
    \18 See GAO/AIMD-98-77, February 26, 1998.

    \19 High Risk Series:  An Update (GAO/HR-99-1, January 1999), and
    Major Management Challenges and Program Risks:  Department of the
    Treasury (GAO/OCG-99-14, January 1999).

    \20 EITC claims do not always result in refunds.  They may also
    reduce tax assessments.

          IRS DID NOT RECONCILE ITS
          FUND BALANCE WITH TREASURY
    ---------------------------------------------------------- Letter :4.4

    During fiscal year 1998, IRS did not reconcile its administrative
    fund balance with Treasury accounts, in accordance with federal
    accounting standards.\21 Treasury policy and prudent financial
    management practices require an agency to routinely reconcile its
    fund balance with Treasury accounts to Treasury's records.
    Reconciling these accounts involves identifying differences between
    IRS and Treasury records, determining the reason for the differences,
    and correcting them.  Differences arise when either IRS or Treasury
    erroneously records or delays recording of deposits and disbursements
    to IRS cash accounts.  Correcting such differences should result in
    adjustments to either Treasury's or IRS' records, or both.  This
    process is similar to a company or individuals reconciling their
    checkbook to the monthly bank statement.

    In January 1999, IRS' contractor provided what it considered to be
    reconciliations of IRS' Treasury fund balance for the 12 months of
    fiscal year 1998.  However, we found that these efforts were
    inadequate in several respects.  For example, material amounts on the
    reconciliations for Treasury and IRS balances did not agree with
    Treasury and IRS records, and reconciling items listed on the
    reconciliations were not investigated and resolved.  Similarly, IRS
    has not been investigating and resolving amounts in its
    administrative suspense accounts.  As of September 30, 1998, IRS had
    items totaling a net credit balance of over $100 million in its fund
    balance with Treasury suspense account, including some items dating
    back to 1989 appropriations.

    Lack of timely, thorough reconciliations makes it difficult if not
    impossible for IRS to determine if operating funds have been properly
    spent, or if reported amounts for operating expenses, assets, and
    liabilities are reliable.  Without performing such reconciliations,
    IRS has no assurance that its fund balance with Treasury is accurate.
    Lack of reconciliations also impact IRS' ability to ensure that it
    complies with the law governing the use of its budget authority.
    Because this fundamental internal control was not followed, we were
    unable to conclude whether IRS' fund balance with Treasury account
    was reliable at September 30, 1998.  This contributed to our
    qualification on IRS' fiscal year 1998 balance sheet.  For the
    future, it will be important for IRS to prepare these reconciliations
    monthly, and timely resolve any differences.  Absent timely,
    appropriate reconciliations of fund balance with Treasury, this
    historically problematic area for IRS will continue to affect its
    ability to produce reliable financial information.

    --------------------
    \21 Statement of Federal Financial Accounting Standards No.  1
    Accounting for Selected Assets and Liabilities.

          WEAKNESSES IN CONTROLS OVER
          PROPERTY AND EQUIPMENT
          RECORDS
    ---------------------------------------------------------- Letter :4.5

    As previously reported,\22 IRS' controls over its property and
    equipment (P&E) records are not adequate to ensure that these records
    provide a complete and reliable record of P&E assets.  IRS cannot
    ensure the completeness of its reported P&E balance because it does
    not have policies and procedures in place to ensure that all P&E
    purchases are identified and capitalized at the appropriate cost in
    accordance with federal accounting standards.\23 Consequently, P&E
    balances are likely materially understated.  IRS also does not record
    individual property transactions in its general ledger P&E account
    throughout the year.  Instead, IRS records adjustments at year-end
    for all property activity during the year.  Consequently, the general
    ledger does not contain the transaction detail information necessary
    to allow IRS to reconcile it to the P&E detailed records.

    Weaknesses in IRS' controls over P&E on hand increase its
    vulnerability to loss.  IRS reported P&E controls as a material
    weakness in its fiscal year 1998 FIA assurance statement to Treasury.
    This issue was also reported as a material weakness by the Department
    of the Treasury's Office of Inspector General in its report on IRS'
    fiscal year 1997 administrative financial statements.  The effects of
    these weaknesses, taken together resulted in our concluding that P&E
    is likely to be materially understated.

    The Comptroller General's Standards for Internal Controls in the
    Federal Government require that documentation of transactions or
    other significant events be complete and accurate.  Property and
    equipment subsidiary records need to be promptly updated to reflect
    changes due to purchases and dispositions.  In addition, all
    transactions should be accurately recorded, and balances should be
    periodically reconciled to the general ledger and to the results of
    physical inventories of P&E on hand.  Without current and accurate
    records, IRS cannot ensure that the P&E items it owns are not lost or
    stolen, that new purchases of equipment are appropriately capitalized
    in its accounting records, or that related principal financial
    statements balances are reliable.

    We found evidence in our audit work that IRS does not have policies
    and procedures in place to ensure that material P&E are recorded in
    IRS' financial statements.  For example, IRS' computer systems
    information shows substantial funding available and used for computer
    systems, such as mainframe consolidation and a new receipts
    processing system.  IRS' computer systems information also shows
    evidence of contractor services related to design, plans, and
    specifications for computer hardware and software projects--costs
    required to be capitalized under federal accounting standards.  Also,
    IRS' financial records show equipment-related expenses of $339
    million in fiscal year 1998.

    Although this significant P&E activity occurred, only about $30
    million was recognized as P&E additions in fiscal year 1998.  We also
    saw evidence of substantial unrecorded capital expenditures in fiscal
    year 1997.  These problems are compounded by IRS' use of a $50,000
    minimum financial statement cost capitalization threshold as
    permitted by Treasury policy.  This amount far exceeds the cost of
    most of the P&E items IRS purchases and results in a material
    distortion of IRS' reported P&E in its financial statements.  We
    found, based on assets included in IRS' property systems, that $1.2
    billion or 69 percent of IRS' gross P&E was not included in property
    and equipment in the financial statements because of the use of this
    threshold to capitalize P&E assets.  Although IRS uses the $50,000
    minimum for financial reporting purposes, it uses a much lower
    threshold for recording and tracking P&E in its subsidiary systems.

    In addition to the P&E completeness problem, IRS' policies and
    procedures for recording P&E transactions impede its ability to
    reconcile the general ledger to related P&E subsidiary records.  IRS'
    field offices record individual property acquisitions and
    dispositions on site throughout the year.  However, IRS' accounting
    system expenses property purchases during the year, then records
    adjustments at year end to reflect P&E dispositions, and to move
    property purchases from expenses to P&E based on subsidiary records
    maintained in the field offices.  As a result, IRS has no assurance
    that the amounts it records in its general ledger and underlying P&E
    subsidiary systems, respectively, are complete and agree with each
    other.  IRS is compelled to manually adjust the general ledger at
    year end to force it to agree with its P&E subsidiary records.  In
    making this adjustment, IRS attempts to eliminate from its nonpayroll
    operating expenses the P&E additions for the fiscal year.  However,
    IRS has no assurance that the amount it removes from nonpayroll
    operating expenses for specific P&E additions reflects the actual
    amount paid.

    Because IRS ultimately relies on its subsidiary P&E records to
    support the reported P&E balance, we tested the reliability of those
    records by attempting to physically verify the existence of selected
    property items.  However, we found that IRS was unable to locate 10
    (7 percent) of the 153 items we selected for review from IRS detailed
    records of P&E, including items such as a Chevrolet Blazer motor
    vehicle, a laptop computer, and a laser printer costing over
    $300,000.  Additionally, we found that 10 (7 percent) of 141 items we
    selected from the floor of IRS' field offices were not included in
    IRS' detailed property records, including items such as a television,
    a facsimile machine, and a video cassette recorder.  We also found
    instances where different IRS field offices had recorded
    substantially identical items at significantly different costs.  For
    example, the cost IRS assigned to substantially identical machines
    used to sort and open mail ranged from $300,000 to $1,000,000 at
    different field offices.

    We observed IRS staff conducting physical inventories of P&E at two
    field offices.  At one office, of 130 computer equipment assets each
    costing over $50,000 identified from IRS P&E records, IRS staff were
    unable to locate 19 (15 percent).  In addition, 20 (5 percent) of 443
    items identified from the floor were not included in IRS' P&E
    records.  At a different office, we found that 11 of 12 (91 percent)
    items over $50,000 that had been disposed of had not been removed
    from the P&E records.  We also found problems with IRS' internal
    controls over physical inventories of P&E.  An April 1998 IRS
    internal audit report on the Northeast Region noted that P&E
    inventory procedures for computer equipment and software were not
    effective for maintaining an accurate inventory or consistently
    followed by all districts in the region.  Also, IRS reported that
    district management did not ensure that the computer property records
    were always updated to reflect an accurate inventory.  These
    discrepancies and reported problems reflect weaknesses in IRS
    property management controls that impair its ability to ensure that
    P&E are used only in accordance with IRS policy and that related
    records are accurate.

    --------------------
    \22 Financial Audit:  Examination of IRS' Fiscal Year 1996
    Administrative Financial Statements (GAO/AIMD-97-89, August 29,
    1997).

    \23 Statement of Federal Financial Accounting Standards (SFFAS) No.
    6 Accounting for Property, Plant, and Equipment (effective beginning
    with fiscal year 1998).

          CONTROLS OVER COMPUTER
          SECURITY ARE INADEQUATE
    ---------------------------------------------------------- Letter :4.6

    As we have previously reported,\24 IRS has significant and
    long-standing weaknesses in controls over its computer information
    systems.  IRS places extensive reliance on these computer information
    systems to perform its basic functions such as processing tax
    returns, maintaining sensitive taxpayer data, calculating interest
    and penalties, and generating refunds.  Consequently, such weaknesses
    could render IRS unable to perform these vital functions, or result
    in the unauthorized disclosure, modification, or destruction of
    taxpayer data.  In December 1998, we reported that as of July 1998,
    IRS was significantly progressing in improving its computer
    security.\25 For example, IRS has centralized responsibility for IRS'
    security and privacy issues in its Office of Systems Standards and
    Evaluation.  The office is implementing a servicewide security
    program to manage risk and has led IRS' efforts in mitigating about
    75 percent of the weaknesses identified in our April 1997 report.\26

    We found, however, serious weaknesses continued to exist in the
    following six functional areas:  (1) security program management, (2)
    access control, (3) application software development and change
    controls, (4) system software, (5) segregation of duties, and (6)
    service continuity.  Continued weaknesses in these areas can allow
    unauthorized individuals access to critical hardware and software
    where they may intentionally or inadvertently add, alter, or delete
    sensitive data or programs.  Such individuals can also obtain
    personal taxpayer information and use it to commit financial crimes
    in the taxpayers' name (identity fraud), such as fraudulently
    establishing credit, running up debts, and taking over and depleting
    banks accounts.  IRS has agreed with our recommendations to address
    these problems and stated that our conclusions and recommendations
    were consistent with its ongoing actions to improve system security
    and mitigate the remaining weaknesses.  We will follow up during
    future audits to assess the effectiveness of IRS' efforts to resolve
    these problems.

    --------------------
    \24 See IRS Systems Security:  Tax Processing Operations and Data
    Still at Risk Due to Serious Weaknesses (GAO/AIMD-97-49, April 8,
    1997) and GAO/AIMD-98-77, February 26, 1998.

    \25 IRS Systems Security:  Although Significant Improvements Made,
    Tax Processing Operations and Data Still at Serious Risk
    (GAO/AIMD-99-38, December 14, 1998).

    \26 See GAO/AIMD-97-49, April 8, 1997.

       REPORTABLE CONDITIONS
    ------------------------------------------------------------ Letter :5

    In addition to the material weaknesses discussed above, we identified
    two reportable conditions which, although not material to the
    principal financial statements, represent significant deficiencies in
    the design or operation of internal controls which could adversely
    affect IRS' ability to meet the internal control objectives described
    in this report.  These conditions concern weaknesses in IRS' internal
    controls over (1) manually processed tax receipts and taxpayer
    information and (2) revenue reporting and distribution to trust
    funds.

          INADEQUATE PHYSICAL SECURITY
          OVER MANUAL TAX RECEIPTS AND
          TAXPAYER INFORMATION
    ---------------------------------------------------------- Letter :5.1

    As we have previously reported,\27 IRS' controls over cash, checks,
    and related hardcopy taxpayer data it manually receives from
    taxpayers are not adequate to reduce to an acceptably low level the
    risk that these payments will not be properly credited to taxpayer
    accounts and deposited in the Treasury, or that proprietary taxpayer
    information will not be properly safeguarded.  We found weaknesses in
    IRS' physical security over tax receipts and taxpayer data on hand at
    IRS field offices and in transit to depository institutions.  In
    addition, we found that delays in background and fingerprint checks
    resulted in new employees being hired and entrusted with taxpayer
    receipts and data before the results of these checks were known.  We
    found that similar weaknesses exist at commercial lockbox banks under
    contract to IRS.\28 Although we do not consider this weakness to be
    material to IRS' principal financial statements, it involves issues
    central to IRS' customer service goals.  It is therefore critical
    that IRS resolve these issues promptly and effectively.

    The Comptroller General's Standards for Internal Controls in the
    Federal Government require that access to resources and records be
    limited to authorized individuals.  Such physical security is
    critical to ensure that receipts are not lost or stolen nor sensitive
    taxpayer data compromised.  However, we found that (1) unattended
    checks and tax returns were often stored in open and easily
    accessible areas, (2) hundreds of millions of dollars of receipts in
    the form of checks, and in one case cash, were transported from IRS
    field offices to financial institutions by unarmed couriers who often
    used unmarked civilian vehicles including, in one instance, a
    bicycle, and (3) individuals were hired and entrusted with access to
    cash, checks, and sensitive taxpayer data before completion of
    background or fingerprint checks.  This problem is particularly acute
    during peak filing season when IRS typically hires thousands of
    temporary employees.  We found similar weaknesses exist at commercial
    lockbox banks IRS contracts with to process tax receipts, including
    the use of unarmed couriers and the hiring of temporary employees
    before background checks are completed.

    In fiscal years 1997 and 1998, IRS identified 56 actual or alleged
    employee thefts of receipts at IRS field offices and lockbox banks
    totaling about $1 million.  However, based on IRS' inspections'
    database, an additional 100 cases were opened during the period in
    which the amount potentially stolen was not quantified.  Further, the
    magnitude of thefts not identified by IRS is unknown.  The weaknesses
    discussed above also expose taxpayers to increased risk of losses due
    to financial crimes committed by individuals who inappropriately gain
    access to confidential information entrusted to IRS.  For example,
    this information, which includes names, addresses, social security
    and bank account numbers, and details of financial holdings, may be
    used to commit identity fraud.  Although receipts and taxpayer
    information will always be vulnerable to theft, IRS has a
    responsibility to protect the government and taxpayers from such
    losses.  IRS substantially agreed with the recommendations we
    provided to address these issues and indicated that it plans to
    address the control deficiencies we identified related to tax
    receipts and taxpayer data.  We will follow up in future audits to
    assess the effectiveness of IRS' corrective actions.

    --------------------
    \27 See Internal Revenue Service:  Physical Security Over Taxpayer
    Receipts and Data Needs Improvement (GAO/AIMD-99-15, November 30,
    1998); Internal Revenue Service:  Immediate and Long-Term Actions
    Needed to Improve Financial Management (GAO/AIMD-99-16, October 30,
    1998); and GAO/AIMD-98-77, February 26, 1998.

    \28 IRS contracts with 10 lockbox banks nationwide to process
    receipts--one for each service center.

          WEAKNESSES IN IRS' REVENUE
          REPORTING AND DISTRIBUTION
          PROCESS
    ---------------------------------------------------------- Letter :5.2

    IRS is unable to currently determine the specific amount of revenue
    it actually collects for Social Security, Hospital Insurance,
    Highway, or other relevant trust funds.  As we previously
    reported,\29 this is primarily because the accounting information
    needed to validate the taxpayer's liability and record the payment to
    the proper trust fund is provided on the tax return, which is
    received months after the payment is submitted.  Further, the
    information on the return only pertains to the amount of the tax
    liability, not the distribution of the amount previously collected.
    As a result, IRS cannot report the specific amount of revenue it
    actually collected for three of the federal government's four largest
    revenue sources, including Social Security, Hospital Insurance, and
    individual income taxes.  In response to our previous reports, IRS
    conducted a study to consider whether it should require taxpayers to
    provide this additional information when they remit their taxes.  The
    results of this study were not available for our review at the
    completion of our audit.

    This condition presents other operational issues for IRS and Treasury
    in the distribution of excise tax receipts to the trust funds.
    Because data is not available to allocate excise taxes to the
    appropriate trust funds when deposits are made, Treasury uses a
    process to estimate the initial distribution of excise taxes.  This
    process involves the use of economic models prepared by the Office of
    Tax Analysis (OTA) to estimate the initial distribution of tax
    receipts.  Treasury's Financial Management Service (FMS) uses these
    estimates to prepare entries for the initial distribution to the
    trust funds, which are then recorded by the Bureau of Public Debt
    (BPD) in the books and records of the trust funds maintained by the
    Treasury.  Subsequent to the initial distribution, IRS certifies
    quarterly the amounts that should have been distributed to the excise
    tax related trust funds using its records of payments received and
    the subsequently provided tax returns.  FMS uses these certifications
    to prepare adjustments to the initial trust fund distributions, which
    are then recorded by BPD.  Typically, there is a 6-month lag between
    the quarter end and the excise tax certification by IRS.

    As we have reported,\30 this process is complex, cumbersome and prone
    to error.  During our fiscal year 1997 audit, we found that
    weaknesses in fundamental internal controls, such as supervisory
    review, allowed errors in the certification process to occur and not
    be detected.  These included taxpayer errors in preparing excise tax
    returns -- errors that IRS did not identify; errors by IRS when
    inputting excise tax information to its master files; and IRS errors
    in using this information in preparing the certification.  We found
    similar problems during our fiscal year 1998 audit.  As long as IRS
    lacks the data to identify the specific amount of revenue received
    for each tax type at the time of receipt, IRS, Treasury, and excise
    tax related trust funds such as the Highway and Airport and Airways
    trust funds, will continue to depend on a complex estimation process
    for determining revenue distributions which continues to be
    vulnerable to errors.

    --------------------
    \29 See Excise Taxes:  Internal Control Weaknesses Affect Accuracy of
    Distributions to the Trust Funds (GAO/AIMD-99-17, November 9, 1998);
    GAO/AIMD-98-77, February 26, 1998; and GAO/AIMD-99-16, October 30,
    1998.

    \30 See GAO/AIMD-99-17, November 9, 1998.

       NONCOMPLIANCE WITH LAWS AND
       REGULATIONS AND FFMIA
       REQUIREMENTS
    ------------------------------------------------------------ Letter :6

    As discussed above, limitations on the scope of our work prevented us
    from testing compliance with the Anti-Deficiency Act.  Otherwise, our
    tests of compliance with selected provisions of laws and regulations
    disclosed one instance of noncompliance which is reportable under
    generally accepted government auditing standards and OMB Bulletin
    98-08, Audit Requirements for Federal Financial Statements.  This
    concerns IRS' noncompliance with a provision of the Internal Revenue
    Code concerning the use of installment agreements to collect
    delinquent taxes.  We also found that IRS' financial management
    systems do not substantially comply with the requirements of FFMIA.

          IRS' USE OF INSTALLMENT
          AGREEMENTS DID NOT COMPLY
          WITH THE INTERNAL REVENUE
          CODE
    ---------------------------------------------------------- Letter :6.1

    Section 6159 of the Internal Revenue Code authorizes IRS to enter
    into installment agreements with taxpayers to satisfy the taxpayer's
    liability.  During our fiscal year 1998 audit, we identified numerous
    instances in which IRS has entered into installment agreements under
    whose terms the payments will not be sufficient to satisfy the
    taxpayers' outstanding tax liability prior to the expiration of the
    statutory collection period for these tax liabilities.\31
    Specifically, in 48 of the 93 unpaid assessment cases we reviewed (52
    percent) where active individual installment agreements were in place
    between the taxpayer and IRS, we found that the payments to be
    received under the installment agreement would not be sufficient to
    fully satisfy the outstanding liability.  For example, in one case,
    an installment agreement required the taxpayer to make payments of
    $25 each month toward an outstanding tax liability due of over $16
    million.  Based on the number of months remaining in the statutory
    collection period, we determined that under the terms of the
    agreement, IRS would only collect a maximum of $1,625, assuming the
    taxpayer does not default on the installment agreement.

    Because these agreements will not result in full satisfaction of the
    outstanding tax liability, the 48 cases are not in compliance with
    Section 6159 of the Internal Revenue Code.  IRS' Collection Division
    recognized this problem.  In March, 1998, the Deputy Commissioner
    issued a memorandum stating clearly that under any new installment
    agreement, the taxpayer must fully satisfy his/her tax liability.
    This memorandum was followed in August 1998 by a memorandum from the
    Chief Operations Officer issuing guidelines on installment agreements
    pending updates to the Internal Revenue Manual.

    --------------------
    \31 The statutory collection period is generally 10 years from the
    date of the assessment.  However, this period can be extended by
    agreement with the taxpayer when an installment agreement is entered
    into.

          IRS' FINANCIAL MANAGEMENT
          SYSTEMS ARE NOT IN
          COMPLIANCE WITH FFMIA
    ---------------------------------------------------------- Letter :6.2

    In our previous audit,\32 we reported that IRS' custodial financial
    management systems did not substantially comply with the Federal
    Financial Management Systems Requirements (FFMSR),\33 federal
    accounting standards, and the SGL at the transaction level.  During
    fiscal year 1998, we found that this condition continued, and that
    IRS' administrative financial management systems also had significant
    problems.  We found that IRS (1) cannot reliably prepare four of the
    six principal financial statements required by OMB 97-01, as amended,
    (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 its FIA assurance statement to
    Treasury, IRS also reported that its financial management systems did
    not substantially comply with FFMIA in fiscal year 1998.

    In addition, IRS does not consistently capture cost information in
    accordance with federal accounting standards.\34 For example, in our
    sample of IRS payroll transactions we tested, we found that most
    employees did not charge their time to individual job codes for
    specific services and activities.  As a result, actual cost
    information for specific services and activities is not available.
    Consequently, IRS is unable to reliably report cost-based performance
    measures in its management discussion and analysis (MD&A) that
    accompanies the principal financial statements, or otherwise report
    cost-based information for its performance plan in accordance with
    the Government Performance and Results Act of 1993.  This deficiency
    also renders IRS unable to include reliable cost-based performance
    information in its budget submission to Congress.

    These are all requirements under FFMSR.  The other four material
    weaknesses we discussed above--controls over refunds, property and
    equipment, fund balance with Treasury, and computer security--also
    are conditions indicating that IRS' systems do not comply with FFMSR.
    These material weaknesses indicate that IRS cannot routinely produce
    auditable principal financial statements and related disclosures in
    conformance with federal accounting standards.  Since IRS' systems do
    not comply with FFMSR, federal accounting standards, and the SGL,
    they also do not comply with OMB Circular A-127, Financial Management
    Systems.

    In May 1997, IRS provided Congress a systems modernization plan
    intended to bring IRS' custodial financial systems into conformance
    with FFMIA.  Planned improvements include (1) an SGL compliant code
    and classification structure which is traceable to detail in the
    master files, (2) automated preparation of financial statement
    balances from the general ledger, (3) improved unpaid assessment
    documentation retention requirements, and (4) extracts of summary
    unpaid assessment information by taxpayer, tax module, account
    status, age, and installment information.  However, in re-evaluating
    the modernization plan in light of the material weaknesses we
    reported in our previous audit, IRS concluded that the current
    modernization strategy cannot achieve compliance within the 3-year
    time frame required by FFMIA.  In IRS' FFMIA noncompliance
    remediation plan for its custodial financial management systems, IRS
    cited plans to develop an alternative approach employing
    modifications to existing systems and additional manual procedures in
    lieu of building some modernized subsystems.  Some of the planned
    financial reporting improvements are embodied in IRS' Financial
    Reporting Release which is currently scheduled to be installed by
    April 2000.  IRS plans to completely address its computer security
    weaknesses by December 2000.  Implementation of the full plan as
    originally envisioned is not expected for a decade or more.

    In October 1998, IRS prepared a remediation plan designed to address
    the material weaknesses cited by the Treasury OIG in its audit of
    IRS' fiscal year 1997 administrative financial statements, which
    reported material weaknesses in IRS' property and equipment and
    accounting for liabilities and accrued expenses.  However, the
    corrective actions detailed in this plan focus primarily on measures
    such as enhancements to policies and procedures relevant to these
    processes and training staff to follow them.  This plan does not
    address the accounting issues and systemic problems affecting P&E and
    accounts payable detailed above, such as the lack of an accounts
    payable subsidiary ledger and the inability to account for P&E in
    accordance with SFFAS No.  6.  In addition, the plan does not address
    the additional weaknesses discussed above, such as an administrative
    general ledger that does not comply with the SGL, financial reporting
    weaknesses that rendered IRS unable to reliably prepare four required
    principal financial statements (all of which report only
    administrative accounts), or the lack of effective management
    oversight of the financial reporting process.

    --------------------
    \32 See GAO/AIMD-98-77, February 26, 1998.

    \33 FFMSR are a series of requirements produced by the JFMIP to
    improve federal financial management through uniform requirements for
    financial information, financial systems, and financial organization.

    \34 Statement of Federal Financial Accounting Standards No.  4,
    Managerial Cost Accounting Standards.

          STATUS OF PRIOR YEAR
          COMPLIANCE ISSUE
    ---------------------------------------------------------- Letter :6.3

    In our audit of IRS' fiscal year 1997 Custodial Financial Statements,
    we reported that IRS certified distributions of excise taxes to the
    recipient trust funds based on amounts assessed taxpayers, rather
    than certifying them based on actual collections, as required by the
    Internal Revenue Code.  We first reported this problem in our audit
    of IRS' fiscal year 1992 financial statements.\35 We also reported
    this issue in our fiscal year 1993 audit and recommended that IRS
    develop a means of capturing information on the specific taxes
    collected for trust funds so that the amounts collected by trust
    funds are readily determinable and excise tax receipts can be
    distributed as required by law.\36

    During fiscal year 1998, IRS certified distributions of excise tax
    revenue collected in the last half of fiscal year 1997 based on
    amounts assessed taxpayers.  IRS developed a method to allocate total
    excise tax collections to specific excise tax related trust funds
    based on the related taxpayer returns and implemented this method
    beginning with the June 1998 certification of first quarter fiscal
    year 1998 excise tax revenue.  This new approach is consistent with
    our recommendation and brings IRS into compliance with the
    requirements of the Code.  However, as discussed above, weaknesses in
    the internal controls over this process persist.

    In addition to the weaknesses and FFMIA noncompliance discussed
    above, we noted other, less significant matters involving IRS' system
    of accounting controls and its operations which we will be reporting
    separately in a management letter to IRS.

    --------------------
    \35 Financial Audit:  Examination of IRS' Fiscal Year 1992 Financial
    Statements (GAO/AIMD-93-2, June 30, 1993).

    \36 See Examination of IRS' Fiscal Year 1993 Financial Statements
    (GAO/AIMD-94-120, June 15, 1994).

       OTHER SIGNIFICANT MATTERS
    ------------------------------------------------------------ Letter :7

    In addition to the material weaknesses and other reportable
    conditions and noncompliance with laws and regulations discussed
    above, we identified two other significant matters which we believe
    should be brought to the attention of users of IRS' principal
    financial statements and other financial reports.  These concern (1)
    the importance of IRS successfully preparing its automated systems
    for the year 2000 and (2) supplementing of the Social Security and
    Hospital Insurance Trust funds by general fund tax revenues.

          YEAR 2000 PROBLEM PRESENTS A
          SIGNIFICANT CHALLENGE FOR
          IRS
    ---------------------------------------------------------- Letter :7.1

    IRS is highly dependent on information technology to carry out its
    mission.  However, most of IRS' information systems were not designed
    to read dates beyond December 31, 1999.  As a result, IRS is in the
    midst of a massive effort to make its information systems Year 2000
    compliant in order to avoid significant disruptions in its
    operations.  IRS' program represents one of the largest civilian Year
    2000 efforts, with an estimated cost of about $1.4 billion.  These
    cost estimates include work needed for its mission-critical
    information systems, telecommunications networks, and buildings.  At
    the outset, IRS faced significant challenges in making its systems
    Year 2000 compliant.  In addition to the size of its effort, IRS
    lacked a comprehensive inventory of information system assets,
    particularly of its information systems infrastructure (i.e., systems
    software, hardware, and telecommunications networks), and IRS' Chief
    Information Officer did not control all mission-critical assets.

    In a June 1998 report,\37 we provided a status of IRS' Year 2000
    efforts.  We reported that IRS had made more progress in fixing its
    applications than its infrastructure, and that two major Year 2000
    system replacement efforts were experiencing schedule slippages.  In
    addition, we identified two risk areas for IRS' Year 2000
    effort--that is, the absence of an integrated master schedule showing
    the interdependencies among the many Year 2000 efforts and a limited
    approach to contingency planning.  If IRS is unable to make its
    mission-critical systems Year 2000 compliant, IRS could be rendered
    unable to properly and promptly process tax returns, issue refunds,
    correctly calculate interest and penalties, effectively collect
    taxes, or prepare accurate principal financial statements and other
    financial reports.

    IRS has been acting to address our concerns about a master schedule.
    The Commissioner is also taking steps to broaden the contingency
    planning effort to help ensure that IRS had adequately assessed the
    vulnerabilities of its core business processes to potential Year 2000
    system failures.  Specifically, we recommended that the Commissioner
    (1) solicit input from the business functional areas to identify core
    business processes and identify those processes that must continue in
    the event of a Year 2000 failure, (2) map IRS' mission-critical
    systems to those core business processes, (3) determine the impact of
    information system failures on each core business process, (4) assess
    existing contingency plans for their applicability to potential Year
    2000 failures, and (5) develop and test contingency plans for core
    business processes if existing plans are not appropriate.

    Since we issued our report, IRS has been taking actions to address
    our recommendations.  IRS had originally planned to have its first
    set of contingency plans by December 15, 1998; however, according to
    its officials, IRS did not meet that milestone.  We plan to continue
    monitoring IRS' progress in developing contingency plans.

    --------------------
    \37 IRS' Year 2000 Efforts:  Business Continuity Planning Needed for
    Potential Year 2000 System Failures (GAO/GGD-98-138, June 15, 1998).

          SOCIAL SECURITY AND HOSPITAL
          INSURANCE ARE SUPPLEMENTED
          BY GENERAL FUND REVENUES
    ---------------------------------------------------------- Letter :7.2

    Taxes collected on behalf of the federal government are deposited in
    the general revenue fund of the Department of the Treasury, from
    which they are subsequently distributed to the appropriate trust
    funds.  Amounts representing Social Security and Hospital Insurance
    taxes are distributed to their respective trust funds based on
    employee wage information certified by the Commissioner of the Social
    Security Administration (SSA).  Consistent with the statutory
    verification process, the Commissioner bases this certification on a
    consideration of both wage information maintained by SSA and wage
    information provided by IRS.

    Because the distribution of the Social Security taxes IRS collects
    from employers is based on this certification rather than actual
    collections, the federal government's general fund revenues
    supplement the Social Security and Hospital Insurance trust funds.
    This supplement occurs primarily because a significant number of
    employers that file tax returns for Social Security and Hospital
    Insurance taxes never actually pay the assessed amounts.  Many of
    these businesses ultimately go bankrupt or otherwise go out of
    business.  Also, a significant number of self-employed individuals do
    not pay the assessed amounts.  As of September 30, 1998, the
    estimated amount of unpaid taxes and interest in IRS' unpaid
    assessments balance was approximately $38 billion for Social Security
    and Hospital Insurance.\38 While these totals do not include amounts
    no longer in the unpaid assessments balance due to the expiration of
    the statutory collection period,\39

    they nevertheless give an indication of the cumulative amount of the
    supplement provided from the general fund.

    --------------------
    \38 We included interest accrued in these amounts because assessments
    distributed to the trust funds earn interest at Treasury-based
    interest rates, similar to IRS' interest accruals.

    \39 As noted earlier, the statutory collection period for collecting
    taxes is generally 10 years from the date of the tax assessment.
    However, this period can be extended under a variety of
    circumstances, such as agreements by the taxpayer to extend the
    collection period, bankruptcy litigation, and court appeals.
    Consequently, some tax assessments can and do remain on IRS' records
    for decades.

       CONSISTENCY OF OTHER
       INFORMATION
    ------------------------------------------------------------ Letter :8

    IRS' management discussion and analysis, supplemental information,
    and other accompanying information contain various data, some of
    which are not directly related to the principal financial statements.
    We did not audit and do not express an overall opinion on this
    information.  However, we compared this information for consistency
    with the principal financial statements and discussed the methods of
    measurement and presentation with IRS officials.  Based on our
    limited work, we found no material inconsistencies with the principal
    financial statements or OMB guidance.  However, given the severity of
    the issues raised earlier with respect to accounting, reporting, and
    internal controls over IRS' administrative activities, such
    comparisons may not be meaningful.

    In performing our review of IRS' key performance indicators, we found
    that the measure related to toll-free telephone level of access\40 is
    potentially misleading.  IRS reports that for fiscal year 1998, the
    toll-free telephone level of access is 89.96 percent.  Based on this,
    readers of IRS' MD&A will likely conclude that over 89 percent of
    callers successfully contacted an IRS representative.  However, IRS
    defines "access" as including all callers who reach IRS' telephone
    system, including those who subsequently hang up before an IRS
    representative comes on the line.  We found that based upon another
    measure IRS refers to as "toll-free telephone level of service,"
    approximately 70 percent of callers to IRS actually succeed in having
    their calls answered by IRS.  We believe this measure, which is not
    included in its MD&A, more accurately represents the percentage of
    callers that successfully contact IRS.

    --------------------
    \40 Toll-free telephone level of access is defined as the sum of the
    number of calls answered and the number of calls that are abandoned
    by the caller before getting assistance divided by total call
    attempts (which consist of calls answered, calls that are abandoned,
    and calls that receive a busy signal).

       OBJECTIVES, SCOPE, AND
       METHODOLOGY
    ------------------------------------------------------------ Letter :9

    Management is responsible for

      -- preparing the annual principal financial statements in
         conformity with the basis of accounting described in note 1 to
         the principal financial statements;

      -- establishing, maintaining, and assessing internal controls to
         provide reasonable assurance that the broad control objectives
         of FIA are met; and

      -- complying with applicable laws and regulations and FFMIA
         requirements.

    We are responsible for obtaining reasonable assurance about whether

      -- the principal financial statements are reliable (free of
         material misstatements and presented fairly, in all material
         respects, in conformity with the basis of accounting described
         in note 1), and

      -- management's assertion about the effectiveness of internal
         controls is fairly stated, in all material respects, based upon
         criteria established under the Federal Managers' Financial
         Integrity Act of 1982 and OMB Circular A-123, Management
         Accountability and Control.

    We are also responsible for testing compliance with selected
    provisions of laws and regulations\41 and FFMIA requirements, and for
    performing limited procedures with respect to certain other
    information appearing in these annual principal financial statements.

    Except as discussed above, in order to fulfill these
    responsibilities, we

      -- examined, on a test basis, evidence supporting the amounts and
         disclosures in the principal financial statements;

      -- assessed the accounting principles used and significant
         estimates made by management;

      -- evaluated the overall presentation of the principal financial
         statements;

      -- obtained an understanding of internal controls related to
         financial reporting, including safeguarding assets, and
         compliance with laws and regulations, including execution of
         transactions in accordance with budget authority;

      -- tested relevant internal controls over financial reporting,
         including safeguarding assets and compliance, and evaluated
         management's assertion about the effectiveness of internal
         controls;

      -- considered compliance with the process required by the Federal
         Managers' Financial Integrity Act for evaluating and reporting
         on internal control and financial management systems;

      -- tested compliance with selected provisions of the following laws
         and regulations (referenced to the United States Code)

    Internal Revenue Code (appendix I),

    Government Management Reform Act of 1994 {31 U.S.C.   3515, 3521
    (f)},

    Civil Service Reform Act of 1978 {5 U.S.C.   5332},

    Fair Labor Standard Act of 1938, as amended {29 U.S.C.   206},

    Civil Service Retirement Act of 1930, as amended {5 U.S.C.   8334},

    Federal Employees' Retirement System Act of 1986, as amended {5
    U.S.C.   8423},

    Social Security Act, as amended {26 U.S.C.   3101, 3121, and 42
    U.S.C.   430},

    Federal Employees Benefits Act of 1959, as amended {5 U.S.C.
    8905, 8906, 8909}, and

    Federal Employees' Group Life Insurance Act of 1980 {5 U.S.C.
    8701}, and

      -- tested whether IRS' financial management systems comply with
         FFMIA requirements:  (1) Federal Financial Management Systems
         Requirements, (2) applicable federal accounting standards, and
         (3) the U.S.  Standard General Ledger at the transaction level.

    We did not evaluate all internal controls relevant to operating
    objectives as broadly defined by FIA, such as those controls relevant
    to preparing statistical reports and ensuring efficient operations.
    We limited our internal control testing to those controls necessary
    to achieve the objectives outlined in our opinion on management's
    assertion about the effectiveness of internal controls.  Because of
    inherent limitations in any internal control system, losses,
    noncompliance, or misstatements may nevertheless occur and not be
    detected.

    As the auditor of IRS' principal financial statements, we are
    reporting under FFMIA on whether IRS' financial management systems
    substantially comply with the Federal Financial Management Systems
    Requirements, applicable federal accounting standards, and the U.S.
    Standard General Ledger at the transaction level.  In making this
    report, we considered the implementation guidance for FFMIA issued by
    OMB in Bulletin 98-08 Audit Requirements for Federal Financial
    Statements.

    We did not test compliance with all laws and regulations applicable
    to IRS.  We limited our tests of compliance to those required by OMB
    under Bulletin 98-08 and which we deemed applicable to the principal
    financial statements of IRS.  We caution that noncompliance other
    than that discussed in this report may occur and not be detected by
    these tests and that such testing may not be sufficient for other
    purposes.

    Except for the limitations on the scope of our work on the principal
    financial statements described above, we performed our work in
    accordance with generally accepted government auditing standards and
    OMB Bulletin 98-08.

    --------------------
    \41 These are laws and regulations that, we believe, have a direct
    and material effect on the principal financial statements.

       AGENCY COMMENTS AND OUR
       EVALUATION
    ----------------------------------------------------------- Letter :10

    In commenting on a draft of this report, IRS stated that it generally
    agreed with the findings and conclusions in the report.  IRS
    acknowledged the issues, concerns, and internal control weaknesses we
    cited, and emphasized its commitment to address these matters.  IRS
    stated that it has assembled a corrective action team under the
    direction of the Chief Financial Officer (CFO) to formulate a
    detailed plan for addressing each of the issues raised in the report.
    IRS stated that it anticipates completing the plan by March 31, 1999.
    IRS also stated that it would be bringing in outside experts to
    assist its staff in resolving known deficiencies and problems with
    respect to the agency's administrative operations.  IRS stated that,
    while its financial management systems were not designed to meet
    current systems and financial reporting standards, the agency is in
    the process of planning and implementing interim solutions until such
    time as enhanced systems are available over the next several years.
    The Chief Information Officer is working in conjunction with the CFO
    to identify priorities and resources needed to complete the necessary
    systems solutions.  We will continue to work closely with IRS and
    evaluate the effectiveness of its corrective actions as part of our
    audit of IRS' fiscal year 1999 financial statements.

    Additionally, IRS stated that it had a number of initiatives underway
    to address several of the issues raised in this report and in our
    prior audits.  First, with respect to its unpaid assessments, these
    initiatives include (1) a review of multiple assessments--trust fund
    recovery penalties--and alternatives to ensure that taxpayer accounts
    are appropriately credited for payments and adjustments made to
    related accounts, and (2) a task force established to address
    documentation standards and record retention policies and practices.
    We will review the results of these initiatives as they are
    completed.  With respect to revenue reporting and distribution, IRS
    also stated that it had recently completed its study on whether to
    require taxpayers to provide information on how payments should be
    applied to specific types of taxes at the time the taxpayer submits
    the payments, and has concluded that at this time IRS would not
    pursue such reporting requirements.  We will review the results of
    this study as part of our audit of IRS' fiscal year 1999 financial
    statements.  We remain concerned, however, that the existing process
    results in IRS' inability to separately report on the specific amount
    of revenue it actually collects for three of the federal government's
    four largest revenue sources, and necessitates the need for a
    multi-stage, complex, and error-prone process to distribute excise
    taxes to the recipient trust funds.

    We agree with IRS' comment that the issue of capitalization
    thresholds for P&E is a governmentwide issue.  We have initiated
    discussions with the OMB on the development of governmentwide
    guidance on P&E capitalization thresholds.  However, as it relates to
    IRS, we do not believe that capitalization thresholds used by other
    agencies are relevant.  It is our position that each federal agency,
    because of its size and diversity of asset base, needs a
    capitalization threshold that is appropriate for its own unique
    circumstances.  As our report notes, IRS' use of a $50,000 threshold,
    established by the Treasury Department CFO Council, resulted in $1.2
    billion (69 percent) of its gross P&E being excluded from the
    September 30, 1998, financial statements.  In addition, IRS'
    financial statements show $339 million of expenses for P&E purchased
    during fiscal year 1998, while only about $30 million (9 percent) was
    actually capitalized.  We continue to believe that the $50,000
    capitalization threshold is inappropriate and significantly
    contributed to the likely material understatement of IRS' September
    30, 1998, P&E balance.

    IRS stated that it continues to report the toll-free telephone level
    of access because it is one of seven high impact agency goals
    identified and tracked by the National Partnership for Reinventing
    Government.  IRS further stated that in the future this measure will
    be replaced with the "toll-free telephone level of service." However,
    reporting of the toll-free telephone level of access as it is
    presented in IRS' MD&A for fiscal year 1998 is potentially
    misleading.  Readers of IRS' MD&A will likely inappropriately
    conclude that 89.96 percent of taxpayers calling IRS actually speak
    to an IRS representative.  The use of IRS' toll-free telephone level
    of service measure, which does not recognize an abandoned taxpayer
    call as a success, is a more appropriate measure.  We support IRS'
    use of the toll-free telephone level of service measure in future
    years.

    The complete text of IRS' response to our draft report is presented
    in appendix II.

    David M.  Walker
    Comptroller General
    of the United States

    February 12, 1999

    PRINCIPAL FINANCIAL STATEMENTS
    =========================================================== Appendix 0

       Balance Sheet

       (See figure in printed
       edition.)

       Statement of Net Cost

       (See figure in printed
       edition.)

       Statement of Changes in Net
       Position

       (See figure in printed
       edition.)

       Statement of Budgetary
       Resources

       (See figure in printed
       edition.)

       Statement of Financing

       (See figure in printed
       edition.)

       Statement of Custodial Activity

       (See figure in printed
       edition.)

       Notes to Financial Statements

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    SUPPLEMENTAL AND OTHER
    ACCOMPANYING INFORMATION
    =========================================================== Appendix 1

       Supplemental Financial
       Information - Unaudited

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       edition.)

       (See figure in printed
       edition.)

       Other Accompanying Information
       - Unaudited

       (See figure in printed
       edition.)

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       edition.)

    MANAGEMENT DISCUSSION AND ANALYSIS
    =========================================================== Appendix 2

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    PROVISIONS OF INTERNAL REVENUE
    CODE TESTED FOR THE FISCAL YEAR
    1998 AUDIT
    =========================================================== Appendix I

    26 U.S.C.   6159 Agreements for Payment of Tax Liability in
    Installments

    26 U.S.C.   6402 Authority to Make Credits or Refunds

    26 U.S.C.   6402 Authority to Make Refund Offsets

    26 U.S.C.   6511 Limitations on Credits or Refunds

    26 U.S.C.   6601 Interest on Underpayment, Nonpayment, or Extension
    of
     Time for Payment of Tax

    26 U.S.C.   6611 Interest on Overpayments

    26 U.S.C.   6621 Determination of Rate of Interest

    26 U.S.C.   6651 Failure to File Tax Return or to Pay Tax

    26 U.S.C.   6654 Penalty for Failure by Individual to Pay Estimated
     Income Tax

    26 U.S.C.   6655 Penalty for Failure by Corporations to Pay
    Estimated
     Income Tax

    26 U.S.C.   9501-9511
     Trust Funds

    (See figure in printed edition.)Appendix II
    COMMENTS FROM THE INTERNAL REVENUE
    SERVICE
    =========================================================== Appendix I

    (See figure in printed edition.)

    (See figure in printed edition.)

    (See figure in printed edition.)

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