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

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   Statement of Net Cost

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   Statement of Changes in Net
   Position

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   Statement of Budgetary
   Resources

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   Statement of Financing

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   Statement of Custodial Activity

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   Notes to Financial Statements

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

   Supplemental Financial
   Information - Unaudited

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   Other Accompanying Information
   - Unaudited

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MANAGEMENT DISCUSSION AND ANALYSIS
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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



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