Financial Audit: IRS's Fiscal Years 2002 and 2001 Financial	 
Statements (15-NOV-02, GAO-03-243).				 
                                                                 
Because of the significance of IRS revenue collections to federal
receipts and, in turn, to the consolidated financial statements  
of the U.S. government, which GAO is required to audit, and	 
Congress's interest in financial management at IRS, GAO audits	 
IRS's financial statements annually to determine whether (1) the 
financial statements IRS prepares are reliable, (2) IRS 	 
management maintained effective internal controls, and (3) IRS	 
complies with selected provisions of significant laws and	 
regulations and its financial systems comply with the Federal	 
Financial Management Improvement Act (FFMIA).			 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-03-243 					        
    ACCNO:   A05505						        
  TITLE:     Financial Audit: IRS's Fiscal Years 2002 and 2001	      
Financial Statements						 
     DATE:   11/15/2002 
  SUBJECT:   Accountability					 
	     Financial management				 
	     Financial management systems			 
	     Financial statement audits 			 
	     Internal controls					 
	     Reporting requirements				 

******************************************************************
** This file contains an ASCII representation of the text of a  **
** GAO Product.                                                 **
**                                                              **
** No attempt has been made to display graphic images, although **
** figure captions are reproduced.  Tables are included, but    **
** may not resemble those in the printed version.               **
**                                                              **
** Please see the PDF (Portable Document Format) file, when     **
** available, for a complete electronic file of the printed     **
** document's contents.                                         **
**                                                              **
******************************************************************
GAO-03-243

                                       A

Report to the Secretary of the Treasury

November 2002 FINANCIAL AUDIT IRS*s Fiscal Years 2002 and 2001 Financial
Statements

GAO- 03- 243

Letter 1 Auditor*s Report 5

Opinion on IRS*s Financial Statements 8 Opinion on Internal Controls 8
Compliance with Laws and Regulations and FFMIA Requirements 10

Consistency of Other Information 11 Objectives, Scope, and Methodology 11
Agency Comments and Our Evaluation 13

Management 15

Discussion and Analysis Financial Statements 73

Balance Sheets 73 Statement of Net Cost 74 Statement of Changes in Net
Position 75 Statement of Budgetary Resources 76 Statement of Financing 77
Statement of Custodial Activity 78 Notes to the Financial Statements 79

Supplemental and 99

Other Accompanying Information Appendixes

Appendix I: Material Weaknesses, Reportable Conditions, and Compliance
Issues 105 Material Weaknesses 105 Reportable Conditions 119 Compliance
Issues 127

Appendix II: Details on Audit Methodology 131

Appendix III: Comments from the Internal Revenue Service 133

Abbreviations

EITC Earned Income Tax Credit FFMIA Federal Financial Management
Improvement Act of 1996 FFMSR Federal Financial Management Systems
Requirements FIA Federal Managers* Financial Integrity Act of 1982 IRS
Internal Revenue Service JFMIP Joint Financial Management Improvement
Program OMB Office of Management and Budget P& E property and equipment
SGL U. S. Government Standard General Ledger

TIGTA Treasury Inspector General for Tax Administration

Lett er

November 15, 2002 The Honorable Paul H. O*Neill The Secretary of the
Treasury Dear Mr. Secretary: The accompanying report presents the results
of our audits of the financial statements of the Internal Revenue Service
(IRS) as of and for the fiscal years ending September 30, 2002 and 2001.
We performed our audits in accordance with the Chief Financial Officers
(CFO) Act of 1990, as expanded by the Government Management Reform Act of
1994. This report contains our (1) unqualified opinions on IRS*s financial
statements, (2) opinion that IRS*s internal controls were not effective as
of September

30, 2002, and (3) conclusion regarding IRS*s noncompliance with two
provisions of laws and regulations that we tested and IRS*s financial
management systems* lack of substantial compliance with the requirements
of the Federal Financial Management Improvement Act of

1996. Our unqualified opinions on IRS*s fiscal years 2002 and 2001
financial statements were made possible by the continued extraordinary
efforts of IRS senior management and staff to compensate for serious
internal control and financial management systems deficiencies. Meeting a

significantly accelerated reporting date for the issuance of the financial
statements for fiscal year 2002 was also a major accomplishment. The
Office of Management and Budget (OMB) required that agencies accelerate
their timeline for issuing audited financial statements. For fiscal year
2002, OMB requires that agencies issue their audited financial statements
by February 1, 2003, and for fiscal year 2004, OMB requires that agencies
issue their audited financial statements by November 15, 2004, or 6 weeks
after the end of the fiscal year. The Department of the Treasury went a
step further and established a goal of completing its fiscal year 2002
audit, including those of its component entities such as IRS, and issuing
its

departmentwide accountability report by November 15, 2002. In our report
on the results of our audits of IRS*s fiscal year 2001 and 2000 financial
statements, 1 we discussed obstacles to IRS*s ability to achieve the

1 U. S. General Accounting Office, Financial Audit: IRS*s Fiscal Years
2001 and 2000 Financial Statements, GAO- 02- 414 (Washington, D. C.: Feb.
27, 2002).

department*s goal. At that time, we noted that if IRS was to meet this
deadline and sustain an unqualified opinion on its financial statements,
the tremendous amount of hard work and commitment IRS demonstrated in
recent years alone would not be sufficient unless accompanied by systemic
changes in how IRS processed its transactions, maintained its financial
records, and reported its financial results. IRS took this message
seriously and made great strides in each of these areas. For example, IRS
made a significant investment in improving its approach to analyzing,
processing, and recording certain transactions throughout the year;
previously, such analyses were not performed until the end of the fiscal
year, an approach that limited our ability to test significant
transactions and balances at interim periods. Other business process
changes, such as better ongoing

reviews of obligation levels and activity, enabled us to reduce the
classification of control issues related to budgetary activity from a
material weakness to a reportable condition. IRS*s actions, coupled with
the continued use of costly, resource- intensive processes to compensate
for the continued serious weaknesses in systems and controls, enabled IRS
to achieve Treasury*s goal.

Nonetheless, it will remain a challenge for IRS management and staff to
sustain the level of effort needed to produce reliable financial
statements until the agency is able to fully address the underlying
systems and internal control issues that have made this process so time
consuming and resource intensive. Presently, IRS continues to lack timely,
accurate, and useful

financial information and sound controls with which to make fully informed
decisions and to ensure ongoing accountability, which is the end goal of
the CFO Act. IRS has made significant progress in addressing its serious
control and systems deficiencies and improving financial

management during the past 5 years under the strong leadership of former
Commissioner Charles Rossotti and Acting Commissioner Robert Wenzel. It is
important that these financial management initiatives continue to receive
the needed support to achieve comprehensive and lasting financial
management reform.

The accompanying report also discusses other significant issues that we
considered in performing our audit and in forming our conclusions that we
believe should be brought to the attention of IRS management and users of
IRS*s financial statements.

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 Efficiency,
Financial Management, and

Intergovernmental Relations, House Committee on Government Reform; and
Subcommittee on Oversight, House Committee on Ways and Means. In addition,
we are sending copies of this report to the Chairman and ViceChairman of
the Joint Committee on Taxation, the Acting Commissioner of Internal
Revenue, the Director of the Office of Management and Budget, the Chairman
of the IRS Oversight Board, and other interested parties. Copies will be
made available to others upon request. In addition, the

report will be made available at no charge on GAO*s Web site at http://
www. gao. gov. This report was prepared under the direction of Steven J.
Sebastian, Director, Financial Management and Assurance, who can be
reached at (202) 512- 3406. If I can be of further assistance, please call
me at (202) 5125500.

Sincerely yours, David M. Walker Comptroller General of the United States

Audi Report or* t s To the Acting Commissioner of Internal Revenue In
accordance with the Chief Financial Officers (CFO) Act of 1990, as
expanded by the Government Management Reform Act of 1994, this report
presents the results of our audits of the financial statements of the
Internal Revenue Service (IRS) for fiscal years 2002 and 2001. 2 The
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*s
administration of its responsibilities for implementing federal tax
legislation. The financial statements do not include an estimate of the
amount of taxes owed the federal government but which have not been
identified by IRS, often referred to as the tax gap.

In its role as the nation*s tax collector, IRS has a demanding
responsibility in collecting taxes, processing tax returns, and enforcing
the nation*s tax laws. The size and complexity of IRS*s operations present
additional challenges to management. IRS is a large, complex organization
with tens of thousands of people in 10 service center campuses, three
computing

centers, and numerous other field offices throughout the United States. In
each of fiscal years 2002 and 2001, IRS collected more than $2 trillion in
tax payments, processed more than 200 million tax returns, and paid about
$281 billion and $251 billion, respectively, in refunds to taxpayers.

One of the largest obstacles facing IRS management today continues to be
the agency*s lack of a financial management system capable of producing
the reliable and timely information its managers need to assist in making
day- to- day decisions. Because of this systems issue and other factors,
IRS continues to face many of the pervasive internal control weaknesses
that we have reported each year since we began auditing its financial
statements in fiscal year 1992. 3 Nevertheless, in fiscal year 2002, for
the

third consecutive year, IRS was able to produce financial statements
covering its tax custodial and administrative activities that are fairly
stated 2 In accordance with OMB Bulletin 01- 09, Form and Content of
Agency Financial Statements, IRS prepared comparative Balance Sheets,
Statements of Net Cost, and Statements of Custodial Activity as of and for
the fiscal years ended September 30, 2002 and 2001. IRS prepared the
Statements of Changes in Net Position, Budgetary Resources, and Financing
for the fiscal year ended September 30, 2002, only. 3 U. S. General
Accounting Office, Financial Audit: Examination of IRS* Fiscal Year 1992
Financial Statements, GAO/ AIMD- 93- 2 (Washington, D. C.: June 30, 1993).

in all material respects. Moreover, IRS was able to produce these
statements by November 15, 2002, only a month and a half after the end of
the fiscal year. 4

The significant acceleration of IRS*s reporting date was a major
accomplishment and represents a significant improvement over previous
years. In our report on the results of our audit of IRS*s fiscal years
2001 and

2000 financial statements, we noted that for IRS to be able to achieve
this ambitious goal for fiscal year 2002, it would need to make
fundamental changes in the way it processed transactions, maintained its
records, and reported financial information. IRS made great strides in
each of these areas in fiscal year 2002. However, these improvements alone
were not enough to make this outcome possible. Many of IRS*s longstanding
systems and internal control weaknesses continued to exist, necessitating
continued reliance on costly compensating processes, statistical
projections, external contractors, substantial adjustments, and

monumental human efforts to prepare a set of reliable financial
statements. These costly efforts would not have been necessary if IRS*s
systems and controls had operated effectively. Strong commitment, hard
work, and a reassessment of certain basic

business processes by both IRS senior leadership and staff were the key to
IRS*s ability to meet Treasury*s goal of both receiving an unqualified
audit opinion on its financial statements and issuing the statements by
November 15, 2002. Part of the reason IRS was able to meet this
accelerated reporting goal was that it made further refinements to its
compensating procedures. Another essential element was IRS*s significant
investment in improving its approach to processing and recording certain
types of transactions

throughout the year, rather than undertaking end- of- year analyses of
transactions and activity to produce financial statement balances* a
process that in prior years took several months to complete. During the
latter half of fiscal year 2002, for example, IRS was able to produce
quarterly financial information on property and equipment acquisitions
within a few weeks after the end of each quarter. Previously, such

information for the entire fiscal year was not available until several
months 4 In 2001, the Office of Management and Budget announced the
executive branch*s intention to significantly accelerate agencies*
financial reporting timeline, requiring that by fiscal year 2004 they
issue their financial statements by November 15. The Department of the
Treasury established its own goal of issuing its fiscal year 2002 audited
financial statements by November 15, 2002. As a component entity of
Treasury, IRS is subject to Treasury*s financial- reporting timeline.

after the fiscal year end. IRS also significantly enhanced its
accountability over budgetary activity by increasing the frequency of its
analyses of outstanding obligations and other budgetary accounts. As a
result of these and other improvements, IRS management had earlier access
to information and we were able to test financial data on an interim basis
during the year rather than almost exclusively at year end.

IRS made notable progress in a number of areas in fiscal year 2002 and has
laid the groundwork for sustainable improvements in several others. IRS*s
continued progress in addressing deficiencies in its controls over

budgetary activity, for example, allowed us to conclude that the remaining
issues related to budgetary activity no longer constitute a material
weakness. At the same time, despite improvements in controls over property
and equipment, financial reporting, and computer security, further

actions are needed, and we continue to consider these issues as well as
management of unpaid assessments and collection of revenue and issuance of
tax refunds to be material weaknesses. 5 Producing financial statements
within a month and a half after the end of the fiscal year while
sustaining an unqualified opinion was a significant accomplishment for
IRS. At the same time, however, the effort it took placed a considerable
strain on IRS resources and required substantial contractor support. IRS
has clearly made progress in improving its financial management, and
several of the process changes IRS made in

fiscal year 2002 represent good financial management practices.
Nevertheless, it will be difficult for IRS personnel to sustain the level
of effort needed to produce reliable financial statements timely without
addressing the underlying systems and internal control problems that cause
this process to be so unnecessarily time consuming and expensive.
Additionally, this process does not produce the reliable, useful, and
timely financial and performance information IRS needs for decision making
on an ongoing basis, which is a goal of the CFO Act, nor can it fully
address the underlying financial management and operational issues that
adversely affect IRS*s ability to effectively fulfill its responsibilities
as the nation*s tax

collector. 5 A material weakness is a condition that precludes the
entity*s internal controls from providing reasonable assurance that
material misstatements in the financial statements would be prevented or
detected on a timely basis. 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 controls
that could adversely affect IRS*s ability to meet the objectives described
in this report.

The challenge for IRS will be to continue the improvements made in recent
years and to develop and implement the fundamental long- term solutions
that are needed to address the internal control weaknesses we have
identified. As we have seen, some of these solutions can be addressed in
the near term through the continued efforts and commitment of IRS senior

management and staff. Others, which involve modernizing IRS*s financial
and operational systems, will take years to fully achieve.

Opinion on IRS*s IRS*s financial statements, including the accompanying
notes, present Financial Statements

fairly, in all material respects, in conformity with U. S. generally
accepted accounting principles, IRS*s assets, liabilities, net position,
net costs, and custodial activity, as of and for the fiscal years ended
September 30, 2002, and September 30, 2001, and IRS*s changes in net
position, budgetary resources, and reconciliation of net costs to
budgetary obligations for the fiscal year ended September 30, 2002.

However, misstatements may nevertheless occur in other financial
information reported by IRS as a result of the internal control weaknesses
described in this report. IRS*s financial statements include tax revenues
collected during the fiscal year as well as the total unpaid taxes for
which IRS, the taxpayer, or courts agree on the amounts owed. Cumulative
unpaid tax assessments for which

there is no future collection potential or for which there is no agreement
on the amounts owed are not reported in the financial statements. Rather,
they are reported as write- offs and compliance assessments, respectively,
in supplemental information to IRS*s financial statements. Also, in
accordance with U. S. generally accepted accounting principles, to the
extent that taxes owed in accordance with the nation*s tax laws are not

reported by taxpayers and are not identified through IRS*s various
enforcement programs, they are not reported in the financial statements
nor in supplemental information to the financial statements. As IRS

discusses in the accompanying information to the financial statements, its
current estimate of the magnitude of these unidentified and unpaid taxes*
referred to as the tax gap* is between $250 billion and $300 billion.

Opinion on Internal Because of the material weaknesses in internal
controls discussed below, Controls IRS did not maintain effective internal
controls over financial reporting (including safeguarding of assets) or
compliance with laws and regulations,

and thus did not provide reasonable assurance that losses, misstatements,
and noncompliance with laws material in relation to the financial
statements would be prevented or detected on a timely basis. Our opinion

is based on criteria established under 31 U. S. C. 3512 (c), (d), commonly
referred to as the Federal Managers* Financial Integrity Act of 1982
(FIA), and OMB*s Circular A- 123, Management Accountability and Control.

Despite its material weaknesses in internal controls and its system
deficiencies, IRS was able to prepare, primarily through compensating
processes and approaches, financial statements that were fairly stated in
all material respects for fiscal years 2002 and 2001. Nonetheless, IRS
continues to face the following key issues that represent material
weaknesses in internal controls:

 weaknesses in controls over the financial reporting process, resulting
in IRS not (1) being able to prepare reliable financial statements without
extensive compensating procedures or (2) having current and reliable
ongoing information to support management decision making and to prepare
cost- based performance measures;

 weaknesses in controls over unpaid tax assessments, resulting in IRS*s
inability to properly manage unpaid assessments and leading to increased
taxpayer burden;

 weaknesses in controls over the identification and collection of tax
revenues due the federal government and over the issuance of tax refunds,
resulting in potentially billions of dollars in improper payments and lost
revenue to the federal government;

 weaknesses in controls over property and equipment, resulting in IRS*s
inability to have reliable and timely information on its balance of
property and equipment throughout the year and to reasonably ensure

that its property and equipment are safeguarded and used only in
accordance with management policy; and

 weaknesses in computer security controls, resulting in increased risk of
unauthorized individuals being allowed to access, alter, or abuse
proprietary IRS programs and electronic data and taxpayer information. The
material weaknesses in internal controls noted above may adversely affect
any decision by IRS*s management that is based, in whole or in part, on
information that is inaccurate because of these weaknesses. In addition,

unaudited financial information reported by IRS, including budget and
performance information, may also contain misstatements resulting from
these weaknesses.

In addition to the material weaknesses discussed above, we identified two
reportable conditions which, although not material weaknesses, represent
significant deficiencies in the design or operation of internal controls
that could adversely affect IRS*s ability to meet the internal control
objectives described in this report. These conditions concern deficiencies
in

(1) controls over budgetary activity, which affect IRS*s ability to
routinely ensure that its budgetary resources are being properly accounted
for, reported, and controlled and (2) controls over hard- copy tax
receipts and

taxpayer data, which increase the government*s and taxpayers* risk of loss
or inappropriate disclosure of taxpayer data. We reported controls over
budgetary activity as a material weakness in our prior audits, but based
on improvements we found during our fiscal year 2002 audit, we have
reassessed it as a reportable condition. We have reported on these
material weaknesses and reportable conditions in prior audits and have
provided IRS numerous recommendations to address these issues. More than
60 of these recommendations were still open as of the date of this report.
IRS has made marked strides in resolving

these matters. We will follow up in future audits to monitor IRS*s
progress in implementing these recommendations. For more details on these
issues, see appendix I.

Compliance with Laws Our tests of compliance with selected provisions of
laws and regulations

and Regulations and disclosed two instances of noncompliance with laws and
regulations that were reportable under U. S. generally accepted government
auditing

FFMIA Requirements standards. These related to IRS*s (1) lack of timely
release of tax liens on

taxpayers* property and (2) failure to ensure that installment agreements
were structured to require that taxpayers fully satisfy their tax
liability within the statutory collection period. 6 Also, IRS*s financial
management 6 Prior to fiscal year 2001, we reported that IRS was not in
compliance with section 6159 of the Internal Revenue Code, which
authorizes IRS to enter into installment agreements with taxpayers to
fully satisfy the taxpayer's liability (see GAO- 01- 394). We did not
identify any

instances of material noncompliance with section 6159 during fiscal year
2001 and therefore did not report it as an area of noncompliance, but we
found instances of noncompliance with the section again in fiscal year
2002.

systems did not substantially comply with the requirements of the Federal
Financial Management Improvement Act of 1996 (FFMIA): (1) Federal
Financial Management Systems Requirements, (2) applicable federal
accounting standards (U. S. generally accepted accounting principles), and
(3) the U. S. Government Standard General Ledger (SGL) at the transaction
level. IRS has readily acknowledged that its financial management systems
do not comply with FFMIA and that it needs to overhaul these systems as
part of its broader systems modernization

efforts. For more details on these issues, see appendix I. Except as noted
above, our tests for compliance with laws and regulations disclosed no
other instances of noncompliance that would be reportable under U. S.
generally accepted government auditing standards or OMB audit guidance.
However, the objective of our audit was not to provide an

opinion on overall compliance with laws and regulations. Accordingly, we
do not express such an opinion.

Consistency of Other IRS*s Management Discussion and Analysis, required
supplemental Information

information, and other accompanying information contain a wide range of
data, some of which are not directly related to the financial statements.
We did not audit and do not express an opinion on this information.
However, we compared this information for consistency with the financial
statements and discussed the methods of measurement and presentation with
IRS officials. Based on this limited work, we found no material
inconsistencies with the financial statements or nonconformance with

OMB guidance. Under OMB guidance for the financial statements of federal
agencies, agencies are asked to strive to develop and report objective
measures that, to the extent possible, provide information about the
costeffectiveness of their programs. We found, however, that because of
the noted internal control and systems limitations, IRS cannot report
reliable cost- based performance measures relating to its various programs
in

accordance with the Government Performance and Results Act of 1993.
Objectives, Scope, and

Management is responsible for (1) preparing the annual financial
Methodology statements in conformity with U. S. generally accepted
accounting principles, (2) establishing, maintaining, and assessing
internal control to

provide reasonable assurance that the broad control objectives of 31 U. S.
C. 3512, (c), (d), FIA are met, (3) ensuring that IRS*s financial
management

systems substantially comply with the requirements of FFMIA, and (4)
complying with applicable laws and regulations.

We are responsible for obtaining reasonable assurance about whether (1)
the financial statements are presented fairly, in all material respects,
in conformity with U. S. generally accepted accounting principles and

(2) management maintained effective internal controls, the objectives of
which are the following:

 Financial reporting* transactions are properly recorded, processed, and
summarized to permit the preparation of financial statements in conformity
with U. S. generally accepted accounting principles and

assets are safeguarded against loss from unauthorized acquisition, use,
and disposition.

 Compliance with 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
financial statements and any other laws, regulations, and

governmentwide policies identified by OMB audit guidance. We are also
responsible for (1) testing whether IRS*s financial management systems
substantially comply with the three FFMIA requirements, (2) testing
compliance with selected provisions of laws and regulations that have a
direct and material effect on the financial statements and laws for which
OMB audit guidance requires testing, and (3) performing limited procedures
with respect to certain other information appearing in these

annual financial statements. For more details on our methodology, see
appendix II.

We did not evaluate all internal controls relevant to operating objectives
as broadly defined by FIA, such as controls relevant to preparing
statistical reports and ensuring efficient operations. We limited our
internal control testing to testing controls over financial reporting and
compliance with laws and regulations. We did not test compliance with all
laws and regulations applicable to IRS. We limited our tests of compliance
to those laws and regulations that had a

direct and material effect on the financial statements or that were
required to be tested by OMB audit guidance that we deemed applicable to
the financial statements for the fiscal year ended September 30, 2002. We

caution that noncompliance may occur and not be detected by these tests
and that such testing may not be sufficient for other purposes.

We performed our work in accordance with U. S. generally accepted
government auditing standards and OMB audit guidance. Agency Comments and

In responding to this report, IRS noted that the report fairly presented
IRS's Our Evaluation progress and its remaining challenges. IRS noted
that, in addition to maintaining its unqualified audit opinion, it also
met the significant

challenge set by the Secretary of the Treasury of completing the fiscal
year 2002 audit by November 15, 2002, 6 weeks after the end of the fiscal
year and 3 and a half months earlier than last year. IRS noted that this
was accomplished by making significant improvements in its financial
management by reassessing and systematically changing how it processes
transactions, maintains financial records, and reports financial results.
IRS cited a number of financial management reforms and improvements, which
contributed to its ability to retain the clean opinion and to meet the
accelerated reporting date. For example, IRS noted that it implemented
procedures to improve the timeliness and accuracy of recording property
and equipment transactions in its accounting records, enhanced its
accountability over budgetary activity by increasing the frequency of its
analyses of outstanding obligations and other budgetary accounts,

conducted a comprehensive assessment of its strategic initiatives to
prioritize the programs relative to its mission and available resources,
revised its information technology security policy and guidance, and began
conducting periodic security reviews of receipt processing areas. In
addition, IRS noted that it took specific actions in fiscal year 2002 to
expedite the resolution of material weaknesses identified under its annual
FIA assessment process, revised its remediation plans for custodial and

administrative financial management systems to align the remediation plans
with its material weakness plans and business system modernization plans,
and included more intermediate target dates to help ensure that it stays
on schedule for bringing its systems into FFMIA compliance.

In its response, IRS recognized that it is only through implementation of
the new integrated financial management system that IRS will be able to
overcome many of the material weaknesses cited in the report. IRS noted
that it would focus on ensuring that its financial management practices
are institutionalized and that its new integrated financial system is
implemented. IRS added that it would continue the improvements made in

the last few years as it develops and implements the fundamental long-
term

solutions needed to address the internal control weaknesses cited in the
report. In its response, IRS agreed with the issues presented in the
report. However, in commenting on the report's discussion of IRS's
controls over budgetary activity, IRS disagreed with the report's
statement that IRS management and staff might enter into obligations that
exceed the budgetary authority made available by Congress. IRS indicated
that it clearly does have the capability to prevent this from happening,
and,

according to IRS, its obligations have never exceeded its budget
authority. However, the weaknesses we identified in IRS's controls over
its budgetary activity, particularly with respect to delays in recording
obligations, increase the risk that IRS could incur obligations in excess
of its budget authority and not timely detect this occurrence. As
discussed in our report, until the obligation of funds is recorded in
IRS*s accounting system,

obligations reflected in the system will understated. This understatement
could lead IRS management to believe the agency has more funding than is
actually available. Our intent is to point out a potential impact of the
internal control weakness we identified. IRS provided a number of
technical comments, not included in its written response, which we
considered in finalizing the report. The complete text of IRS's response
is included in appendix III.

David M. Walker Comptroller General of the United States

November 1, 2002

Management Discussion and Analysis

Department of the Treasury Internal Revenue Service

Management Discussion and Analysis Fiscal Year 2002

1

those goals. each follows:

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

I I. . I In nt tr ro od du uc ct ti io on n

The mission of the Internal Revenue Service ( IRS) is to provide America s
taxpayers top quality service by helping them understand and meet their
responsibilities and by applying the tax law with integrity and fairness
to all. The IRS is responsible for the collection of about $ 2 trillion in
Federal tax payments. At the IRS, the mission statement serves as the
central theme and guiding business philosophy for management actions and
organizational decision making.

The IRS is executing its mission with increasing effectiveness and
efficiency. We have identified three strategic goals and critical
performance measures to track our progress against

We use a balanced measures approach for each performance measure
addressing business results, customer satisfaction, and employee
satisfaction. Over the past year, our measures show we made great progress
in a number of high priority areas, such as e- filing, telephone and in-
person taxpayer service, protection of taxpayer rights and burden
reduction. We stabilized and refocused our key compliance activities and
are identifying and attacking systematic areas of non- compliance, such as
the promotion and use of abusive tax devices. Internal morale has
improved, and perhaps most importantly, we are regaining the confidence of
the public and other stakeholders.

Mission, Strategic Goals, and Guiding Principles The IRS mission statement
accurately describes our role, as well as the public s expectation as to
how we should perform that role. In the United States, the Congress passes
tax laws and requires taxpayers to comply with them. The taxpayer s role
is to understand and meet their tax obligations - and most do, since
roughly 98% of the taxes collected are paid without active intervention by
the IRS. The IRS role is to help the majority of taxpayers who are willing
to comply with the tax law, while seeing to it that the minority who are
unwilling to comply are not allowed to burden their fellow taxpayers. The
IRS recognizes that it must meet the highest standards in performing this
role.

The IRS has formulated three strategic goals needed to achieve our
mission. If progress is made on all three of these goals, we can be
confident that we are moving toward achieving our mission and meeting the
public s expectations. The strategic goals and a brief description of

.* Top- quality service to each taxpayer in every interaction Whenever the
IRS deals with a taxpayer, we should give first- quality service and
treatment that is helpful. We should provide

better guidance to taxpayers, reducing the chances of error and the time
and effort required. We should give accurate, timely and convenient
assistance to taxpayers, and should inform them promptly and treat them
professionally if we intervene in the form of an examination, a collection
action, or a notification.

.* Top- quality service to all taxpayers through fair and uniform
application of the law Our tax system depends on each person who is
voluntarily meeting his or her tax obligations having

confidence that his or her neighbor or competitor is also complying.
Therefore, when taxpayers do not voluntarily meet their tax obligations,
the IRS must use its enforcement powers to collect the taxes that are due.

.* Productivity through a quality work environment By ensuring our
employees are satisfied, we are able to provide services more efficiently,
getting the greatest value for every dollar we

2

organization. Organization Internally, INTERNAL REVENUE SERVICE

Management Discussion and Analysis For the Fiscal Year Ended September 30,
2002

spend. Good productivity requires employee satisfaction. This means our
employees must have the management support, tools and equipment they need
to provide good service to our customers, and there must be effective
communication vertically and laterally throughout the

Guiding principles are a link between our strategic goals and the actions
we take to achieve them. All IRS executives, managers and employees are
expected to manage and operate through these guiding principles.

The following guiding principles describe how we will operate in achieving
our strategic goals.

.* Understand and solve problems from the customer s point of view.

.* Enable managers to be accountable, with the requisite knowledge,
responsibility, and authority to take action.

.* Align measures of performance at all organizational levels.

.* Foster open, honest communication.

.* Insist on total integrity.

.* Demonstrate effective stewardship of assets and information entrusted
to the IRS.

IRS structure closely resembles the private sector model of organizing
around customers with similar needs. The IRS created four customer-
focused operating divisions to best serve taxpayers: Wage and Investment,
Small Business and Self- Employed, Large and Mid- Size Business, and Tax
Exempt and Government Entities. There are also a number of functional
units, including Appeals, the Taxpayer Advocate Service, and Criminal
Investigation.

the Modernization and Information Technology Services organization, which
includes the Business Systems Modernization Office, and the Agency- Wide
Shared Services unit provide information technology and administrative
support, respectively, to all divisions.

Chief Counsel Business Systems

Modernization Information Technology Wage and Investment

Support Services

Commissioner Deputy Commissioner Deputy Commissioner for Modernization/
CIO

Agency- Wide Shared Services Appeals

Services

Asst. Deputy Commissioner

Chief Financial Officer Chief, EEO and

Diversity Senior Counselor

Functional Divisions

National Taxpayer Advocate

Operating Divisions

Small Business and Self Employed

Taxpayer Advocate

Service Large and Mid- Size

Business

National Headquarters Communications and Liaison

Criminal Investigation

Tax Exempt and Government Entities

August 14, 2002

3

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

Within the four divisions, operations are structured principally along
three program areas: pre- filing, filing, and compliance. Pre- filing
services are provided before returns are filed to assist taxpayers in
preparing correct returns. Filing and account services are those provided
to a taxpayer in the process of filing a return and paying taxes,
including electronic filing and payment. Compliance services are provided
to a taxpayer after a return is filed to identify under- reporting, non-
filing and nonpayment.

The Wage and Investment Division ( W& I) serves individual and joint
filers with wage and investment income only, almost all of which is
reported by third parties. Most of these taxpayers deal with the IRS only
once a year, when filing their returns, and most receive refunds.
Compliance issues are limited, concentrated on dependent exemptions,
credits, filing status, and deductions. Through its field organization, W&
I provides information, support and assistance taxpayers need to fulfill
their tax obligations. It also conducts processing, account management,
and compliance services through eight campus locations.

The Small Business and Self- Employed Division ( SB/ SE) serves fully or
partially self- employed individuals and small businesses. Since business
income and a range of taxes are involved, compliance issues can be
complex. The possibility for errors in collection and compliance are
greatest in this group and consequently, this group has considerably more
frequent dealings with IRS compliance functions. SB/ SE has a compliance
field organization that includes both examination and collection.
Processing, account management, compliance services, and education and
outreach are provided at two campuses.

The Large and Mid- Size Business Division ( LMSB) serves corporations with
assets of more than $ 10 million. While collection issues are rare, many
complex issues such as tax law interpretation, accounting, and regulation,
many with international dimensions, frequently arise. LMSB is
predominantly a field organization that is structured into five industry
groups: Communications, Technology and Media; Financial Services; Heavy
Manufacturing and Transportation; Natural Resources and Construction; and
Retailers, Food, Pharmaceuticals and Healthcare.

The Tax Exempt and Government Entities Division ( TE/ GE) serves a wide
range of customers including small local community organizations,
municipalities, major universities, pension funds, state governments,
Indian tribal governments and tax exempt bond issuers. TEGE is charged
with administering detailed and complex provisions of law. Its efforts are
generally not intended to raise money, but rather to ensure that these
entities stay within the policy guidelines that enable them to maintain
their tax- exempt status.

The Appeals organization resolves tax controversies without litigation on
a basis that is fair and impartial to both the Government and the
taxpayer. Appeals provides an independent channel for taxpayers who have a
dispute over a recommended enforcement action.

The Chief Counsel s principal customer base consists of the IRS
Commissioner, the Operating Divisions, and the functional units of the
IRS, as well as the General Counsel and Tax Legislative Counsel at
Treasury. Chief Counsel provides impartial interpretation of the internal
revenue laws and legal advice and representation for the IRS. The Chief
Counsel has established a senior legal executive as the Division Counsel
for each operating division to participate fully in the plans and
activities of the operating division s management and to provide legal
advice and representation.

4

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

Communication and Liaison ( C& L) is a functional business unit with five
offices, each of which partners with the operating and functional
divisions to support IRS business objectives and communications goals and
ensures cross- divisional coordination. The offices also partner with
their external customers to ensure that two- way communications exist
between IRS, its employees and various stakeholder groups. C& L manages
relationships with the media, Congress, state and local governments, and
other external stakeholders.

The Criminal Investigation ( CI) unit enforces the criminal provisions of
the Internal Revenue Code. CI operates through a structure of 35 field
offices under the supervision of Special Agents in Charge ( SACs) . The
SACs report to Headquarters through six Directors of Field Operations
located in key cities across the country. CI supports the strategies of
the four operating divisions to enhance tax administration and foster
voluntary compliance.

National Headquarters ( NHQ) includes the Office of the Commissioner,
Deputy Commissioner, Assistant Deputy Commissioner, Chief Financial
Officer, Senior Counselor to the Commissioner, Competitive Sourcing
Program, National Headquarters Management and Finance, Servicewide EEO/
Diversity, Office of Tax Administration Coordination, Commissioner s
Complaint Processing & Analysis Group, Strategic Human Resources, and
Research, Analysis and Statistics of Income. NHQ focuses on strategic
direction, capital allocations, and building partnerships with key
stakeholders, e. g. , Congress, Office of Management and Budget.

The Taxpayer Advocate Service ( TAS) exists to help taxpayers resolve
problems that have not been resolved through normal IRS channels. TAS is
an independent program headed by the National Taxpayer Advocate. Each
state and IRS Service Center has at least one local Taxpayer Advocate who
is independent of the local IRS office and reports directly to the
National Taxpayer Advocate. Operating Division Taxpayer Advocates work
directly with operating divisions to identify and recommend solutions to
systemic problems.

The Modernization, Information Technology and Security Services ( MITS)
organization provides information technology solutions that anticipate and
meet enterprise- wide needs.

The Agency- Wide Shared Services organization ( AWSS) provides efficient
and standardized common services to all organizational components of the
IRS, such as, personnel, security, and facilities management.

5

for marginal progress. Main Objectives:

.* Make filing easier may be due

Make Filing Easier a. Results Summary

2001.

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

I II I. . P Pe er rf fo or rm ma an nc ce e G Go oa al ls s a an nd d R Re
es su ul lt ts s

When all things are considered, the IRS performed well in 2002. This was
in the face of unanticipated funding dilemmas ( e. g. , unfunded increased
pay raise and postage) , changing program priorities ( e. g. , greater
focus on more complicated and time consuming high- risk cases) and the
impact of 9/ 11 ( e. g. , suspension of notices in targeted geographic
areas) . In addition, any discussion or review of IRS performance must
consider the context in which performance goals are set. FY 2002 marks the
second year in which the IRS has set corporate goals for its balanced
measures under the agency s new program and organizational structure.
Thus, FY 2002 goals were set with one year s experience in the new IRS.
The learning process for goal development continues. To drive the agency
to high levels of performance, the IRS set aggressive goals with the
knowledge that it is best to push for greater performance than settle

The IRS uses performance measures to determine its effectiveness in
meeting the three IRS strategic goals. The FY 2002 performance information
that follows is organized by the main objectives within each strategic
goal.

Strategic Goal 1: Top- quality service to each taxpayer in every
interaction.

.* Provide top- quality service to taxpayers needing help with their
returns or accounts

.* Provide prompt, professional, helpful treatment to taxpayers in cases
where additional taxes Whenever the IRS deals with a taxpayer, we strive
to give quality service. how well we help them understand and meet their
tax obligations.

Major Results and Accomplishments

all returns being filed electronically. b. Improved Electronic Filing

The measures of our success in this goal are whether or not taxpayers
believe we are meeting their expectations and

.* Increased the number of e- filed individual returns by 17% over FY 2001
resulting in 36% of

.* Increased number of Federal Tax Payment Transactions Paid
Electronically by 3% over FY

.* Introduced a newly designed and more accessible web site. Increased the
number of web site hits to 3. 4 billion and downloaded files to 436
million projected through the end of FY

2002. This represents increases of 31% and 38% respectively over FY 2001.

.* The number of taxpayers e- filing from their home computers is up 38%
over last year.

.* Increased the number of private letter rulings completed by 19% over FY
2001.

.* Added 29 electronic forms and schedules for individual and business
filers.

6

new e- filers. c. Reducing Burden

plans. January 2003. a. Results Summary

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

.* Opened up e- file eligibility to over 99% of all individual taxpayers,
adding 38 million potential

.* Virtually all 1040 forms and schedules could be filed electronically
this year and no paper signature document was required.

.* Expanded the check- the- box initiative to allow taxpayers to designate
a friend, family member or tax professional to talk to the IRS to correct
errors during processing of returns.

.* For tax years beginning with 2002, will exempt 2.6 million corporations
from filing Schedules L, M1 and M2 at a burden reduction of 61 million
hours.

.* Allowing more businesses to use the cash method of accounting.

.* Indefinitely suspended the requirement for taxpayers filing Schedule F
of Form 5500.

.* Simplified forms, such as the Schedule D for reporting capital gains.

.* Rewrote and simplified procedures, such as those for distributions from
qualified retirement

.* Created the Office of Taxpayer Burden Reduction.

.* Working to develop a methodology for calculating the number of taxpayer
hours that will be saved through burden reduction efforts.

d. Simplifying Forms and Notices

.* Reduced lines on forms, such as the Schedule D to report capital gains.

.* Eliminated 11 lines on Form 6251 for the Alternative Minimum Tax and
working with a contractor to redesign Form 941, Employers Quarterly
Federal Tax Return.

.* Simplified determination letters for the nearly one million employee
plans.

.* Began sending out six redesigned notices, including those dealing with
math errors, balance due, overpayments and offsets.

.* Redesigning 24 additional notices; released eleven and remaining 13
will be released in Provide top- quality service to taxpayers needing help
with their returns or accounts.

.* On the American Customer Satisfaction Index ( ACSI) Survey, taxpayers
gave the IRS an overall score of 62, an 11% increase in satisfaction among
individual tax filers over 2000,

and a 22% increase over 1999. This was the largest favorable gain of the
30 federal agencies surveyed by the ACSI.

.* The 2002 annual rating for IRS in the Roper Starch customer
satisfaction survey was 44% - a 12 point increase over our result of 32%
in 1998. It does, however, reflect a small

decrease from the 2001 score of 46% .

.* By the end of the 2002 filing season, taxpayers were receiving correct
responses to 84% of their telephone tax law questions and 90% of their
telephone account questions compared

to the overall rates for FY 2001 of 79% and 88% respectively.

.* Access to telephone service and time spent waiting, while still below
private sector standards, improved substantially. Average wait time is
down 26% from last year. Assistor

access rose from 56% only two years ago to nearly 70% this year.

7

accurately. 14. may be due a. Results Summary

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

b. Improvements in Telephone Service

.* Increased toll- free phone assistance with regard to: level of service,
quality of tax law responses, and quality of responses to account
inquiries.

.* Organized telephone Customer Service Representatives by specialization
on a division- wide basis to utilize call routing more effectively.
Trained assistors in one or more technical and

account topics, enabling them to be more proficient in assisting customers
quickly and

.* Implemented toll- free script changes to better address the needs of
Business Master File ( BMF) callers and to address the significant number
of inquiries regarding the tax rebate.

.* Implemented an automated voice recognition service to provide taxpayers
the amount of the advanced credit, reducing burden on the telephone
system.

.* Increased staffing for Spanish language Customer Service
Representatives. c. Expanded Face- to- Face Services

.* Offered walk- in service during the filing season at more than 400
locations nationwide for face- to- face meetings to resolve account or
case problems.

.* At many sites, walk- in service was offered on 12 Saturdays between
January 27 and April d. Special Assistance in Response to 9/ 11

.* Issued guidance to resolve tax- related issues, including setting up
appropriate tax relief and postponement of certain filing deadlines.

.* Established a dedicated toll- free line for impacted victims and
families in response to the September 11 tragedy.

Provide prompt, professional, helpful treatment to taxpayers in cases
where additional taxes

.* Field Collection customer satisfaction and quality stayed at FY 2001
levels.

.* Field Exam customer satisfaction and quality increased slightly above
FY 2001.

.* Service Center Exam customer satisfaction declined slightly and quality
stayed the same.

.* Automated Collection System level of service and customer satisfaction
declined below FY 2001 as volume was greater than expected from new levy
programs.

b. Enhanced Customer Service

.* Throughout the year, and at a variety of locations, held Problem
Solving Days at 46 Taxpayer Assistance Centers to resolve long- standing
taxpayer issues for those who cannot

take advantage of weekday problem solving services.

.* Created the Tax Resolution Representative position. These IRS employees
will receive the training and authority to provide one- stop- service for
a broad range of issues.

.

8

obligations.

Balanced Measures

Description: Organizations ( EO) INTERNAL REVENUE SERVICE Management
Discussion and Analysis

For the Fiscal Year Ended September 30, 2002

c. Special Assistance in Response to 9/ 11

.* Developed computer programs to suppress assessments of penalties and
interest, allowing individuals impacted by the September 11 tragedy
additional time to meet their federal tax

.* Froze the accounts of taxpayers who lived in the Federal Disaster and
Emergency Areas of New York, New Jersey, Virginia, and 11 other counties
in Connecticut and New York. The

freeze indicator alerted IRS employees of a taxpayer' s disaster status.

.* Advised affected taxpayers who lived outside of the federal disaster
and emergency areas to contact the IRS to obtain tax relief.

A. Employee Plans and Exempt Organization ( EP/ EO) Determination Letters

Cases established and closed on the Tax Exempt/ Government Entities
Determination System. This measure is an indication of the volume of
activity in Employee Plans and Exempt Organizations. Determinations are
taxpayer- initiated requests for specific rulings or approvals with
respect to an Employee Plan or Exempt Organization issue.

FY 2002 Performance: Exempt closures were at the planned level, but
Employee Plans ( EP) determinations were substantially below plan. With
the closure of the remedial plan amendment period scheduled for December
2001, EP expected to receive 120, 000 determination requests in FY2002.
However, due to a two- month extension of the deadline ( granted in
response to 9/ 11) and overall consolidation in the pension plan market,
IRS received slightly more than half that number of applications. As a
result, EP issued fewer than half of the planned 106, 000 determination
letters. There was a positive trend among the receipts toward more pre-
approved plans. Reduced determination workload freed up resources to
support other critical program goals such as the examination program.

EP/ EO Determination Letters

FY2002 FY2000 FY2001 Plan Actual 109, 461 109, 326 190, 800 129, 680
Future Plans: IRS plans to stabilize resources and improve performance in
Exempt Organization determinations. Dedicated groups reporting to
Determination Management will improve consistency and efficiency to keep
up with steadily increasing customer demand. To further improve
productivity, IRS began a pilot of a new method of reviewing applications
in FY2002 and is designing a new form for determination applicants to use
beginning in FY2004. Not only should customers find this new form easier
to use, but it should also reduce the resources necessary to review each
application.

The existing system for processing determination letter requests has
severe shortcomings. The redesign and replacement of this system with the
new Tax Exempt Determination System ( TEDS) will provide critical business
capabilities required by customers, while improving overall system
performance and reliability. Release 1 will be piloted in FY 2003.

9

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

B. Private Letter Rulings Completed

Description: Total number of Private Letter

Private Letter Rulings Completed

Rulings ( PLRs) completed by the Office of FY2002 the Chief Counsel. PLRs
are written

FY2000 FY2001 Plan Actual statements that address specific, tax- related

1, 913 2, 428 2, 000 2, 896 issues pertaining to the taxpayer and the

IRS about the tax treatment of particular Future Plans: IRS Chief Counsel
Division

matters before a taxpayer s return is filed. will move toward greater use
of Revenue

These techniques reduce taxpayer burden, Rulings, a key Published Guidance
product,

eliminate controversy, and enhance and reduce use of Private Letter
Rulings, an

voluntary compliance, even before the Advance Case Resolution product, as
a

taxpayer is involved. means of providing guidance to taxpayers.

Consistent with its major strategy and FY 2002 Performance: Private Letter

operational plans, Chief Counsel Division Rulings have been a very popular
and high

will work with IRS Operating Divisions and growth program for Chief
Counsel because

Treasury to identify and address emerging of their positive impact on the
taxpayer of

issues through Published Guidance, and reducing burden and resolving
questions

integrate efforts directed to the Published about tax code interpretation
up front.

Guidance program with the IRS Operating Divisions.

C. Taxpayer Advocacy Projects

Description: An Advocacy Project is an

Taxpayer Advocacy Projects

Operating Division Taxpayer Advocate FY2002 project to address an
identified operational

FY2000 FY2001 Plan Actual issue that adversely affects a group of

88 92 88 63 taxpayers.

Future Plans: This measure is slated for FY 2002 Performance: Taxpayer
Advocate

deletion from the Critical Measures list for Services ( TAS) originally
planned to open

FY 2003. 88 projects in FY 2002. However, TAS only

opened 67 because they focused on the quality and impact of their projects
instead of the raw number opened.

10

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

D. Percent Individual Returns Filed Electronically

Description: The number of electronically

Percent Individual Returns Filed

filed individual tax returns divided by the

Electronically

total number of individual returns filed. FY2002 Includes all returns
where electronic filing is

FY2000 FY2001 Plan Actual permitted ( Practitioner e- file, TeleFile, VITA

28% 31% 35% 36% [ Volunteer Income Tax Assistance ] , On

Line Filing, Federal/ State returns, etc. ) Future Plans: To continue a
solid e- file

marketing campaign, IRS will use its FY 2002 Performance: The IRS can
provide

research strategies to identify and educate the customer service taxpayers
deserve

targeted EROs ( Electronic Return only with the efficiencies of
modernization,

Originators) , self- preparers and filers who especially electronic filing
and processing.

use paper instead of electronic media. IRS Each year, Electronic Tax
Administration

will focus on those non- EROs who currently ( ETA) works with
Modernization,

file a significant volume of paper returns and Information Technology and
Security

current EROs who file high volumes of Services ( MITS) to allow more
submissions

computer prepared returns as paper tax to be filed electronically. As a
result, in FY

returns. 2002 over 46 million individual returns were

filed electronically. Focused advertising and In addition, IRS will
continue to develop key

marketing as well as expansion of electronic messages to display on the
IRS Digital Daily

signature and payment options contributed web site, the Servicewide
Electronic

to success in this area in FY 2002. Research Program web site, and

Continued growth is expected as we QuickAlerts to encourage e- filing by
tax

increase the number of forms and professionals and taxpayers. IRS
territory

schedules available for use in electronic offices will expand distribution
of the e- file

filing. marketing toolkit and related publications

through local outreach efforts and promote e- filing through partnering
opportunities which may include seminars, training, presentations at
Nationwide Tax Forums, advertising, public service announcements and
coordination with Stakeholder Partnership, Education and Communications (
SPEC) . If we are successful in this marketing, IRS may more rapidly
approach the 80% Congressional mandate for e- filing and concurrently
reduce return error rates.

11

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

E. Electronic Federal Tax Payments System

Description: All individual and business tax charge installment agreement
payments for

type payments made directly through the tax year 1998 or later. The
acceptance of

Electronic Federal Tax Payment System installment agreement payments by
way of

( EFTPS) , through IRS e- file, directly through credit card furthers the
Service' s goals of

payroll service providers, or through credit expanding electronic payment
options. The

card processors. acceptance of credit cards reduces the

number of misapplied payments, minimizes FY 2002 Performance: Fiscal years
2000

insufficient funds conditions, and reduces and 2001 saw a 2% increase over
the prior

lockbox volumes and related fees. year. Based on the IRS marketing and
anticipated growth, an expected 5%

In 2002, the IRS extended PIN authority to increase established the
original planned

selected tax practitioners. As a result, target of 67. 4 million. The
actual

nearly 15 million PIN' s were used, saving performance, however, stayed at
the 2%

the IRS about $ 4 million in direct labor costs growth level in line with
historical growth

alone. rates.

Electronic Federal Tax Payments ( 000)

Offering convenient, easy to use electronic FY2002 payment options, such
as credit card

FY2000 FY2001 Plan Actual payments, encourages taxpayer

63, 380 64, 366 67, 438 66, 029 compliance, reduces internal paper

processing burdens, and promotes the use Future Plans: IRS continues to
improve and

of electronic commerce when transacting expand the use of Personal
Identification

with the Service. Taxpayers may now use Number ( PIN) programs to allow
taxpayers

any of the four major credit cards VISA, ,

nationwide to file electronically using a self- Mastercard, American
Express or Discover

selected PIN and a shared secret known for federal tax payments. . The
current

only to the taxpayer and the IRS. This will year Form 1040 balance due,
Form 1040ES reduce the need for the paper signature

and Form 4868 payments can be made jurat and produce savings.

with a credit card. Taxpayers can also

12

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

F. Toll- Free Customer Satisfaction

Description: Represents the customers

Toll- Free Customer Satisfaction

overall level of satisfaction with the services

( 4 point scale)

provided by the IRS Toll- Free program. FY2002 Survey recipients are asked
to rate IRS

FY2000 FY2001 Plan Actual performance on a four- point scale, where 1

3. 46 3. 45 3. 54 3. 44 indicates Very Dissatisfied and 4 indicates

Very Satisfied . Limitations on the survey Future Plans: The two areas for
top- priority

data not affecting the statistical validity improvement efforts are the
automated

include: only customers calling one of the answering system and ease of
getting

IRS toll- free telephone numbers are through by phone. To reduce the
demand

included in the sample. Calls are selected for phone access, IRS
implemented Internet

based on a sampling pattern that includes Refund/ Fact of Filing to
provide on- line

variables for the hour of day, day of week, ability to check refund status
through the

and time of year. Customers calling when IRS. gov web site.

IRS monitors are not available ( Saturday, Sunday and some evening hours)
are

To increase accessibility to assistors, IRS is excluded from the survey.

making changes in the routing of calls and scripting of telephone systems.
IRS will FY 2002 Performance: The IRS barely

implement recommendations from the missed meeting the plan because of

Customer Contact Engineering Study customer dissatisfaction with getting

group s plan to optimize the use of outward connected to the appropriate
live assistor or

facing Toll- Free numbers by configuring automated application to address
their

these numbers to relate directly to issue. While we missed the plan, 55%
of

taxpayers inquiries. . Rather than using one customers did rate service as
a 4 out of 4

or two general numbers for all inquiries, and only 2% rated service as a
1.

customers will call a telephone number relative to the inquiry at hand.
This plan will enable taxpayers to reach assistors with fewer levels of
prompting and will decrease the number of customers who hang up due to the
complexity of the menu system.

Telephone numbers on notices, letters, and bills will direct customers to
prompts related to their circumstance, and not to tax law- related
prompts. A team is being formed to identify and implement the technical
aspects of the changes. IRS expects these changes to have a positive
impact on customer satisfaction, which should be reflected in survey data
available in 2003.

13

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

G. Toll- Free Customer Service Representative ( CSR) Level of Service

Description: Reported as the percentage of

Toll- Free Customer Service

taxpayers that call IRS toll- free services and

Representative ( CSR) Level of Service

want to talk to an assistor, and get to speak FY2002 to one. Factors used
to arrive at the level of

FY2000 FY2001 Plan Actual service provided by assistors and taken into

59. 0% 56. 4% 71. 5% 68. 0% consideration in the calculation are callers

selecting an automated application, Future Plans: IRS will implement

receiving a busy signal or abandoning while recommendations from the
Customer

in queue waiting for an assistor. Contact Center Optimization study,

including a call router to build a pyramid of FY 2002 Performance:
Assistor level of

specialization that will enable us to route service shows the percentage
of taxpayers

each customer to an employee having the who want to talk to an assistor
who actually

appropriate skill level to successfully reach an assistor. Level of
service was

address the customer s issue. Once negatively impacted by problems with
the

implemented, we will also utilize CSR call call routing system and several
weeks with

recording technology for purposes of quality higher than anticipated call
demand made

review, training and evaluation. This will up of residual rebate issues.

optimize employee commitment to quality customer service, enhance
performance feedback systems and improve the value of training modules.

IRS will make modifications to the scripting, routing and handling of
taxpayer calls in order to improve access levels and customer
satisfaction. We plan to test a skill- based routing concept, which
involves rules- based routing to agent groups of similarly skilled
employees, as opposed to the current system of routing to applications,
based upon menu selection chosen. This will allow us to more easily use
one group of employees to staff 2 or 3 similar applications. This concept
will be tested early FY 2003, and if successful, we will fully deploy
skill- based routing at the end of the FY 2003 filing season.

14

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

H. Toll- Free Tax Law Quality

Description: The percentage of customers

Toll- Free Tax Law Quality

receiving accurate responses to their tax FY2002 law inquiries. This
evaluates the customer

FY2000 FY2001 Plan Actual ( external) , administrative ( internal) and

73% 75% 78% 81% regulatory accuracy of this service.

Future Plans: IRS plans to implement the FY 2002 Performance: The FY2002
goal

Embedded Quality Review System. The was met because of a strong accuracy

new quality attributes place more focus on score for responses to taxpayer
questions.

the customer experience and will provide us Continued focus on the
individual factors

with a better indication of our accuracy, that contribute to the overall
score including

professionalism and timeliness. Evaluating the standards associated with
case

quality within our product lines focusing on documentation was also a
contributor to

the customer s experience will build improvement.

commitment and capability among employees and managers, thus providing
opportunities to improve our performance in all areas of our balanced
measures. Improved accuracy will increase customer satisfaction and reduce
repeat calls, aiding achievement of the level of service plan.

I. Toll- Free Account Quality

Description: The percentage of customers

Toll- Free Account Quality

receiving accurate responses to their FY2002 account inquiries. This
evaluates the

FY2000 FY2001 Plan Actual customer ( external) , administrative (
internal)

60% 69% 72% 74% and regulatory accuracy of this service.

Future Plans: The IRS will continue to align FY 2002 Performance: The
FY2002 goal

toll- free sites according to specialty areas. was met because of a very
high accuracy

We will enable front- line employees to score for responses to taxpayer
inquiries

access accurate, up- to- date information about their accounts. Increased

about taxpayers accounts and to adjust management attention and focused
training

accounts immediately. We will continue to to improve knowledge of the
Customer

increase taxpayer access and customer Service Representatives contributed
to the

satisfaction through the intelligent call increase in this area. The
significant

routing system by routing calls to sites improvement in the scores in FY
2001

dedicated to specific types of work. continued into FY 2002 with
additional

Intelligent call routing will also be used to progress made in focusing on
both quality

route calls to Customer Service and quantity on account cases.

Representatives ( CSRs) who will specialize in specific areas of
expertise.

15

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

J. Customer Satisfaction Walk- In

Description: Represents the customers completely satisfied with our
promptness of

overall level of satisfaction with the services service, and dissatisfied
customers were not

provided by the IRS at its Taxpayer satisfied with our resolution of their
question

Assistance Centers. The scores represent or issue. While the target was
missed, 86%

the average overall level of customer of customers rated service
performance as

satisfaction ( Keystone question) from the a 4 or 5 on a five- point
scale, and only 8%

Customer Satisfaction transactional of customers rated service performance
at a

surveys. Survey recipients are asked to 1 or 2.

rate IRS performance on a seven- point scale, where 1 indicates Very
Dissatisfied

Customer Satisfaction Walk- In ( 7 pt.

and 7 indicates Very Satisfied . A Limitation

Scale 2000/ 2001, 5 pt. Scale after

that may affect the validity of the data is the

January 2002)

method in which the survey is conducted. FY2002 This is a comment card
hand out survey.

FY2000 FY2001 Plan Actual The taxpayer receives a survey card after

6. 48 6. 40 4. 68 4. 41 being served. A very small number of cards

are returned. This non- response bias Future Plans: Field Assistance will
continue

leads to a small sample size that may not to concentrate on identifying
ways to

represent the whole population. address customer expectations and

perceptions of the promptness of service FY 2002 Performance: Based on our

including explaining the automated analysis of the data, IRS did not meet
the

numbering system at sites and advising plan because even those customers
who

taxpayers of the approximate wait time. were satisfied overall were still
not

K. EP/ EO Customer Satisfaction

Description: Customers overall level of opportunity, Time Spent on Audit.
In

satisfaction with the way their cases were addition, employee and
stakeholder input

handled by the IRS Employee Plans and has been solicited to identify
actions to

Exempt Organizations Examination further improve service to the EP/ EO

programs. Scores represent the average customers.

overall level of customer satisfaction ( Keystone Question) from the
Customer

EP/ EO Customer Satisfaction

Satisfaction Transactional Surveys. Survey

( 7 pt. Scale)

recipients are asked to rate IRS FY2002 performance on a seven- point
scale, where

FY2000 FY2001 Plan Actual 1 indicates Very Dissatisfied and 7 indicates

5. 71 5. 70 5. 70 5. 78

Very Satisfied . Future Plans: The IRS Tax- Exempt and FY 2002
Performance: Customer

Government Entities Division ( TE/ GE) is satisfaction has improved as
Area

expanding customer satisfaction managers promote effective case

measurement efforts. management practices to reduce cycle time

and address the highest improvement

16

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

L. Employee Plans ( EP) / Exempt Organizations ( EO) Examination Quality

Description: Level of quality in the EP & EO practices and incorporate
quality goals into

examination program is measured by the Area managers performance plans.

Tax Exempt Quality Measurement System.

EP/ EO Examination Quality

FY 2002 Performance: IRS established FY2002 aggressive goals to improve
the quality of

FY2000 FY2001 Plan Estimate examinations over FY2001 results. Though

83% 73% 81% 75% still short of its goal, EP made significant

improvements in quality through site visits Future Plans: For FY2003, IRS
has formed

by Quality Review staff to address quality a task team to review the
quality standards

concerns and distribution of Frequently to ensure that measurement
reflects actual

Asked Questions to all employees. EO, on technical and procedural quality.
Removing

the other hand, continued to have problems determination work from the
responsibilities

with targeted elements of Examination of both Examination agents and
managers

Planning, Examination Scope and will promote efficiency, consistency and

Workpapers, despite actions to share best quality in Examination.

M. Telephone Customer Satisfaction Automated Collection System ( ( ACS)

Description: Represents the customer s

Telephone Customer Satisfaction ACS

perception of IRS service received through

( 4 pt. Scale)

contact with employees in the Automated FY2002 Collection System call
centers. Limitations

FY2000 FY2001 Plan Actual on survey respondents not affecting the

3. 41 3. 46 3. 53 3. 38 statistical validity are as follows: ACS

outgoing calls are not included in the survey Future Plans: In FY2003, IRS
will better

due to technological limitations, and align workload to staffing to
improve the

customers calling when IRS monitors are ease of reaching a representative.
IRS will

not available ( Saturday, Sunday and some identify and implement process
and

evening hours) are excluded from the infrastructure requirements to move
the

survey. Customer satisfaction is measured Automated Collection System (
ACS) from 9

on a 4- point scale. 1 indicates Unsatisfied

stand- alone sites to an enterprise- operating and 4 indicates Very
Satisfied .

environment that better balances telephone operations with management of
notice FY 2002 Performance: Telephone

issuances and case closures. By the end of Customer Satisfaction was
impacted

FY 2003, ACS will complete consolidation of significantly in the factor,
difficulty in getting

inventory. through to representatives by phone

because of higher than planned incoming call demand, which also negatively
affected ACS Level of Service ( LOS) . Customers report high degrees of
satisfaction in the areas of courtesy, attitude and professionalism.

17

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

N. Automated Collection System Telephone Level of Service

Description: The percentage of calls

ACS Telephone Level of Service

attempted by taxpayers compared to the FY2002 number of calls answered (
calls which

FY2000 FY2001 Plan Actual abandon after having been answered but

79. 0% 77. 5% 80. 0% 69. 0% while in queue for the next available assistor

are not included in the count of calls Future Plans: In addition to
consolidating

answered) in the Automated Collection ACS inventory, IRS has developed
call

System ( ACS) . recording capability for use in training ACS

assistors. Implementation is contingent FY 2002 Performance: The start- up
of the

upon funding. State Income Tax Levy Program and the

Federal Payment Levy Program increased call demand, significantly
affecting the workplan. Although resources were redirected, IRS was unable
to meet the incoming volume. IRS is assessing the increased volume of
calls and evaluating the methods used to forecast calls to better align
workload to staffing. The reduced level of service also negatively
impacted Customer Satisfaction.

18

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

O. Customer Satisfaction Collection Field

Description: Customers overall level of for improvement in FY2003. In
FY2002,

satisfaction with the way their cases were satisfaction was highest among
taxpayers

handled by the IRS Field Collection who had a case time of 120 days or
less,

program. The following limitations are were self represented, or were in a

placed on the Collection sample: only those delinquency investigation.
Targeted

customers who owe money to the IRS and training, procedural improvements,
a re-

have been referred to Collection are examination of the documentation

sampled. Samples drawn from the standards were all factors examined by the

Collection Quality Measurement System re- engineering team put in place as
a result

( CQMS) database only include three types of the FY 2001 results.

of closures; Currently Not Collectible/ Hardship, Installment

Customer Satisfaction Collection Field

Agreements, and Full Pays. The sample

( 7 pt. Scale)

does not include: cases with no case FY2002 history, cases for customers
the IRS cannot

FY2000 FY2001 Plan Actual locate, cases where the statute has expired,

4. 60 5. 01 5. 00 4. 97 bankruptcy cases, deceased taxpayers, and

defunct or insolvent corporations. For Future Plans: IRS will continue
reengineering

cases involving an Offer in Compromise, initiatives in Collection

only those offers that are accepted by the operations. The Collection
Quality

IRS are currently included. Customer Measurement System will also be re-

satisfaction is measured on a 7- point scale. engineered, as we
incorporate features from

1 indicates Very Unsatisfied and 7 indicates the joint Small Business and
Self- Employed

Very Satisfied . and Wage and Investment Divisions

embedded quality effort. IRS will examine FY 2002 Performance: Field
Collection' s

and refine data gathering and reporting FY2002 actual was only 3
hundredths below

systems, making available quality review their FY2002 plan. While they
missed the

information to improve training and training goal, this difference is not
statistically

management for front- line employees. significant. They are in the process
of

analyzing their results to continue the drive P. Field Collection Quality

Description: Score awarded to a reviewed

Field Collection Quality

Collection case by a third- party reviewer FY2002 using the Collection
Quality Measurement

FY2000 FY2001 Plan Actual System standards. Each standard if met,

84% 84% 85% 84% has a value. Values are totaled to arrive at

the score with deductions in the overall Future Plans: IRS will continue
to

composite score for failure to meet a incorporate features of the embedded

standard designated as critical. quality effort to Collection operations.

Among these features will be an FY 2002 Performance: The score was

assessment indicating whether or not we slightly below the plan target of
85% .

are measuring the right program aspects as Defects occurred primarily in
Clear Action

well as where we stand in assigning top to Dates and Case Documentation.

bottom accountability for case quality.

19

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

Q. Automated Underreporter Quality

Description: Quality of all Automated

Automated Underreporter Quality

Underreporter ( AUR) account actions as a FY2002 result of taxpayer
inquiries or internal

FY2000 FY2001 Plan Actual requests. Quality of casework in the

93% 95% 97% 94% underreporter area is measured on paper

closed cases only. Future Plans: IRS expects the AUR paper

quality score to drop slightly from FY 2002 FY 2002 Performance: While
still 94% ,

levels due to the increase in complexity of quality defects have increased
in

work resulting from more Schedule K- 1s. comparison to the prior year.
Defects are

Using analyses of error trends arising from primarily attributable to
Inventory

this more complex work, IRS will ensure Management/ Case Controls,
Transaction

training efforts and new job aides target Code ( Account Action) , and

problem areas. IRS will also develop Correspondence ( IRS Procedure) . The

business requirements to record phone calls AUR sites have implemented
various steps

to improve case quality, managerial to decrease errors associated with the

oversight, and employee accountability. defects. Flyers/ alerts and Job
Aids

addressing the errors were issued, and weekly meetings at which top errors
were discussed were held with managers.

R. Service Center Exam Customer Satisfaction

Description: Customer s overall level of treatment and listening to
concerns.

satisfaction with the IRS Service Center Aspects of attitude,
professionalism and

Examination process. The following staff courtesy rank the highest.
Significant

limitations are placed on the service center increases have been noted in
aspects of

examination sample: sole proprietors and explanation of rights,
explanation of process

self- employed individuals and farmers, as and records required.

well as individual shareholders and partners examined as a result of a
corporate audit

Service Center Exam Customer

are included in the sample; the sample

Satisfaction ( 7 pt. Scale)

excludes businesses that file corporate and FY2002 partnership returns,
individuals who did not

FY2000 FY2001 Plan Actual respond to correspondence and audit

4. 04 4. 18 4. 45 4. 03 appointment letters, individuals IRS cannot

locate and individuals with an international Future Plans:

address. Customer satisfaction is IRS will embed quality into our Service

measured on a 7- point scale. 1 indicates Center Compliance programs,
providing a

Very Unsatisfied and 7 indicates Very

higher- quality experience for taxpayers and

Satisfied.

engaging managers in the delivery of our services. Identifying customer
service FY 2002 Performance: The target was

trends and issues earlier will allow us to missed because of low scores on

react to our customer needs more rapidly, discussing length of process,
explanation of

increasing customer satisfaction. adjustments, perception of fairness of

20

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

S. Service Center Examination Quality

Description: Quality of actions taken while

Service Center Examination Quality

working service center examination cases. FY2002 Each site s quality
reviewer reviews a

FY2000 FY2001 Plan Actual sample of cases and writes a review record

70% 71% 74% 71% for each case.

Future Plans: IRS will continue efforts to FY 2002 Performance: The target
was

embed quality into Service Center missed in FY2002 because of the large

Compliance operations. Compliance will number of overage cases that were
closed.

process cases more efficiently with less Long cycle times negatively
impacted the

systemic work disruptions by implementing quality score. Since the overage
cases were

the Correspondence Examination closed in FY2002, average cycle time

Automation Support system as a should drop in FY2003 and the quality score

replacement to Report Generation System rise accordingly.

Batch Processing. The Inventory Management Tool, which predicts the
receipt of taxpayer correspondence and phone calls, will be used to ensure
started cases can be handled timely. Audit issues initiated through
improved system processes will produce resource savings.

T. Examination Customer Satisfaction

Description: Represents the level of whose examinations had a relatively
short

satisfaction customers receive from cycle time. Further reducing cycle
time

interactions with IRS Field Examination offers the largest improvement
opportunity.

employees. Scores represent the average The hiring of additional resources
in

overall level of customer satisfaction FY 2001 and resultant productivity
gains,

( Keystone Question) from the Customer particularly in working through the
case

Satisfaction Transactional Surveys. Survey backlog ( reducing overall
cycle time) , was a

recipients are asked to rate IRS significant contribution to the
improvement

performance on a seven- point scale, where in the score over the FY 2001
level and

1 indicates Very Dissatisfied and 7 indicates achievement of the FY 2002
target.

Very Satisfied . A limitation on survey data not affecting the statistical
validity in the

Field Exam Customer Satisfaction

survey population is based solely on the

( 7 pt. Scale)

audit closures of individual taxpayers. Audit FY2002 closures involving
estate, corporate, excise

FY2000 FY2001 Plan Actual and gift tax returns are not included in the

4. 41 4. 65 4. 70 4. 73 survey population. The results also do not

include contacts the Examination division Future Plans: IRS will continue
to fulfill the

had with individuals that did not result in an vision of the Examination
Re- engineering

audit closure. project, to make the Examination process

easier and faster for taxpayers, minimizing FY 2002 Performance: The
highest

the accrual of interest on additional satisfaction was by taxpayers whose
cases

assessments, while ensuring consistency were handled by a tax professional
and/ or

and fairness.

21

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

U. Examination Case Quality Score

Description: The score awarded to a

Field Exam Case Quality Score

reviewed Field Examination case by a FY2002 Quality Reviewer using the
Examination

FY2000 FY2001 Plan Actual Quality Measurement System quality

58% 70% 72% 73% standards.

Future Plans: We will improve the FY 2002 Performance: Continued focus on

Examination process by combining targeted improvement areas coupled with

database systems to provide faster results. the reduction in cycle time (
a quality

We will enhance our examination inventory standard) were major
contributions to

selection processes by incorporating more continued achievement of the
target.

data from additional sources. We will also improve our ability to identify
non- compliance electronically and automate routine examination processes
to optimize our resources.

V. Taxpayer Advocate Casework Quality Index

Description: Measure of effectiveness in

Taxpayer Advocate Casework Quality

meeting customer expectations based on a

Index

random sample of cases reviewed and FY2002 scored against customer service
standards

FY2000 FY2001 Plan Estimate of timeliness, accuracy, and communication.

65% 72% 80% 80% FY 2002 Performance: Taxpayer Advocate

Future Plans: Taxpayer Advocate Service Service met this goal and greatly
exceeded

field offices will continue to focus on FY2001 performance by having each
office

improving case quality through locally set a goal and make an improvement
plan

developed action plans. IRS will study around the three standards listed
above to

those offices making the greatest achieve that goal.

improvement to see what best practices may be applicable elsewhere.

22

Main Objectives: a. Results Summary

FY 2001. developed.

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

Strategic Goal 2: Top- quality service to all taxpayers through fair and
uniform

.* Increase overall compliance

.* Increase fairness of compliance Increase overall compliance

application of the law.

Our tax system depends on each person who is voluntarily meeting his or
her tax obligations having confidence that his or her neighbor or
competitor is also complying. We cannot allow those taxpayers who do not
comply to place a burden on those who do.

Major Results and Accomplishments

.* Field Collection Taxpayer Delinquent Account closures decreased 4% and
Taxpayer Delinquent Investigation closures increased 18% over FY 2001.

.* Automated Underreporter case closures are up 16% over FY 2001.

.* Increased the number of examinations for Coordinated Industry Cases by
27% over

.* Automated Collection System Closures declined noticeably below FY 2001
levels because of the suppression of notices as a result of the 9/ 11
crisis, which delayed the issuance of

liens and levies on ACS inventories. Also, the need to address increased
incoming call volume pulled resources from the time available to close
assigned cases.

b. Improved Communications and Service

.* Placed significant media attention on Abusive Tax Schemes in order to
alert Taxpayers to the schemes and prevent potential tax problems.

.* Piloted an accelerated determination processing program to ascertain
types of applications suitable for accelerated processing and to track
time savings and trends in issues

.* As part of a national strategy to combat abusive schemes, placed
emphasis on crossfunctional training and multi- function coordination in
the identification of fraudulent trust

promotions and the use of civil and criminal enforcement actions. Engaged
in outreach activities to educate people to recognize and avoid fraudulent
trust promotions.

c. New Initiatives and Program Improvements

.* Identified five serious compliance problem areas: promoters of tax
schemes; misuse of devices such as trusts and passthroughs to hide or
improperly reduce income; pay large accumulations of employment taxes; and
erroneous refund claims.

injunctions and criminal investigation of promoters. use of

complex and abusive corporate tax shelters to reduce taxes improperly;
failure to file and

.* Revamped compliance programs to refocus resources and to use a full
scope of tools and techniques ranging from educating the public to
systematically identifying promoters and

participants, to reinvigorating enforcement actions such as summons
enforcement,

23

Program ( ASFR) . organizations. a. Results Summary b. Reengineering

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

.* Began matching information reported on Schedule K- 1 with income and
losses reported on Form 1040 and other schedules.

.* Reinvigorated the use of long dormant enforcement tools that deal with
serious cases of non- compliance and tax schemes, e. g. , aggressively
identifying promoters and schemes

through summonses of records, including John Doe summonses on credit card
accounts in offshore tax havens and vendor summonses to refine that data.

.* Initiated 43 contacts of promoters to uncover lists of taxpayers
participating in shelters.

.* Launched a tax shelter disclosure initiative. d. Special Assistance in
Response to 9/ 11 created to assist in relief efforts. revised and
published as Publication 3833) . Increase fairness of compliance

As of August 2002, processed 1,664 disclosures from 1, 206 taxpayers who
came forward. These disclosures cover 2, 264 tax returns and involved more
than $ 30 billion in claimed losses or deductions.

.* Commenced a test to gauge the effectiveness of the Automated Substitute
for Return

.* Initiated summons procedures on all major credit card companies and
commenced initial examinations from credit card leads ( off shore credit
card data & charges) .

.* Intercepted Slavery Reparation scheme credit cases and stopped
erroneous payments from approximately 17,000 erroneous claims this fiscal
year.

.* Published the Tax Shelter Disclosure Initiative, providing taxpayers
with a 120- day opportunity period to voluntarily disclose their
participation in tax shelters and other

questionable items that may have resulted in an underpayment of tax. For
taxpayers who voluntarily disclosed, the IRS promised to waive certain
accuracy- related penalties.

.* Announced a voluntary compliance program to help Section 527 political
organizations comply with their new reporting requirements. Sent letters
to organizations that appeared to

have some confusion with their reporting requirements.

.* Established a special program to expedite processing of applications
from organizations

.* Provided compliance guidance and a single point of contact to new
disaster relief

.* Posted a draft publication, Disaster Relief: Providing Assistance
through Charitable Organizations, to the IRS website within days of the
September 11 attacks ( subsequently

.* Provided extensions and other relief in response to the attacks.

.* Increased number of examinations for individual returns greater than $
100, 000 by 20% over FY 2001. Decreased number of examinations for
individual returns less than $ 100, 000 by

4% over FY 2001. These data reflect success in shifting focus to high-
income taxpayers.

.* Revisiting the examination workload model and planning processes to
include more data on other return types and to incorporate non- filer and
non- payment data.

.* Placed all innocent spouse claim processing at the Cincinnati
Centralized Innocent Spouse Operation and provided increased and
specialized skills for examiners working claims.

24

Balanced Measures

the actual count. assigned cases.

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

.* Implemented an automated decision- making tool to lead examiners
through the complex decision- making process and to assist them in making
timely and accurate decisions.

c. Focus on Higher Risk Areas

.* Improving the methodology of examination workload planning for higher
income individuals.

.* Implementing new systematic way to identify returns with a high
probability of omitting income. Previously, these returns were only
identified by indirect examination techniques.

.* Shifting audit and enforcement forces to focus more resources on
tracking down highincome taxpayers who fail to report income or hide it
offshore.

.* Reorienting agents so that most of their activities are focused toward
the highest- risk areas.

.* Increased focus on promoters of abusive tax schemes by: identifying
flow- through entities used to mask questionable structured transactions;
addressing abusive schemes through

enforcement; implementing the Schedule K- 1 matching program; directing
research efforts to profile promoters and build our understanding of trust
filing reporting issues; developing skilled employees; and targeting
educational products and outreach to influence tax compliance behaviors.

d. Improved Communications

.* Improved service to taxpayers by reducing the time it takes to notify
them of innocent spouse claim decisions.

.* Provided innocent spouse literature to Low Income Tax Clinics and
Volunteer Income Tax Assistance tax return preparation sites.

A. Automated Collection System Closures Taxpayer Delinquent Accounts ( (
TDA)

Description: Number of entity delinquent account closures produced in the
Automated Collection System. Entities closed using codes related to
systemic reduction of inventory are not included in

FY 2002 Performance: TDA closures were impacted by 1) the suppression of
notices as a result of the 9/ 11 crisis which delayed the issuance of
liens and levies on ACS inventories, 2) holiday moratorium on notices was
instituted a week earlier this year compared to last year, and 3) increase
in incoming calls and time spent on calls detracted from the time
available to close

ACS Taxpayer Delinquent Accounts

FY2002 FY2000 FY2001 Plan Actual 1, 052, 221 1, 006, 600 1, 012, 628 950,
696 Future Plans: IRS will shift the mix of cases for Automated Collection
System work in FY 2003. TDA entities are traditionally high priority
inventory and the emphasis on high priority cases will increase the number
of TDA closures. Additional factors that will contribute to increased TDA
dispositions include: an overall refocus on ACS mission of collecting
delinquent accounts and securing delinquent returns, ACS employees hired
in FY 2002 should become more productive in FY 2003 as they continue to
gain experience, and the percent of direct time to total time should
increase due to reduced training.

25

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

B. Automated Collection System Closures Taxpayer Delinquent Investigations
( ( TDI)

Description: Number of entity delinquent

ACS Taxpayer Delinquent

investigation closures produced in the

Investigations

Automated Collection System. Entities closed FY2002 using codes related to
systemic reduction of

FY2000 FY2001 Plan Actual inventory are not included in the actual count.

412, 150 297, 791 317, 906 190, 411 FY 2002 Performance: The number of TDI

Future Plans: To better identify TDI cases, closures did not meet the FY
2002 plan

certain TDI select codes will be worked because of a management decision
in

thoroughly, and the results used to improve February 2002 to shift
inventory priorities

TDI case creation. Additionally, productivity that resulted in a change in
the mix of

is planned to recover to FY 2001 levels. closures of TDAs and TDIs.

C. Field Collection Number of Cases Closed Taxpayer Delinquent Account (
TDA)

Description: A count of the number of actual segment cases between Area
and Territory

TDA dispositions completed by Revenue Offices; and Service Center Workload

Officers. A TDA disposition occurs on the Realignment.

Integrated Data Retrieval System ( IDRS) when the status of an account
changes from

Field Collection # Cases Closed TDA

an open status to any closed status as FY2002 defined in Section 8 (
Document 6209 -

FY2000 FY2001 Plan Actual Automated Data Processing ( ADP) / IDRS

771, 455 757, 392 804, 085 724, 430 Information. ) Data is reported as
modules.

Future Plans: The shift toward higherpriority FY 2002 Performance: TDA
closures were

TDA entities will increase the adversely impacted by a variety of factors

number of cases closed. IRS will continue including the suppression of
notices and

re- engineering initiatives to increase enforcement actions due to
September 11th

productivity. attacks; concentration on working higher

risk cases; computer reprogramming to

26

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

D. Field Collection Number of Cases Closed Taxpayer Delinquent
Investigation ( TDI)

Description: Count of the number of actual

Field Collection # Cases Closed TDI

TDI dispositions completed by Revenue FY2002 Officers. A TDI disposition
occurs on

FY2000 FY2001 Plan Actual Integrated Data Retrieval System ( IDRS)

144, 764 119, 451 107, 119 140, 737 when the status of an investigation
changes

from an open status to a closed status as Future Plans: Re- engineering
initiatives will

defined in Section 8 of Document 6209 increase productivity. However, due
to an

( Automated Data Processing ( ADP) / IDRS emphasis on priority TDA work,
we expect a

Information. ) Data is reported as entities. decrease in the number of TDI
closures.

Process improvements will reduce the amount of FY 2002 Performance: The
target was

direct time spent resolving a TDI. exceeded as a result of efforts to re-
balance

inventories and increasing the percentage of time applied to TDI cases.

E. Automated Underreporter Closures

Description: Total number of closures of

Automated Underreporter Closures

Automated Underreporter Cases. FY2002 FY2000 FY2001 Plan Actual

FY 2002 Performance: We surpassed our 2, 888, 900 2, 511, 424 2, 919, 980
2, 922, 182

plan through the implementation of improved workload selection systems and

Future Plans: IRS will refine selection management practices resulting
from

criteria in our Automated Underreporter partnering efforts between
Headquarters

( AUR) unit to coincide with our strategic and Field Management on the use
of

priorities. As a result, we anticipate closing Management Information
Systems data.

more leads in the AUR unit. IRS will develop, test and implement a
centralized AUR workload selection model. IRS will implement a research
study of each AUR income category to gather data for analysis of screen-
outs, seldom worked categories, minimally productive categories, and
categories with potential for productive Correspondence Examination cases.
Differences across categories and subcategories, operating divisions, and
campuses will also be analyzed in order to maximize workload selection.

27

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

F. Individual Return Examinations Greater Than $ 100K

Description: Number of Individual ( Form

Individual Return Examinations > $ 100K

1040) returns closed by Field Examination FY2002 with a total positive
income or total gross

FY2000 FY2001 Plan Actual receipts greater than $ 100, 000.

63, 217 50, 827 54, 468 60, 894 FY 2002 Performance: The goal was

Future Plans: IRS will develop and exceeded because productivity was
higher

implement a strategy for high income than planned in some case categories,
and

taxpayers. Research of higher income there were improvements in direct

taxpayers has revealed potential pockets of examination time ( DET)
applied. The hiring

non- compliance in income strata of $ 1 of additional resources in FY 2001
( 565

million Total Positive Income ( TPI) and Revenue Agents and 108 Tax
Compliance

above. We will use new national Officers) and completion of their initial

Unreported Income Discriminate Index training significantly improved the

Function ( UI DIF) formulas in conjunction productivity, closing the gap
created in past

with the new TPI strata to surface potential years. More management
attention paid to

non- compliant returns for audit. Our most case management and maintaining
optimal

experienced field revenue agents will work inventory levels were also
primary

these cases. We will redirect our traditional contributors to improvement
in this area.

audit program to include taxpayers with incomes over $ 100, 000. Since
many higher income taxpayers invest in various flow- through entities to
defer or hide potential taxable income, we will continue to build our
understanding of the filing, reporting and payment attributes of
Partnerships and Trusts.

IRS will assess examination coverage across 1040 non- EITC filers and
develop a strategy for addressing compliance issues in this area. Workload
identification business rules will be designed and tested to identify non-
compliant returns. Focus will be on expanded coverage of the higher income
Wage and Investment population.

G. Individual Return Examinations Less Than $ 100K

Description: Number of Individual ( Form

Individual Return Examinations < $ 100K

1040) returns closed by Field Examination FY2002 with a total positive
income or total gross

FY2000 FY2001 Plan Actual receipts less than $ 100, 000.

187, 891 145, 144 122, 313 139, 576 FY 2002 Performance: See measure F.

Future Plans: See measure F. above. above.

28

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

H. Total Returns Examined

Description: Combined count of the Number

Total Returns Examined

of Individual ( Form 1040) returns closed by FY2002 Field Examination.
This measure is the

FY2000 FY2001 Plan Actual sum of measures F and G.

251, 108 195, 971 176, 781 200, 470 FY 2002 Performance: See measure F.

Future Plans: See measure F. above. above.

I. Number of Business Returns Examined

Description: Includes all Large and Mid-

Number of Business Returns Examined

Sized Business returns closed outside of FY2002 coordinated industry, and
Small

FY2000 FY2001 Plan Actual Business/ Self Employed corporation and

103, 112 84, 748 81, 369 85, 190 schedule C and F examinations.

Future Plans: IRS will increase emphasis on FY 2002 Performance: Fiscal
year to date

shelters, establish a strategy to address closures are somewhat under
plan, but

high- risk passthrough entities related to high starts and inventories are
in line to

wealth individuals, continue the Compliance accomplish full year targets.

Initiative Project on passthrough entities, Accomplishments are also
expected to

and continue reduction in staff years applied increase with the
realignment of $ 5 million

to Coordinated Industry Cases through the to $ 10 million cases from the
Large and Mid

use of issue management strategies. Size Business Division to Small

Business/ Self Employed.

29

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

J. Number of Cases Examined Large Case

Description: Number of regular Coordinated

Cases Examined Large Case

Industry cases ( CIC) closed during the FY2002 period ( R1 cases; i. e. ,
not including claim

FY2000 FY2001 Plan Actual cases, cases returned from Appeals, or

369 417 566 528 non- examined closures) . A Coordinated

Industry case consists of one or more tax Future Plans: IRS highest
priority for

years of the primary taxpayer ( usually a resources will be to address
abusive

large corporate return) plus all related shelters, especially at the
promoter level.

returns examined in conjunction with the For non- shelter coordinated
industry

primary taxpayer. workload, we will use an issue driven

approach, based on risk analysis results, FY 2002 Performance: The FY 2002

and smartly employ issue management Performance was 528 Cases or 93% of
the

strategies to reduce examination time and 566 planned. There is no single
barrier to

to determine scope. We will apply explain this performance, although the

resources to pre- filing activities with the goal increased focus upon
abusive shelters

of reducing the issues that are resolved in a frequently increases cycle
time. While short

post- filing, contentious environment. We of the target, this level of
performance

will develop procedures and policies to demonstrates a significant
improvement

engage all employees in the use of from the Large & Mid- Size Business

productivity improvement tools such as pre- Division Stand- up year ( FY
2000) when 328

filing products, risk analysis, improved were closed, and FY 2001 when 417
were

planning, and other issue management closed. In fact, FY 2002 performance
for

strategies. These activities should directly CIC closures reflects a 43%
increase from

improve cycle time, currency, and quality. FY 2000 and the number of CIC
closures for

FY 2002 exceeds the performance in each of the last 5 years.

K. Number of Returns Closed Large Case

Description: Coordinated Industry Corporate

Number of Returns Closed Large Case

returns ( F1120 and associated Partnership FY2002 and Employment Tax
forms) closed with

FY2000 FY2001 Plan Actual designated activity codes.

3, 578 3, 734 3, 453 4, 851 FY 2002 Performance: IRS surpassed the

Future Plans: CIC returns are a function of a plan because of a greater
than expected

work product ( CIC Cases) rather than a number of Employment Tax Returns

planned output. In contrast to Industry associated with Coordinated
Industry

returns, where goals and targets are Cases.

established, these returns are a result of examination of a key taxpayer.
For Coordinated Industry we plan an examination for a key taxpayer case,
but the related returns ( e. g. , Partnership, Excise Tax, Employment Tax,
etc. ) are more a byproduct than an intended outcome.

30

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

L. Employee Plans / Exempt Organizations Examinations Closed

Description: Number of Employee Plans

EP/ EO Examinations Closed

and Exempt Organizations return FY2002 examinations closed in all
categories.

FY2000 FY2001 Plan Actual 19, 080 15, 988 11, 900 13, 549 FY 2002
Performance: The FY 2002 goal

was based on an assumption about the Future Plans: By removing
determination

number of determination letter receipts that work from the
responsibilities of both

would come in and how many Full- Time Examination agents and managers,

Equivalents ( FTEs) would need to be realignment of resources will promote

diverted from examination casework to efficiency, consistency and quality
in

cover that workload. Since determinations Examination. To improve
productivity in the

were lower than forecast, Examination FTEs face of declining resources in
FY2003, IRS

were moved back to doing examinations is aggressively pursuing the use of
limitedscope

and the additional FTEs enabled surpassing and correspondence audits.
Limitedscope

the goal. audits were initiated in FY2002, and

more are planned in FY2003 and FY2004. Beginning in FY2003, IRS will also
implement recommendations from a study of time- per- case and related
returns now underway, as well as any findings regarding the effectiveness
of the limited- scope approach.

M. Criminal Investigations Completed

Description: Cumulative count of the dedicated to income tax related

number of all subject criminal investigations investigations.

completed by Criminal Investigation during the fiscal year. This includes
investigations

Criminal Investigations Completed

that resulted in a criminal prosecution FY2002 recommendation to the
Department of

FY2000 FY2001 Plan Actual Justice as well as investigations that were

3, 499 3, 340 3, 280 3, 201 discontinued due to a lack of evidence or to

a finding that the original allegation was Future Plans: IRS will increase
emphasis

false. on promoters of abusive foreign and

domestic trusts, and schemes based on FY 2002 Performance: IRS achieved

frivolous legal arguments. The Criminal approximately 98 percent of its
year- end

Investigation Division will partner with the plan for total investigations
completed, a

Small Business and Self- Employed and significant accomplishment in light
of

Large and Mid- Size Business Divisions in redirection of resources to the
war on

their efforts to identify abusive tax schemes, terrorism. IRS also shifted
criminal

promoters, and abusive tax shelter investigation inventory mix, reducing
the

activities. time spent on narcotics related

investigations, and increasing the resources

31

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

N. Appeals Cases Closed

Description: Total Cases Closed equals the

Appeals Cases Closed

total number of cases closed in Appeals, FY2002 including both non-
docketed and docketed

FY2000 FY2001 Plan Actual cases. ( A docketed case is one in which a

54, 986 54, 748 67, 560 68, 015 taxpayer has filed a petition in the Tax

Court. ) This measure is currently reported Future Plans: One of our top
priorities is to

in workunits. A workunit represents a single reduce the length of time it
takes for a case

case or group of related cases, which are to go through Appeals ( cycle
time) . We are

being considered by Appeals as one unit for taking a multifaceted approach
to achieve

settlement of decision purposes. this goal. IRS plans to balance inventory

among teams, within areas, across Appeals FY 2002 Performance: Appeals
exceeded

Operating Units and nationally. IRS will its FY2002 plan by closing 68,
015 cases.

pursue workload prioritization to ensure Improved resource allocations,
case

appropriate resources are spent on the right development practices, better
management

cases, and process cases more efficiently and communications resulted in
more

based on particular characteristics of certain efficiency and greater
productivity during

case segments. IRS also plans to test the FY 2002 making it possible for
Appeals to

use of Fast Track Mediation for new types achieve its target.

of casework and permanently implement and actively promote the Fast Track
Settlement program.

O. Taxpayer Advocate Service ( TAS) Closed Cases

Description: Number of cases worked in

TAS Closed Cases

TAS and closed on the Taxpayer Advocate FY2002 Management Information
System.

FY2000 FY2001 Plan Actual 237, 885 248, 011 252, 289 234, 327 FY 2002
Performance: The closure target

was missed because receipts were Future Plans: Additional training, cross-

significantly lower than forecast. The training and experience by Taxpayer

original plan number was based on the Advocate Service case advocates,
along

assumption that case receipts would with National Customer Service
Agreements

decrease approximately 1.5% from the prior with IRS Operating Divisions,
should

year, however, TAS receipts decreased at a continue the Advocate' s
efficiency in closing

much higher rate. cases. Since receipts, and consequently

closures, are decreasing, TAS is changing this measure to focus on the
efficiency of processing cases instead of just the raw number. In FY2003,
TAS is replacing this critical measure with the Case Closure to Receipt
Ratio.

32

Main Objectives: a. Major Results

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

Strategic Goal 3: Productivity Through a Quality Work Environment

.* Increase employee job satisfaction

.* Increase productivity and staffing to levels necessary to adequately
close the tax gap and manage workload growth and expansion in scope

Employee satisfaction is one measure of management effectiveness and, as
such, is viewed as an early indicator of the ability to succeed in meeting
the mission and providing quality products and services to the public. By
ensuring our employees are satisfied, we are able to provide services more
efficiently, getting the greatest value for every dollar we spend. Good
productivity requires employee satisfaction. This means our employees must
have the management support, tools and equipment they need to provide good
service to our customers, and there must be effective communication
vertically and laterally throughout the organization.

Major Results and Accomplishments

.* The overall level of IRS employee satisfaction reached 55% in FY 2002,
exceeding FY 2001 by 4% and the FY 2002 target by 1% .

.* This year a record 82, 027 ( 69% ) employees responded to our annual
census survey.

.* In an effort to reduce errors inherent in a paper survey and to provide
workgroup reports much quicker, IRS piloted a totally paperless survey in
two of its campus locations. Moving

to a paperless process in the campuses will provide employees with the
same flexible survey application available in locations other than the
campuses.

.* Improvement in the area of training and career development continued to
increase as evidenced by higher employee satisfaction scores in these
areas.

.* Began greater focus on Employee Health and Safety and established
related measures.

.* The addition of the employee scholarship program targeted at key
staffing needs reinforced our commitment to employee development.

.* The Human Resources Investment Fund, established in response to earlier
employee feedback about training needs, continued as a complement to the
scholarship program.

.* An electronic data base of Employee Satisfaction meetings, issues
arising from these meetings and actions taken as a result of the meetings
will expand our ability to identify

cross- cutting issues and best practices. The database will also
facilitate our ability to hold managers accountable for actions taken in
response to Employee Satisfaction data.

.* IRS has addressed employee health and safety by replacing old desks and
chairs with ergonomically correct models.

33

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

Balanced Measures

A. Agency Wide Employee Satisfaction

Description: Measure of employee s needs, is continuing as a complement to
the

satisfaction with their job at the IRS. At the scholarship program.

Service- wide level the results of Survey Item CO 1 ( Considering
everything, how

Agency Wide Employee Satisfaction

satisfied are you with your job? ) are used as FY2002 the sole determining
factor in the externally

FY2000 FY2001 Plan Actual reported results. Additionally, survey

59% 51% 54% 55% questions regarding the employees

perception of management practices, Future Plans: IRS has conducted an

organizational barriers, and overall work analysis of the top and bottom
10% of

environment that impacts an employees' workgroups to determine what drives

efforts to do a good job are used in the scores. Survey questions that
deal with

internally reported results. employee recognition, development,

opinions and progress have the greatest FY 2002 Performance: Improvement
was

impact for groups falling in this category. In most notable in the areas
of overall job

FY 2003, IRS will more actively involve the satisfaction, recent
recognition or praise for

second line manager in evaluation of those doing a good job, and increased
feelings of

work groups most in need of improvement job importance. IRS strongest
performance

and development of plans to improve both was in the areas of ensuring
employees

manager skills and workgroup scores. know what is expected of them,
creating a

caring environment, and engendering a IRS also plans to improve
readability of the

commitment to quality work. IRS provided survey and will expand the use of
electronic

results of SURVEY2002 to employees for ( telephone and web- based) survey
tools to

discussions in workgroups this summer, make it easier for employees to
participate.

with subsequent action plans developed to ensure continued improved
working

Several current activities will be continued in conditions.

the future to sustain progress in this area. An electronic database of
Employee In an effort to reduce errors inherent in a

Satisfaction meetings, issues arising from paper survey and provide
workgroup reports

these meetings, and actions taken as a much quicker, IRS piloted a totally

result of the meetings, will expand our ability paperless survey in two
campus locations.

to identify cross- cutting issues and best Moving to a paperless process
in the

practices, and will facilitate our ability to campuses will provide
employees with the

hold managers accountable for actions same flexible survey application
available in

taken in response to Employee Satisfaction locations other than the
campuses.

data. Operating Divisions are providing managers with new tools to improve
their Responses to questions about training and

ability to take action in response to survey development continue to
improve. The

results and workgroup meetings. For addition of the employee scholarship

example, SBSE has a managers guide to program targeted at key staffing
needs will

employee satisfaction on- line and W & I has reinforce our commitment to
employee

a " Managers' Tool for Engaging the development. The Human Resources

Workforce, " on- line and has developed a Investment Fund, established in
response to

training course for managers on Employee earlier employee feedback about
training

Engagement.

34

September 30, 2002. action plans.

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

B. Lost Work Day Case Rate

Description: The Lost Work Day Case Rate is the number of Federal Employee
Compensation Act claim cases with lost time filed in the current fiscal
year per 100 full- time equivalent employees. Each division is analyzing
their specific data to determine the drivers of new claim cases and will
prepare action plans addressing them once their analysis is complete.

FY 2002 Performance: IRS formed a new team this year to define the
national strategy for the Safety and Health Program. The team began work
toward developing

Federal Managers Financial Integrity Act ( FMFIA) the Concept of
Operations that will result in

a Strategic Plan for the Safety and Health Program.

Lost Work Day Case Rate

FY2002 FY2000 FY2001 Plan Actual N/ A N/ A N/ A 1.01 Future Plans: IRS
will integrate the Safety and Health Program into our Strategic Planning
Process for the next cycle ( FY 2005) .

I II II I. . S Sy ys st te em m C Co on nt tr ro ol ls s a an nd d L Le eg
ga al l C Co om mp pl li ia an nc ce e

In accordance with the requirements of the Federal Managers Financial
Integrity Act, , the Service evaluated its systems of internal controls
for the fiscal year ending

The Service provides qualified assurance that the objectives of the FMFIA
are being achieved with regard to Section 2 ( procedures and records of
the organization) and Section 4 ( systems that carry out financial
management functions and accounting systems that carry out unique
programs) . This qualified assurance is based on our identification of
material weaknesses and reportable conditions, all of which are being
addressed by corrective

This summer we thoroughly reassessed our material weaknesses. As discussed
below, we are proposing to close, downgrade or consolidate several,
reducing the number remaining open from 14 to 9. Top executives reviewed
each remaining material weakness to identify the key issues and determine
what types of actions could be taken to more expeditiously resolve them.
We identified procedural modifications that could be implemented quickly
wherever possible, instead of waiting for the longer- term systemic
solutions. All of these actions enabled us to move up the planned closing
dates of the following material weaknesses:

.* Demonstrate Capability to Manage Replacement of Tax Processing and
Business Systems ( from FY 2010 to several years earlier, specific date to
be determined)

.* Financial Accounting of Revenue Custodial ( ( from FY 2009 to FY 2006)

.* Financial Statements Administrative ( ( from FY 2005 to FY 2003) Three
other material weaknesses will close in the same fiscal years as
previously planned and one other had its planned closing date extended by
one year.

35

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

Federal Financial Management Improvement Act ( FFMIA) As of September 30,
2002, the Service s financial management systems did not substantially
comply with the FFMIA. Plans are in place to resolve the material
weaknesses causing this condition. The estimated dates for bringing our
financial management systems into substantial compliance are 2006 for the
custodial and 2004 for the administration functions. The initiatives
associated with these plans are in the IRS Modernization Blueprint. Due to
changes in the Business Systems Modernization plan, the 2006 date for
custodial accounting is under evaluation.

Laws and Regulations As of September 30, 2002, the IRS did not always
comply with section 6325 of the Internal Revenue Code regarding the
release of federal tax liens nor with section 6159 of the code regarding
the structuring of installment agreements.

Performance Measures The Service provides assurance that the IRS Critical
Performance Measures are reliable. During the year, IRS has enhanced the
level of detail required for its critical measures to ensure reliability
and validation and verification of data. Data owners are now required to
provide information on management controls in place for data submitted and
used in reports.

Continuity of Operations IRS is addressing continuity of operations
planning in critical areas and the planning is sufficient to reduce risk
to reasonable levels.

Improper Payments Within current law and resources available, IRS will
continue to focus on assuring that controls are adequate to minimize
erroneous EITC payments. The most significant actions for program
improvement include implementation of the joint IRS- Treasury Task Force
recommendations.

Reports Consolidation Act of 2000 The IRS FY 2002 Performance and
Accountability Report was prepared to comply with the Reports
Consolidation Act of 2000. This act authorizes the consolidation of
Federal financial and performance management reports while also satisfying
the requirements of the Government Performance and Results Act.

Limitations of the Financial Statements The principal financial statements
have been prepared to report the financial position and results of
operations of the entity, pursuant to the requirements of 31 U. S. C.
3515( b) . While the statements have been prepared from the books and
records of the entity in accordance with generally accepted accounting
principles ( GAAP) for Federal entities and the format prescribed by OMB,
the statements are in addition to the financial reports used to monitor
and control budgetary resources which are prepared from the same books and
records. The statements should be read with the realization that they are
for a component of the U. S. Government, a sovereign entity.

36

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

IV I V. . Fu F ut tu ur re e Ch C ha al ll le en ng ge es s

This report discusses many of the IRS major accomplishments in FY 2002.
The improvements in service and widespread redirection of compliance
programs toward higher priorities reflect the benefits of a more customer-
focused and accountable organization. We remain committed to reach even
higher levels of performance in the coming years, but we also must
acknowledge the many challenges ahead.

Our strategic planning process is the major vehicle through which we
identify and assess challenges to our continuing success. We use this
systematic approach to inform our decision making as we allocate resources
and direct our management focus to achieve IRS goals. We are also guided
by the General Accounting Office ( GAO) and the Treasury Inspector General
for Tax Administration ( TIGTA) who have identified Management Challenges
and High- Risk Areas facing the IRS over the last several years (
discussed in the next sub- section) . Together, these sources of
information reveal four key areas upon which we must focus in the next few
years

Modernizing Systems and Business Processes; Compliance and Enforcement;
Customer Service; and Employee Satisfaction .

Modernizing Systems and Business Processes The modernization of the IRS
tax administration and internal management systems and processes is the
greatest long- term challenge we face. Successful implementation of new
systems and processes will increase: ( 1) customer satisfaction through
more timely and accurate handling of taxpayer returns, refunds and
accounts management; ( 2) employee satisfaction through a more productive
workforce that will, for example, reduce rework caused by errors inherent
in the current manual processes; and ( 3) business results as greater
accuracy will increase quality and greater efficiencies will increase
quantity. Systems modernization will take approximately ten years to
accomplish. In FY 2003, our plans project the following accomplishments: (
1) implementation of a new Integrated Financial System, ( 2) an Enterprise
Systems Management strategy to provide network and systems management to
improve information technology infrastructure availability and
performance, ( 3) the deployment of Customer Account Data Engine Release
1, authoritative computations and data stores for individual taxpayer
account and return data, ( 4) the deployment of Enterprise Data Warehouse
/ Custodial Accounting Project Release 1, integrated, reliable tax
operations and internal management information, ( 5) the implementation of
Security and Technology Infrastructure Release, a technical infrastructure
for secure phone and electronic communication, and ( 6) the deployment of
HR Connect, which allows employees to manage their human resources
information online.

Compliance and Enforcement The most current projection of our nation s
gross tax gap ( i. e. , Federal taxes owed but not paid voluntarily and
timely) is somewhere between $ 250 billion and $ 300 billion. Some of the
most serious and current compliance problem areas include: promoters of
tax schemes of all varieties; the misuse of devices such as trusts and
offshore accounts to hide or improperly reduce income; abusive corporate
tax shelters; underreporting of tax by higher- income individuals; and the
failure to file and pay large amounts of employment taxes by some
employers. Efforts in FY 2003 and beyond will address these compliance
areas through better education of the public; systematically identifying
promoters and participants; improving the efficiency of exam and
collection efforts through reengineering; and reinvigorating enforcement
actions such as summons enforcement, injunctions and criminal
investigation of promoters. We must continue to make significant progress
in collecting better compliance and noncompliance data, as well as in
quantifying our corporate level strategic compliance

37

2003.

Customer Service surveys. discussed, INTERNAL REVENUE SERVICE Management
Discussion and Analysis

For the Fiscal Year Ended September 30, 2002

measures. These two goals will be achieved in large part through our new
National Research Program ( NRP) . The first available data on payment
compliance and return filing compliance recently became available. Initial
data on reporting compliance will be available in October

Over the past several years, the IRS has achieved an increase in public
perception scores on both American Customer Satisfaction Index and the
Roper Starch

The most recent data from Roper Starch, however, shows a slight decrease
in 2002 below 2001. Although the Roper Starch score remains above the
levels recorded in 1998 through 1999, the drop must be taken seriously.

Employee Satisfaction Results from our 2002 survey of all employees showed
an increase in employee satisfaction. This followed a drop in 2001 that we
believe was attributable to the uncertainty and change that naturally
comes from a reorganization of significant magnitude. Even though overall
scores increased in 2002, the survey indicated areas for improvement. For
2003 we must continue to increase engagement of front- line managers so
that they are full partners in the new IRS. Our management team must also
work to more actively engage our front- line employees, so those employees
know they are valued and appreciated.

Management Challenges and High Risk Areas IRS has undertaken specific
actions to address each of the Management Challenges and High- Risk Areas
identified by GAO and TIGTA. Measures within our program activities show
progress in addressing them. The first twelve Management Challenges and
High Risk Areas listed below are those identified and prioritized by TIGTA
in January 2002. The last two areas

Collect Unpaid Taxes and Revamp Business Practices to Meet Taxpayer Needs
are additional carry over items from GAO s list published in January 2001.

Security of the IRS Employees and Facilities

Recent terrorist activity in the United States demonstrated very
graphically that the physical security of IRS employees, equipment, and
structures should be of utmost concern to IRS management. Immediately
after the terrorist attacks, Facilities Management Officers were directed
to assess all IRS offices and take actions necessary to safeguard
personnel and assets in concert with the General Services Administration (
GSA) and local law enforcement.

In FY 2002, IRS addressed this challenge through the following
accomplishments:

.* Developed National Physical Standards that establish security
enhancements for areas such as guard services, blast mitigation, and IRS
infrastructure.

.* Conducted an assessment of all IRS buildings and facilities based upon
current and proposed security standards.

.* Developed contingency plans for all ten IRS campuses to address
hazardous materials threats for the upcoming filing season.

.* Purchased and distributed protective equipment, result of the anthrax
threats. events on mission achievement.

such as gloves, masks, and lab coats, as a

.* Consolidated all mail- opening activities throughout IRS.

.* Participated in government- wide programs that plan for and minimize
the risk of catastrophic

38

assets.

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

.* Developed posters, tri- fold brochures, and a Director s briefing
package to provide information and instruction to managers and employees
regarding anthrax and other

hazardous materials threats.

.* Developed a plan to upgrade communications systems such as public
address and closed circuit television for all ten IRS campuses.

.* Developed an action plan to address deficiencies in offices that do not
meet the National Physical Security Standards.

.* Completed Phase 1 and 2 initiatives to contain Service Center Automated
Mail Processing System and mail extraction units in all campuses to
isolate these areas from other units.

In FY 2003, IRS will continue to respond to this challenge through the
following planned actions:

.* Continue to work with GSA and law enforcement agencies to safeguard
personnel and

.* Closely monitor procedures regarding the inspection of incoming mail
and packages.

.* Continue implementation of security enhancements.

.* Continue to participate in government- wide programs that plan for
disaster response.

.* Take actions to improve and institutionalize changes for campus mail
operations.

.* Complete security risk assessments of all level 1, 2, and 3 buildings
and implement all necessary corrective measures and/ or upgrades
identified.

Security of the IRS Information Systems

Although computer security has measurably improved, computer security
control weaknesses continue to place automated systems and taxpayer data
at serious risks to both internal and external threats. As the primary
revenue collector for the United States, IRS is a target for both
terrorists and hackers. This threat has increased over the last few years
with more interconnectivity of systems. Until stronger security controls
are in place over its information systems, tax- processing operations
remain vulnerable to disruption. Furthermore, the sensitive taxpayer data
maintained by IRS is at risk of being disclosed to unauthorized
individuals, modified and improperly used, or destroyed, thereby
unnecessarily exposing taxpayers to financial crimes such as identity
fraud.

In FY 2002, IRS addressed this challenge through the following
accomplishments:

.* Established Security Services organization to create corporate security
solutions.

.* Focused on evaluating and improving IRS security programs and
processes, and identifying how to implement security capabilities that are
balanced with operational requirements.

.* Conducted reviews of IRS facilities and programs to evaluate and test
security controls, and assisted IRS organizations to set up internal
security review processes.

.* Monitored IRS networks to prevent cyber attacks. In FY 2003, IRS will
continue to respond to this challenge through the following planned
actions:

.* Conduct reviews to evaluate security performance in key business areas,
mitigate the IRS computer security material weaknesses. .

such as remittance processing, and work with IRS business units to
mitigate these weaknesses.

.* Improve the adequacy of physical, logical, communications, and
personnel security, operating practices, software quality assurance
activities and business resumption plans to

39

facilities. Center.

effort. developed.

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

.* Use a model facilities approach to improve the consistency of security
controls across IRS

.* Continue to improve the ability to prevent, identify and resolve cyber
attacks by completing build- out and improving operational readiness of
the Computer Security Incident Response

.* Conduct regular assessments of the overall state of security in IRS;
use the security assessment framework as a guide to improve and better
measure IRS security capabilities.

Systems Modernization of the IRS

The ability to balance the goals of helping taxpayers meet their tax
responsibility and improving overall compliance with tax laws depends on
the successful completion of the modernization

Modernization of technology is crucial to implementing the new business
vision of providing world- class service to taxpayers. While the
development of new technology evolves, existing operations must continue,
and improvements must be made to meet the needs of tax administration and
demonstrate IRS commitment to improved service to taxpayers.

. In FY 2002, IRS addressed this challenge through the following
accomplishments:

.* Implemented repeatable management processes.

.* Ensured ongoing projects are aligned with the Enterprise Architecture (
EA) in accordance with the compliance certification process.

.* Fully implemented a risk management program.

.* Established a centralized Configuration Management repository.

.* Fully defined and institutionalized standard configuration management
procedures.

.* Identified configuration items for current production environment
impacted by near- term modernization project releases.

In FY 2003, IRS will continue to respond to this challenge through the
following planned actions:

.* Identify and implement efforts to slow projects to match management
capacity.

.* Focus on better cost and schedule estimating and on building reserves
in plans.

.* Continue strong governance and rigid adherence to Enterprise Life
Cycle.

.* Identify and address all potential funding problems by scaling back or
deferring some projects, improving estimates and releasing funds annually
to reduce administrative burden.

.* Identify and correct inconsistencies in implementing key systems,
focusing on 14 key management processes.

.* Provide special executive focus in acquisition and contracting areas.

.* Develop a detailed plan for maturing all management processes presented
to GAO/ TIGTA and implement a monthly progress reporting process.

Integrating Performance and Financial Management - Performance Management
/ GPRA

Balanced measures are being aligned with the employee performance
evaluation system to clearly link the work of individual managers and
employees to the mission and goals. Additionally, the effectiveness of
compliance improvement initiatives and current compliance levels can not
be accurately determined until a measure of taxpayers voluntary compliance
is

40

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

In FY2002, IRS completed the following actions:

.* Almost all functions have approved balanced measures composed of
business results quantity and quality, customer satisfaction and employee
satisfaction.

.* Divisions used balanced measures to report to the Commissioner on
executing their workplans, and also as the cornerstones for building their
strategic plans.

.* Divisions are in the process of deploying and setting targets for their
balanced measures down to the Area office ( or equivalent) level.

.* Began implementing Embedded Quality ( EQ) , which revamps the way
quality is measured, calculated, and reported in the sites. EQ will create
accountability by connecting employee

evaluations directly to the corporate balanced measures in a fair and
meaningful way.

.* IRS replaced the manual process to collect, collate and report
performance data by automating these steps through the Data Mart and
Business Performance Management

System ( BPMS) for most of the IRS critical measures.

.* IRS continues to develop its strategic measures, and included seven
strategic measures in the FY2004 OMB Budget Submission - four related to
tax administration and three on

worker safety. Three of the tax administration strategic measures in the
budget had historical data: Payment Compliance, Filing Compliance and
Potentially Collectible Inventory ( PCI) . Data for the fourth, Reporting
Compliance, will be available by December 31,2002.

.* Expanded participation in American Customer Satisfaction Index. In
FY2003, IRS will continue to respond to this challenge through the
following actions:

.* Continue to automate data collection and reporting through Data Mart
and BPMS.

.* Beginning with linking collection workplans to reducing PCI, divisions
are in the process of linking their operational critical measures to
relevant strategic measures to better align

resource decisions to achieving strategic outcomes.

.* Major operating divisions are developing their own strategic measures.

Integrating Performance and Financial Management - Financial Management

IRS current financial systems alone cannot produce reliable information
necessary to prepare financial statements in accordance with federal
accounting standards. financial systems cannot provide reliable cost
accounting information.

In FY2002, IRS completed the following actions:

.* IRS has completed the Architecture Phase of the CAP. The data produced
from

the current financial system has to be reconciled with other subsidiary
systems to produce reliable financial statements. Further, IRS does not
fully comply with the requirements of the Federal Financial Management
Improvement Act ( FFMIA) . IRS remediation plans do not identify resource
commitments for all remedial actions, independent verifications were not
performed for all implemented remedial actions, and sufficient
explanations were not provided for the necessity of revised remedial
action intermediate target dates. In addition, the current

To improve overall financial management, IRS is implementing two major
systems: the Custodial Accounting Project ( CAP) and the Integrated
Financial System ( IFS) .

In FY2003, IRS will continue to respond to this challenge through the
following actions:

41

2002. 2003.

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

.* The Systems Development Phase of the CAP is scheduled for completion in
December

.* Deployment of Build 1 of Taxpayer Accounts Sub Ledger ( TASL) is
scheduled for March

.* The first release of IFS is scheduled for deployment on October 1, 2003
and will include the Core Financial System as defined by the Joint
Financial Management Improvement

Program ( General Ledger, Accounts Payable, Accounts Receivable, Funds and
Cost Management, and Financial Reporting) , as well as Budget Formulation.

Processing Returns & Implementing Tax Law Changes during the Filing Season

The filing season impacts every American taxpayer and is therefore always
a highly critical concern. Many programs, activities and resources have to
be planned and managed effectively for the filing season to be successful.
Reconciliation Act of 2001.

Complexity of the Tax Law

Critical programming changes for the filing season must receive priority
over other programming requests. This is further complicated by the
modernization efforts that are updating and replacing the very core tax
processing systems needed to deliver a successful filing season. In
addition, IRS must ensure systems capacity and telecommunications will
accommodate the new electronic filing requirements and the accuracy and
utility of information received and processed.

In FY 2002, IRS completed the following actions:

.* Implemented a secure transaction- based web site.

.* Incorporated new procedures required by the Economic Growth and Tax
Relief

.* Completed centralization of all employment tax processing, including
information returns, by consolidating operations in two Submission
Processing sites.

In FY 2003, IRS will continue to respond to this challenge through the
following planned actions:

.* Continue to use workload forecasting to ensure the required number of
employees is available for each telephone product line and ensure tools
are updated and available timely.

.* Continue to identify training needs and develop training plans to
improve performance.

.* Conduct CPE training to ensure assistors are knowledgeable of tax law
changes.

.* Ensure the Corporate Filing Season Readiness Process is operational and
covers all aspects of the filing season, including the Annual Readiness
Certification.

.* Conduct pilot and roll out the Remittance Transaction Research ( RTR)
system.

.* Implement registered user access to enable authorized third parties and
practitioners to request and receive transcripts electronically, submit
account inquiries, powers of attorney

and disclosure authorizations electronically.

.* Implement taxpayer identification number ( TIN) matching with payers.

.* Expand e- filing options by adding and converting additional forms.
According to the FY 2000 Taxpayer Advocate s Annual Report to the
Congress, the highest- ranked problem individual and business taxpayers
had with IRS was tax law complexity. The problems that exist because of
this complexity range from individual to corporate and international tax
issues. Stakeholders from divergent constituencies have informed decision-

42

employers. INTERNAL REVENUE SERVICE Management Discussion and Analysis

For the Fiscal Year Ended September 30, 2002

makers about the problems and recommended solutions. It is unlikely that
the Internal Revenue Code will be simplified at one time. Therefore, IRS
has the challenge to remove as much complexity as possible as a service to
taxpayers. The effect of tax law complexity is compounded as IRS
modernizes. Since complexity can be a major factor in the cost of
operations, IRS must devote resources to simplifying taxes while at the
same time modernizing its systems and processes.

In FY 2002, IRS completed the following actions:

.* Integrated Probe and Response methodology into IRS publications and
made their use the standard tool for Field Assistance technical employees.

.* Trained Customer Service Representatives in one or more technical and
account topics, enabling them to be more proficient in assisting customers
quickly and accurately.

In FY 2003, IRS will continue to respond to this challenge through the
following actions:

.* The National Taxpayer Advocate s FY2001 Annual Report contains 28
legislative proposals, 19 of which are described in detail as key
recommendations. The legislative

recommendations taken as a whole represent proposals the NTA believes will
reduce complexity of the Code, reduce taxpayer burden in complying with
requirements, IRS burden in administering the tax system.

penalty and interest, and collection procedures.

Tax Compliance Initiatives

The most current analysis estimates that our nation s gross tax gap ( i.
e. , data as well as quantifying our corporate level strategic compliance
measures. compliance will be available in October 2003. In FY 2002, IRS
completed the following actions:

that can be addressed through the use of soft notice and math error
treatments. and reduce

.* The NTA has also identified potential legislative issues to be
developed for the 2002 Annual Report to Congress and continues to work
with members of Congress and their staffs to

increase understanding and support of the key legislative recommendations
contained in the 2001 report. The NTA has addressed complex issues such as
family status, alternative minimum tax, installment agreements for less
than full payment, joint and several liability,

Federal taxes and related payments owed but not paid) is somewhere between
$ 250 billion and $ 300 billion. Some of the most serious and current
compliance problem areas include: promoters of tax schemes of all
varieties; the misuse of devices such as trusts and offshore accounts to
hide or improperly reduce income; abusive corporate tax shelters;
underreporting of tax by higher- income individuals; and the failure to
file and pay large amounts of employment taxes by some

Efforts in FY 2003 and beyond will address these compliance areas through
better education of the public; systematically identifying promoters and
participants; improving the efficiency of exam and collection efforts
through reengineering; and reinvigorating enforcement actions such as
summons enforcement, injunctions and criminal investigation of promoters.
We must continue to make significant progress in collecting better
compliance and non- compliance

These two goals will be achieved in large part through our new National
Research Program ( NRP) . The first available NRP data on payment
compliance recently became available. Initial data on reporting

.* Analyzed Correspondence Examination programs to determine areas of non-
compliance

43

modernization plans. INTERNAL REVENUE SERVICE Management Discussion and
Analysis

For the Fiscal Year Ended September 30, 2002

.* Developed improvement strategies to address escalating and aged Offers
in Compromise ( OIC) inventory and to reduce open OIC inventory within six
to twelve months.

.* Enhanced and realigned the current Examination legacy systems to help
identify the most productive returns to examine. Information will be made
available to examiners to conduct

more effective examinations.

.* Expanded the range of information documents and returns that may be
filed electronically for Corporate Taxpayers.

In FY 2003, IRS will continue to respond to this challenge through the
following planned actions:

.* Deploy a range of initiatives using education and outreach to improve
the overall rate of voluntary compliance.

.* Increase efficiency and effectiveness by updating and re- engineering
work processes to make better use of resources.

.* Advance the use of Voluntary Compliance Agreements, reducing the need
for traditional enforcement actions.

.* Fully implement K- 1 matching program and target enforcement efforts
towards promoters and participants of abusive tax schemes.

.* Implement improved processes to move to an issue- driven compliance
process that will result in productivity savings and redirect these
savings to the highest compliance work.

.* Compliance, with the assistance of SB/ SE Research, is in the process
of analyzing the Potentially Collectible Inventory reports to identify the
causes of growth and develop a

course of action to impact continued growth.

.* Explore the use of limited scope examination processes to improve case
resolution.

.* Apply alternative dispute resolution procedures and other issue
resolution programs to resolve tax shelter issues in timely and consistent
manner.

Providing Quality Customer Service Operations

Providing top quality service to every taxpayer in every transaction is an
integral part of IRS IRS provides customer service in many ways, including
toll- free telephone service, electronic customer service, written
communications to taxpayers, walk- in service, and accurate and timely tax
refunds. Each of these services affects taxpayers ability and desire to
voluntarily comply with the tax laws.

In FY 2002, IRS completed the following actions:

.* Created a bar- coding system for adjustment notices and refund checks
so they can be mailed in the same envelope.

.* Developed a formal training plan and schedule to improve employee
knowledge of tax law, marketing, communication, and relationship
management skills.

.* Targeted and built quality relationships with internal and external
partners and intermediaries to educate and support taxpayer and
practitioner programs.

.* Provided employers with access to on- line employment tax and wage
information through the Simplified Tax and Wage Reporting System.

.* Reconfigured the Practitioner Hotline into a centralized system.

.* Trained Customer Service Representatives in one or more technical and
account topics, enabling them to be more proficient in assisting customers
quickly and accurately.

44

and externally.

1999 Returns, INTERNAL REVENUE SERVICE Management Discussion and Analysis

For the Fiscal Year Ended September 30, 2002

.* Analyzed and trained the volunteer workforce to create subject matter
experts both internally In FY 2003, IRS will continue to respond to this
challenge through the following planned actions:

.* Add 7 new forms that can be electronically filed in 2003.

.* Implement and improve availability of on- line services such as
Internet Employer Identification Number ( EIN) , Centralized Authorization
File and Practitioner Priority Services.

.* Improve e- services for practitioners.

.* Enhance electronic interactions ( such as e- filing and e- paying) ,
augment communication with taxpayers through the development of e-
government operations, and provide

employers with access to on- line employment tax and wage information.

.* Implement recommendations developed as part of the Service s
Multilingual Initiative.

.* Review computer- generated notices and correspondence to improve
quality and clarity.

.* Configure outward facing Toll- Free numbers to relate directly to
taxpayers inquiries. .

.* Provide new and expanded services through Internet Refund/ Fact of
Filing ( IRFOF) to reduce toll- free demand and offer customers
alternative methods of service.

.* Provide taxpayers a way to resolve tax problems every day at Taxpayer
Assistance Centers.

.* Address issues associated with Globalization by using Tax Attaches
stationed overseas.

Erroneous Payments; Noncompliance with EITC

The President and the Congress have expressed concerns with the large
amount of erroneous payments made by Federal agencies each year. The risk
of improper payments increases in programs with complex criteria for
computing payments, a significant volume of transactions, or emphasis on
expediting payments. Although many IRS programs are susceptible to
erroneous payments, the Earned Income Tax Credit ( EITC) Program is
particularly vulnerable. Subsequent to studies showing billions of dollars
of EITC noncompliance, Congress provided additional funding and
enforcement tools to improve compliance. In 1998, a five- year compliance
initiative directed at major sources of EITC noncompliance was initiated.
In addition, IRS received from Congress and implemented additional
statutory authority to deny questionable claims during initial processing
( math error processing) .

Despite its compliance initiative, which has saved the Government over $ 5
billion, the most recent compliance study, Compliance Estimates For Earned
Income Tax Credit Claimed on

released in February 2002, estimates a 31- 36% implementation, and is on-
going at this time. error rate and a 27- 32% unrecovered overclaim rate.
EITC non- compliance results from three major error sources: ( 1)
taxpayers claiming EITC amounts based on children with whom they do not
have the required relationship and/ or with whom they did not reside for
at least six months of the tax year; ( 2) taxpayers claiming EITC amounts
based on erroneously reporting their filing status and ( 3) income
misreporting. To address the systemic flaws in the current EITC program,
and to address the complexity of the EITC law, which was highlighted in a
then- recent Taxpayer Advocate Report to Congress, Secretary O Neill
convened an EITC task force. This mission of this joint Treasury- IRS task
force was to achieve the objectives of the EITC program while reducing
taxpayer confusion and increasing the accuracy of the administration of
benefits. The task force was convened in March 2002 and presented final
recommendations in July 2002. In August 2002, Secretary O' Neill approved
the recommendations and also approved the formation of an IRS
implementation team charged with development of an implementation plan.
This team began a study of the cost and business process changes necessary
for

45

compliance.

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

In FY 2002, IRS completed the following actions:

.* Convened a Task Force to thoroughly examine complexity and compliance
issues of EITC and recommend fundamental program changes to reduce
complexity and improve

.* Expanded use of the Dependent Database ( DDb) as an external data
source to identify non- compliant taxpayers.

.* Expanded examinations of the Duplicate TIN repeater population.

.* Began study of data supplied to DDb by the Federal Case Registry of
Child Support Orders.

.* Created the EITC Executive Advisory Council.

.* Realigned EITC Project Office to enhance strategic program development
and execution.

.* Participated in a government- wide task force on erroneous payments. In
FY 2003, IRS will continue to respond to this challenge through the
following planned actions:

.* Assess overall EITC compliance, identify knowledge gaps and plan
additional research.

.* Assess marketing/ awareness campaigns that target eligible EITC non-
claimant population.

.* Analyze processing year 2002 audit results to refine existing DDb
business rules.

.* Identify, investigate, and prosecute promoters of EITC- related refund
schemes.

.* Finalize EITC preparer cases being actively investigated and prepared
for prosecution.

.* Assess Federal Case Registry of Child Support Orders study data to
determine if using expanded math error authority to deny EITC will improve
compliance efforts.

.* Continue to address the EITC Task Force recommendations.

.* Continue our participation in a government- wide task force on
erroneous payments.

.* Better integrate EITC Program Office into the IRS established strategic
planning process. .

.* Continue to expand and refine tools used by campus examiners in EITC
examinations.

Taxpayer Protection and Rights

The legislative changes required by the Restructuring and Reform Act of
1998 ( RRA 98) continue to have a profound impact. RRA 98 included
fundamental changes to tax law procedures, and required IRS to change its
organizational structure from one that was geographically structured to
one that was set up to serve particular groups of taxpayers with similar
needs. Most RRA 98 provisions, including massive training programs for
thousands of employees, have been modified or implemented. Significant
management attention will be required to evaluate the effectiveness of the
reforms. Additionally, IRS reorganization focus on taxpayer groups
presents both a risk of treating groups of taxpayers differently and an
opportunity to use specialized knowledge to promote compliance among all
taxpayers equitably. IRS is committed to treat all taxpayers equitably,
and strategic plans indicate equitable treatment of taxpayers is included
in efforts to promote compliance among business taxpayers.

In FY 2002, IRS completed the following actions:

.* Implemented a secure transaction- based web site.

.* Ensured alternative signature initiatives comply with IRS
authentication policy.

.* Implemented the next phase of the Checkbox initiative to allow
taxpayers to designate an individual preparer to serve as their designee
to discuss tax matters and notices with IRS.

46

arguments.

Human Capital

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

.* Combined the Centralized Authorization Files into a central repository
to eliminate the need for taxpayers to submit multiple third party
authorization requests for numerous issues.

.* Evaluated performance by deploying balanced measures to the appropriate
levels.

.* Linked Critical Job Elements and performance expectations to
organizational quality goals.

.* Redesigned examination work processes and assessed legal requirements.

.* Redesigned internal Collection processes, policies and procedures, and
updated workload selection and inventory delivery systems.

In FY 2003, IRS will continue to respond to this challenge through the
following planned actions:

.* Continue to administer the credit card contract to ensure protection of
taxpayer data and credit card numbers.

.* Reduce the volume of paper jurats, expand alternative methods of
signature.

.* Evaluate computer security to ensure protection of taxpayer
information.

.* Review and assess implementation of Title VI of the Civil Rights Act of
1964 to certify that all tax preparation sites provide equal access and
non- discriminatory services.

.* Ensure documentation does not include specific labeling of taxpayers
raising frivolous tax

.* Reinforce the requirements to provide a statement to taxpayers at
initial meetings that advises them of the Taxpayer Advocate s
independence.

.* Develop a standard practice for IRC Section 7803 ( c) ( 4) ( iv) ,
which states that local taxpayer advocates may choose not to disclose
contact with or information provided by a taxpayer.

GAO considers strategic human capital management as a high- risk area for
the government, and the President s FY 2001 budget has added human capital
to its list of Priority Management Objectives. Inadequate attention to
strategic human capital management has created a government- wide risk of
eroding the capacity of some agencies to perform their missions.
continuing need to properly staff, train, and provide adequate tools for
employees.

In FY 2002, IRS completed the following actions: promote and encourage
individual and organizational excellence.

.* Expanded the pay band system to all front- line and mid- level
managers. customer service, project management, finance, accounting, and
leadership. prepare our participants for top- level leadership positions.
schools in their local areas. relationships with community- based
organizations.

Like many other government agencies, IRS faces a range of serious
personnel management issues, ranging from recruiting, training, and
retaining employees to problems associated with IRS recent reorganization
and modernization efforts. During FY 2001, IRS struggled with a

.* Used the Senior Manager Pay Band system to more effectively allocate
salary resources to

.* Continued to offer an extensive array of web- and computer- based
training for employees via the Internet, Intranet, and by CD- ROM covering
subjects such as communications,

.* Continued to provide an extensive array of executive development
training activities that

.* Continued to encourage executives to establish relationships with their
alma mater or with

.* Continued partnerships with employee organizations to help recruiters
establish

47

Collect Unpaid Taxes

seizures, casework.

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

.* Continued the state- of- the- art advertising campaign that was
established to promote IRS as an employer of choice.

.* IRS has established a strategic human capital strategy that consists of
four principal elements: Renewal, Training and Development, Performance,
and Transition.

In FY 2003, IRS will continue to respond to this challenge through the
following planned actions:

.* Sustain recruitment efforts over the long term with continued entry-
level intake in key front- line occupations remaining a high priority.

.* Maintain a continued labor market presence through electronic and print
advertising.

.* Continue to streamline and automate the hiring process.

.* Emphasize a management development pipeline.

.* Implement a mid- career recruiting strategy.

.* Implement an IRS- wide learning strategy, including additional
investment in e- learning.

.* Continue expansion of pay- for- performance system to all remaining
front- line managers.

.* Increase bonus and staffing flexibility to strengthen the linkage
between executive performance and compensation.

.* Capitalize future transition efforts on past experience; coordinate
efforts such as workload realignment to maximize placement of employees
while addressing business needs.

Reliable and timely financial, operational, and compliance data is not
available to help target efforts to collect billions of dollars in unpaid
taxes. As a result, the Federal government is exposed to significant
losses of tax revenue while compliant taxpayers bear an undue burden of
financing the government s activities. Certain key collection actions,
such as levies and

have declined since 1997 during IRS modernization efforts and because of
the IRS Restructuring and Reform Act of 1998 ( RRA98) impacts. These
declines may increase the incentives for taxpayers to either not report or
underreport their tax obligations. Attempts to identify taxpayers that
have not paid the taxes they owe are made through various enforcement
programs. IRS inability to fully pursue such cases is attributable to a
decrease in staff, reassignment of collection employees to support
customer service activities, and additional staff time needed to implement
certain taxpayer protections that were included in RRA98. Additionally,
inadequate financial and operational information has hindered development
of cost- based performance information for tax collection and enforcement
programs.

In FY 2002, IRS completed the following actions:

.* Developed a risk- based compliance strategy to use knowledge regarding
taxpayer behavior, history, and needs in the collection decision process
to ensure that the highest priority cases

get worked first and reduce the number of accounts closed as currently not
collectible.

.* Centralized the processing of Offers in Compromise.

.* Used non- Compliance resources during the filing season to minimize
impact on Compliance

.* Redesigned internal processes, policies, and procedures, and updated
the antiquated system of workload selection and inventory delivery.

In FY 2003, IRS will continue to respond to this challenge through the
following planned actions:

48

sites. single platform.

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

.* Provide credit card payment option for delinquent taxes ( individuals)
, installment agreement payments and extension- related payments and
expand credit card options to BMF returns.

.* Develop and implement a comprehensive nonfiler strategy.

.* Identify and target noncompliance with employment tax deposit and
payment requirements.

.* Continue efforts to gain full participation in the State Income Tax
Levy Program.

.* Align Collection legacy systems.

.* Implement a modernized collection system.

.* Tailor treatment streams and route cases to appropriate functions and
employees.

.* Develop educational products and a marketing plan to address abusive
flow- throughs, tax shelters, trust filers and their practitioners.

.* Develop and implement a strategy for High- Income Taxpayers.

.* Fully implement the K- 1 matching program, reconciling partnership
income reporting documents to the beneficiaries of this income on federal
income tax returns.

Revamp Business Practices to Meet Taxpayer Needs

The ability to balance the goals of improving customer service and
improving overall compliance depends in part on successful modernization
of business practices.

In FY 2002, IRS completed the following actions:

.* Completed centralization of all employment tax processing to two
Submission Processing

.* Tested feasibility of correspondence imaging to allow Customer Service
Representatives immediate on- line access to customer correspondence.

.* Improved and enhanced employee manuals and tools.

.* Provided new tools and information such as the Remittance Transaction
System ( RTR) , Notice Viewing, and Correspondence Imaging to employees.

.* Improved training to Toll- free/ Adjustments workforce by determining
skill gaps.

.* Integrated business systems such as Automated Offer in Compromise,
Automated Lien System, Inventory Delivery System and Automated Trust Fund
Recovery System onto a

.* Provided a single- point for electronic filing and test prototype
solutions for the combined electronic transmission of federal and state
employer quarterly tax and wage reports.

.* Prototyped an application to provide employers a quicker method to
securely access, apply for, and receive a Federal EIN on- line.

.* Reconfigured the Practitioner Hotline to a centralized system.

.* Centralized the processing of Offers in Compromise ( OIC) .

.* Continued efforts to ensure that work is allocated to the proper
operating division by implementing standardized criteria to reassign
compliance cases.

.* Responded to taxpayer demand and implemented pre- filing agreement
program. In FY 2003, IRS will continue to respond to this challenge
through the following planned actions:

.* Establish customer liaisons for media and publications.

.* Continue to work with industry to enable online tax return entry and
submission at no cost.

.* Expand electronic tax products for business.

.* Enhance customer experience by routing calls to appropriate assistors.

.* Improve and enhance employee manuals and tools.

49

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

.* Continue to deploy the Integrated Case Processing system.

.* Redesign business processes to provide service around an industry
rather than geographically to provide better service for each taxpayer.

.* Move to an issue- driven examination process for large and midsize
businesses.

.* Re- engineer the Published Guidance process.

50

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

V. V . Fi F in na an nc ci ia al l Hi H ig gh hl li ig gh ht ts s

Stewardship Information Analysis a. Overview of Revenue and Administrative
Accounts The IRS financial statements and footnotes received an
unqualified audit opinion for the third consecutive year for
administrative accounts and the sixth consecutive year for revenue
accounts. Administrative accounts reflect resources used and expenses
incurred in administering the tax laws. Revenue accounts reflect net taxes
receivable and taxes collected to support the federal government.

The Balance Sheet reflects total assets of $ 24. 71 billion. Of these
assets, almost 81 percent are Federal Taxes Receivable. These receivables
are the amounts expected to be collected from past due accounts. The
decrease in assets of $ 0. 53 billion is mainly attributable to a decrease
in the IRS fund balance with Treasury. . The majority of the liabilities,
a little over 86 percent, consist of Federal Taxes Receivable due to
Treasury.

The Statement of Custodial Activity shows that IRS programs resulted in $
2. 016 trillion in Federal receipts. IRS collections constitute 95 percent
of the Federal Government receipts, as shown in the following chart.

Total Federal Receipts Non- IRS IRS

Collections 5% Collections

95%

b. Financing Sources

Budget Fiscal Year 2002 Appropriations ( ( Percent) The IRS receives the
majority of its funding through annual, multi-

Tax Law Processing, Assistance,

year, no- year and trust fund

and Management Enforcement appropriations which are available

( PAM) ( TLE)

40% 37% for use within certain specified

statutory limits. There are three major and several minor operating

Earned Income

appropriations. The Processing,

Tax Credit ( EITC) Assistance and Management

2%

appropriation funds the processing of tax returns and related

Business Systems Information Services

documents, assistance for

Modernization ( IS) 17%

taxpayers in the filing of their

( BSM) 4%

returns and paying taxes due,

51

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

matching information with returns, conducting internal audit reviews and
security investigations, and managing financial resources. The Tax Law
Enforcement appropriation provides funds for the examination of tax
returns and the administrative and judicial settlement of taxpayer appeals
of examination findings. The Information Services appropriation funds
costs for data processing and information and telecommunications support
for the Service s activities. The Business Systems Modernization Account
and the Earned Income Tax Credit appropriations are the most significant
of the minor operating appropriations. The former funds capital asset
acquisitions of information technology systems. The latter provides
resources for expanded customer service and outreach, strengthened
enforcement, and enhanced research to reduce claims and erroneous filings
associated with the Earned Income Tax Credit.

Besides appropriations, the Service utilizes other financing sources.
These include net transfers from other federal agencies, and imputed
financing ( subsidies from other federal funds that cover specific
expenses such as retirement benefits) .

c. Use of Resources The Statement of Net Cost reflects the use of
resources in carrying out the agency s major programs. The major programs
are Pre- filing, Filing and Account

How the Service Used Its Resources ( in Percent)

Services, Compliance, and Administration of the Earned Income

Filing and Tax Credit ( EITC) . Pre- filing

Compliance Account Services

activities include taxpayer education

Services 58%

and outreach, pre- filing agreements,

33%

and tax publication issuance and

Administration Pre- Filing

distribution. Filing and account

Taxpayer of Earned services activities include the filing

Assistance Income Tax of tax returns, current account

and Education Credit

status, and processing of taxpayer

6% 3% information. Compliance activities include document matching,
audits, and criminal

investigation activities. Administration of the EITC activities includes
pre- filing, filing and account services, and compliance activities.

Revenue and Refund Trend Information Federal tax revenues are collected
through six major classifications: individual income, corporate income,
excise taxes, estate and gift taxes, railroad retirement, and Federal
unemployment taxes. Overall revenue receipts ( approximately $ 2.016
trillion) for FY 2002 decreased by approximately 5 percent. Individual
income taxes, which include both FICA and SECA taxes, decreased by 7
percent. Corporate income taxes increased by 13 percent. Collections from
all other tax sources were relatively stable from 2001 to 2002.

The decline in receipts is predominately due to the 2001 recession, the
decline in the stock market, and the September 11, 2001 terrorist attacks.
These occurrences resulted in reductions in relatively highly- taxed forms
of income, especially wages and salaries, and indicates that much of the
decline in these forms of income is attributable to the recession. At the
same time, the decline in the stock market reduced capital gain receipts
and further reduced taxes on wage and salary income. The entire amount of
Federal revenue received in 2002 was distributed to Treasury.

52

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

Collections of Federal Tax Revenue

1, 900 1, 800 1, 700 1, 600 1, 500

1, 714 1, 400

1, 844 1, 300

1, 200 1, 100 1, 000

900 800 700 600 500

211 400 52 27 5 7

FY 2002 $ 300 200

187 52 29 100 5 7

FY 2001 $ Individual,

Corporate Excise Estate & Gift Railroad

Federal FICA/ SECA,

Income Retirement

Unemployment and other

Tax Class

Federal tax refund activity, which includes tax, interest, the special tax
rebate authorization, payments for Earned Income Tax Credits, and Child
Tax Credits in excess of the tax liability

$ 281 the $ to in Billions

was billion. This increase from FY 2001 activity is attributable Job
Creation and Worker Assistance Act ( the Economic Stimulus Bill) that
affects both individuals and corporations by reducing the tax rate for
individuals, extending the $ in Billions

corporation carry- back period for net operating losses from two to five
years, and temporarily extending a number of tax reductions that had
expired December 31, 2001.

Overall refund disbursements increased by 12 percent. The table below
shows that the largest dollar volume tax classes, Individual, FICA/ SECA,
and the other refunds appear to remain relatively consistent; however, in
FY 2001 approximately $ 36 billion was disbursed for the special tax
rebate, which means the remaining disbursements were approximately $ 175
billion. When FY 2001 and 2002 are normalized to exclude the special tax
rebate refunds for these same tax classes in FY 2002 ( $ 212 billion)
increased by approximately 21 percent. Corporate Income refunds increased
by 76 percent, which offset increased corporate tax receipts. Other tax
class refunds remained relatively consistent.

Federal Tax Refund Activity

225 210 195 180 165 150 135 120

212 105

211

Dollars

90

FY 2001 Railroad Retirement 9, 000, 000

75

FY 2002 Railroad Retirement 8, 000, 000

60 45

67

FY 2001 Federal Unemployment 133, 000, 000 FY 2002 Federal Unemployment
124, 000, 000

30 38

1 1 0 0 15

1 1 0 0 FY

Individual, Corporate Income Excise Estate & Gift Railroad

Federal FY

2002 $ FICA/ SECA, and

Retirement Unemployment

2001 $ other

Tax Class 53

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

Analysis of Unpaid Assessments As reflected in the supplemental
information

Figure 1: Components of IRS' $ 249

to IRS' fiscal year 2002 Financial

Billion of Unpaid Assessments as of

Statements, the unpaid assessment

September 30, 2002

balance was about $ 249 billion as of September 30, 2002. This unpaid

Compliance

assessment balance represents

( $ 25)

assessments resulting from taxpayers filing

Taxes Receivable ( $ 87)

10%

returns without sufficient payment; as well

35% 55%

as from the Service s enforcement programs such as Examination,

WriteOff

Underreporter, Substitute for Return, and

( $ 137)

Combined Annual Wage Reporting. The majority of this balance is not
considered a receivable. In addition, a substantial portion of the amounts
considered receivables is largely uncollectible.

Under federal accounting standards, unpaid assessments require taxpayer or
court agreement to be considered federal taxes receivable. Assessments not
agreed to by taxpayers or the courts are considered compliance assessments
and are not considered federal taxes receivable. Assessments with little
or no future collection potential are called write- offs.

Figure 2: Components of IRS $ 137 Billion of Write offs as of

Of the $ 249 billion balance of unpaid

September 30, 2002

assessments, $ 137 billion represents write- offs. Write- offs principally
consist of

Other 11%

Deceased

amounts owed by defunct corporations and

3%

include many failed financial institutions

Financial Hardship

resolved by the Federal Deposit Insurance

29% Defunct Corporation

Corporation ( FDIC) and the former

27%

Resolution Trust Corporation ( RTC) .

Insolvent/

Taxpayers with extreme economic and/ or

RTC/ FDIC Bankruptcy

financial hardships, deceased taxpayers,

Unable to Locate 4% Insolvent

5%

and taxpayers who are insolvent due to

21%

bankruptcy owe the remaining amounts. In addition, $ 25 billion of unpaid
assessments represent amounts that have not been agreed to by either the
taxpayer or a court. These assessments result primarily from various
Service enforcement programs to promote voluntary compliance. Due to the
lack of agreement, these compliance assessments have less potential for
future collection than the unpaid assessments that are considered federal
taxes receivable.

54

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

The remaining $ 87 billion of unpaid

Figure 3: Components of IRS'

assessments represent federal taxes

$ 87 Billion of Taxes Receivable as of

receivable. About $ 67 billion ( 77% ) of this

September 30, 2002

balance is estimated to be uncollectible due primarily to the taxpayer' s
economic situation, including individual taxpayers who

Taxes Receivable Collectible Taxes Receivable - are unemployed, are
currently in

Uncollectible ( $ 20)

( $ 67) 23%

bankruptcy, or have other financial

77% problems. However, under certain conditions, IRS may continue
collection action for 10 years after the assessment. Thus, these accounts
may still ultimately have some collection potential if the taxpayer' s
economic condition improves.

About $ 20 billion, or about 23% , of federal taxes receivable is
estimated to be collectible. Components of the collectible balance include
installment agreements with estates and individuals; confirmed payment
plans through bankruptcy; and some newer amounts due from individuals and
businesses with a history of compliance. The taxes receivable amount from
September 30, 2001, to September 30, 2002, increased $ 7 billion from $ 80
billion to $ 87 billion. The percent estimated to be collectible at
September 30, 2002 ( 23% ) , decreased from September 30, 2001 ( 25% ) .

Figure 4: Unpaid Taxes and Interest and Penalty Components of $ 249
Billion in Unpaid Assessments as of

It is also important to note that the unpaid

September 30, 2002

assessment balance contains unpaid assessed tax, penalty, and interest;
and accrued penalty and interest computed

Taxes

through September 30, 2002. About $ 160

36%

( $ 89) billion ( 64% ) of the unpaid assessment

64%

balance as of September 30, 2002, contains

Interest &

interest and penalties, as depicted in Figure

Penalties ( $ 160)

4, and are largely uncollectible. Interest and penalties are such a high
percentage of the balance because IRS must continue to accrue them through
the 10- year statutory collection date, regardless of whether an account
meets the criteria for financial statement recognition or has any
collection potential. For example, interest and penalties continue to
accrue on write- offs, such as FDIC and RTC cases, and on exam assessments
where taxpayers have not agreed to the amount assessed. The overall growth
in unpaid assessments during fiscal year 2002 was mostly attributable to
the accrual of interest and penalties.

55

Human Capital Competitive Sourcing

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

A AD DD DE EN ND DU UM M: : P Pr re es si id de en nt t s s M Ma an na ag
ge em me en nt t A Ag ge en nd da a

The IRS made steady progress on the President s Management Agenda this
year and we still have room for improvement. The table below summarizes
the status and progress ratings for IRS in the second, third and fourth
quarters of FY 2002. In " Progress" ratings, the area where we can have
the most short- term impact, we received two greens and three yellows. In
" Status" ratings, we received one green, two yellows and two reds. The
IRS was not rated in the first quarter for any agenda item, and received
ratings in the area of Budget & Performance Integration in the third and
fourth quarters only.

IRS Overall Ratings as of September 30, 2002

Budget & Performance Integration Not Yellow = partially meets scorecard
criteria Red = does not meet criteria

Major Accomplishments and Future Plans

level of the organization. competitive sourcing. additional functional
areas.

.* Completed direct conversion of 93 FTE. Status Progress

Q2 Q3 Q4 Q2 Q3 Q4

Human Capital Y G G G G G

Competitive Sourcing G G Y G G Y

Rated Y Y Not salary adjustments directly to performance evaluations. 500
FTE; and convened PWS teams for 560 FTE.

Rated Y Y

E- Government Y G R G G G

Financial Performance R R R R R Y

Green = meets OMB Scorecard criteria for factor being rated

.* IRS has developed a rigorous, quantitatively- driven succession
planning and management system that assesses current and projected
candidate supply/ demand at each management

.* IRS implemented a pay- for- performance system for its executives and
managers that links

.* IRS was awarded two prestigious Creative Excellence Awards, sponsored
by the Society for Human Resources Management, for its interactive
professional recruitment efforts.

.* Established a program for FY 2002 and FY 2003 to review approximately
4500 FTE for

.* Completed feasibility studies in five functional areas, and studies are
ongoing in seven

.* A- 76 Project Development Began Performance Work Statements ( ( PWS)
for 500 FTE; began streamlined competition for 30 FTE; convened most
efficient organization team for

56

E- Government

FY 2001. and fact of filing.

Businesses.

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

Budget & Performance Integration

.* Developed and used for first time ever, data on program performance
gaps to develop strategic plans and prioritize budget initiatives.

.* Developed integrated financial and performance plans that tie budget to
performance for each program. Plans were certified by Division
Commissioners to assure accountability.

.* Enhanced the use of performance data and program evaluations in the
budget decisionmaking process to create stronger linkage between current
performance and future- year

performance goals.

.* Will continue development and reporting of corporate strategic measures
and will use data to begin discussion and development of servicewide
outcome goals.

.* Will realign IRS budget structure to help link costs to program
results.

.* Will develop the Integrated Financial System and deploy a cost module
that is interfaced with program area data systems to provide both direct
and indirect cost data to support

budget requests and execution.

.* Increased the number of e- filed individual returns by 17% over FY 2001
resulting in 36% of all returns being filed electronically.

.* The number of taxpayers e- filing from their home computers is up 38%
over last year.

.* Implemented electronic payment via the internet for the 2002 filing
season.

.* Increased the number of Federal Tax Payment Transactions Paid
Electronically by 3% over

.* Implemented internet based taxpayer access to answers for their
inquiries regarding refunds

.* Introduced a newly designed and more accessible web site. Increased the
number of web site hits to 3. 4 billion and downloaded files to 436
million projected through the end of FY

2002. This represents increases of 31% and 38% respectively over FY 2001.

.* Will continue efforts with industry partners to develop the free
internet filing web page, to be hosted on IRS. gov.

.* Will continue initiatives on EZ Tax Filing and Expanding Electronic Tax
Products for

Financial Performance

.* .* Achieved clean audit opinion by November 15 through significant
improvements in the timing and accuracy of financial data throughout the
fiscal year.

.* Administrative and Revenue Accounting Divisions achieved the Treasury
June target for 3- day close for both timeliness and quality.

.* Revising the Remediation Plan to reflect a comprehensive set of actions
to improve IRS financial management systems and ensure they meet federal
requirements and standards.

.* Addressed components of material weaknesses in internal controls, e. g.
, controls over material balances in the general ledger and recording of
transactions; quarterly reporting of

capital items; timely recording of adjustments; and consistent
implementation of existing computer security policies and procedures.

.* Formed an implementation team to develop procedures, processes, and
costs associated with recommendations of joint Treasury and IRS task force
to address erroneous payments.

57

internal controls. Access Projects) .

INTERNAL REVENUE SERVICE Management Discussion and Analysis For the Fiscal
Year Ended September 30, 2002

.* .* Actions are on schedule for long- term solutions to address six
material weaknesses in

.* .* Integrated Financial System is on schedule for implementation on 10/
1/ 03.

.* .* Custodial Accounting Project ( CAP) Build 1 will be deployed
November 2003. All future dates and builds of CAP/ EDW ( Enterprise Data
Warehouse) are under review due to

changes in the Business Systems Modernization Plans ( dependent on
Modernized Data

58

Financial Statements

Balance Sheets

Department of the Treasury Internal Revenue Service

Balance Sheet As of September 30, 2002 and 2001

( In Millions)

2002 2001 Assets

Intragovernmental: Fund balance with Treasury and cash ( Note 2) $ 1,652 $
2, 070 Due from Treasury ( Note 13) 1,287 1,419 Accounts receivable, net (
Note 3) 7 33 Advances to government agencies 126 128 Total
Intragovernmental 3,072 3,650

With the Public: Federal Taxes receivable, net of

allowance for doubtful accounts ( Notes 5, 13) 20, 000 20, 000 Accounts
receivable, Net ( Note 3) 1 3 Advances to the public 15 15 Other assets (
Notes 4, 13) 78 195 Total with the Public 20, 094 20, 213

Property and equipment, Net ( Note 6) 1,546 1,381

Total Assets $ 24, 712 $ 25, 244 Liabilities

Intragovernmental: Due to Treasury ( Notes 5, 13) 20, 000 20, 000 Accrued
expenses ( Note 7) 142 89 Other liabilities ( Note 8) 90 81 Total
Intragovernmental 20, 232 20, 170

Federal tax refunds payable ( Note 13) 1, 287 1,419 Accounts payable (
Note 7) 51 27 Accrued expenses ( Note 7) 424 608 Other liabilities ( Note
8) 962 1,071 Capital lease liability ( Note 9) 158 125 Contingencies (
Note 10) 9 6

Total Liabilities $ 23, 123 $ 23, 426 Net Position

Unexpended Appropriations 1, 039 1,380 Cumulative Results of Operations
550 438

Total Net Position $ 1,589 $ 1, 818 Total Liabilities and Net Position $
24,712 $ 25,244

The accompanying notes are an integral part of these statements - 1 -

Statement of Net Cost

Department of the Treasury Internal Revenue Service

Statement of Net Cost For the Years Ended September 30, 2002 and 2001

( In Millions)

Program 2002 2001 Pre- Filing Taxpayer Assistance and Education

Full cost $ 711 $ 579 Exchange revenue ( 69) ( 48) Net cost of program 642
531

Filing and Account Services

Full cost $ 3,382 $ 3,099 Exchange revenue ( 31) ( 18) Net cost of program
3,351 3,081

Compliance Services

Full cost $ 5,937 $ 5,601 Exchange revenue ( 163) ( 170) Net cost of
program 5,774 5,431

Administration of Earned Income Tax Credit

Full cost $ 270 $ 255 Exchange revenue - Net cost of program 270 255

Net Cost of Operations ( Note 18) $ 10, 037 $ 9,298

The accompanying notes are an integral part of these statements - 2 -

Statement of Changes in Net Position

Department of the Treasury Internal Revenue Service Statement of Changes
in Net Position For the Year Ended September 30, 2002

( In Millions)

Cumulative Results of

Unexpended Operations

Appropriations Beginning Balances $ 438 $ 1, 380

Budgetary Financing Sources:

Appropriations received ( Note 11) 9,509 Canceled appropriations and
rescissions ( Note 19) - ( 103) Appropriations used 9,747 ( 9,747)

Other Financing Sources:

Imputed financing from costs absorbed by others 455 Transfers in/ out
without reimbursement 10 Transfers to General Fund ( 63 ) Total Financing
Sources 10, 149 ( 341) Net Cost of Operations ( 10,037) Ending Balances $
550 $ 1, 039

The accompanying notes are an integral part of these statements - 3 -

Statement of Budgetary Resources

Department of the Treasury Internal Revenue Service Statement of Budgetary
Resources For the Year Ended September 30, 2002

( In Millions)

Budgetary Resources

Budget Authority: Budgetary appropriations received ( Note 11) $ 9, 582
Unobligated balance, beginning of period 441 Spending authority from
offsetting collections ( Note 21) 164 Recoveries of prior year obligations
109 Permanently not available ( Note 19) ( 103)

Total Budgetary Resources $ 10, 193 Status of Budgetary Resources

Obligations incurred ( Note 20) $ 9, 751 Unobligated balance available (
Note 2) 217 Unobligated balance not available ( Note 2) 225

Total Status of Budgetary Resources 10, 193 Relationship of Obligations to
Outlays

Obligated balance, net, beginning of period ( Note 12) 1, 635 Obligated
balance, net, end of period ( Note 12) ( 1,225)

Outlays: Disbursements 10, 077 Collections ( 189)

Net Outlays $ 9, 888

The accompanying notes are an integral part of these statements - 4 -

Statement of Financing

Department of the Treasury Internal Revenue Service

Statement of Financing For the Year Ended September 30, 2002

( In Millions)

Resources Used to Finance Activities:

Budgetary Resources Obligated: Obligations incurred ( Note 20) $ 9, 751
Less: spending authority from offsetting collections and recoveries ( 273)
Net Obligations $ 9, 478 Imputed financing from costs absorbed by others
455 Transfers in/ out without reimbursement 10 Exchange revenue not in the
budget ( Note 11) ( 136)

Total Resources Used to Finance Activities $ 9, 807 Resources Used to
Finance Items Not Part of the Net Cost of Operations:

Change in budgetary resources obligated for goods, services, and benefits
ordered but not yet provided 329 Resources that finance the acquisition of
assets ( 515) Total Resources Used to Finance Items Not Part of the Net
Cost of Operations ( 186)

Total Resources Used to Finance the Net Cost of Operations $ 9, 621
Components of the Net Cost of Operations That Will Not Require or Generate
Resources in the Current Period:

Components Requiring or Generating Resources in Future Periods: Increase
in annual leave liability 15 Other 8

Total Components of Net Cost of Operations That Will Require or Generate
Resources in Future Periods 23

Components Not Requiring or Generating Resources:

Depreciation and amortization 393

Total Components of Net Cost of Operations That Will Not Require or
Generate Resources in the Current Period 416

Net Cost of Operations $ 10, 037

The accompanying notes are an integral part of these statements - 5 -

Statement of Custodial Activity

Department of the Treasury Internal Revenue Service Statement of Custodial
Activity For the Years Ended September 30, 2002 and 2001

( In Billions)

2002 2001 REVENUE ACTIVITY

Collections of Federal Tax Revenue ( Note 16)

Individual income, FICA/ SECA, and other $ 1, 714 $ 1, 844 Corporate
income 211 187 Excise 52 52 Estate and gift 27 29 Railroad retirement 55
Federal unemployment 77

Total Collections of Federal Tax Revenue 2,016 2,124

Increase/ ( Decrease) in federal taxes receivable, net - ( 2)

Total Federal Tax Revenue 2,016 2,122

Distribution of federal tax revenue to Treasury 2, 016 2,124 Increase/ (
Decrease) in amount due to Treasury - ( 2)

Total Disposition of Federal Tax Revenue 2,016 2,122 NET FEDERAL REVENUE
ACTIVITY $ - $ - FEDERAL TAX REFUND ACTIVITY ( Note 17) Total Refunds of
Federal Taxes $ 281 $ 251 Appropriations Used for Refund of Federal Taxes
( 281) ( 251)

NET FEDERAL TAX REFUND ACTIVITY $ - $ -

The accompanying notes are an integral part of these statements - 6 -

Notes to the Financial Statements

Internal Revenue Service Notes to the Financial Statements For the Years
Ended September 30, 2002 and 2001

Note 1. A. Reporting Entity

Summary of Significant

The Internal Revenue Service ( the Service) is a bureau of the U. S.
Department of the Treasury ( Treasury) . The

Accounting

Service originated in 1862, when Congress established the Office of the
Commissioner of the Internal Revenue. In

Policies

1952, the Bureau was reorganized by Congress and in 1953 became the
Internal Revenue Service ( IRS) . In fiscal year ( FY) 2001, the Service
completed the implementation of a plan to reorganize its structure and
management in accordance with the IRS Restructuring and Reform Act enacted
by Congress in 1998. The Service implemented a modernized structure built
around taxpayer needs. Currently, the organization consists of :

Four operating divisions Wage and Investment addresses the needs of
taxpayers with wage and investment income only. Small Business and Self-
Employed serves self- employed individuals and small businesses. Tax-
Exempt and Government Entities supports employee plans, tax exempt
organizations, and government entities. Large and Mid- Size Business
serves corporations, sub- chapter S corporations, and partnerships with
assets greater than $ 5 million. Each of these divisions performs the
functions of processing and examination of tax returns for its constituent
taxpayers. Wage and Investment performs collection activities related to
its own customers. Small Business and Self- Employed performs collection
activities on its customer accounts as well as those of Tax Exempt and
Government Entities and Large and Mid- Size Business. Two service
organizations Modernization and Information Technology Services and Agency
Wide Shared Services provide central support to all areas of the Service;
Separate specialized independent channels for taxpayers Appeals and
Taxpayer Advocate Service divisions are independent of the operating
divisions and other units of the Service. The Taxpayer Advocate Service
reports directly to Congress. A line unit, Criminal Investigation, has
sole responsibility for investigation of criminal violations of the tax
law and is independent of the operating divisions; Chief Counsel provides
tax advice, guidance, and legislative services to all components of the
Service; and National Headquarters fills the role of setting broad policy,
providing executive oversight, reviewing plans and goals of the operating
units, and developing major improvement initiatives.

The mission of the Service is to provide America s taxpayers top- quality
service by helping them understand and meet their tax responsibilities and
by applying the tax law with integrity and fairness to all.

B. Basis of Presentation

The balance sheet reports the Service s financial position as of September
30, 2002 and 2001. Net cost and custodial activity are reported for the
years ended September 30, 2002 and 2001. Changes in net position,
budgetary resources, and financing are reported for the year ended
September 30, 2002.

These statements include the accounts of all funds under the Service s
control, which have been established to account for the resources of the
Service, as well as funds for the purpose of recording tax revenues and
refunds. They were prepared from the Service s accounting and financial
management systems in accordance with OMB Bulletin No. 01- 09, Form and
Content of Agency Financial Statements , and the Service s accounting
policies, which are summarized in this note.

C. Basis of Accounting

The accompanying financial statements are presented on a basis in
accordance with generally accepted accounting principles ( GAAP) . - 7 -

Internal Revenue Service Notes to the Financial Statements For the Years
Ended September 30, 2002 and 2001

Balance Sheet, Statement of Changes in Net Position

These statements are presented on the accrual basis of accounting. Under
the accrual method, revenues are recognized when earned, and expenses are
recognized when costs are incurred or goods or services are received,
without regard to receipt or payment of cash.

Statement of Net Cost

The statement of net cost presents the full costs incurred by the Service
in performing its mission, net of related exchange revenues. Full costs
include direct costs, indirect costs assigned in a manner that reflects
direct consumption of resources, and a proportionate share of other
indirect costs. Where practicable, indirect costs are assigned directly.
Where not practicable, they are allocated on a reasonable and consistent
basis. General and administrative expenses ( G & A) are included in
indirect costs. G & A includes costs for headquarters administration,
human resources, equal employment opportunity, education, procurement,
general legal services and other miscellaneous administrative services.

Program costs are aggregated across divisional lines into broad- based
cost centers - pre- filing, filing, compliance and administration of the
earned income tax credit- - described below. In general, these cost
centers encompass all costs within the span of their activities. However,
earned income tax credit costs are segregated from other pre- filing,
filing, and compliance activities and reported separately as costs of
administration of the earned income tax credit.

Exchange revenues include user fees from the public and reimbursable
revenue from other government agencies. They are reflected as offsetting
revenues against related program costs. User fees include general fund
receipts as well as receipts the Service is allowed to use as a financing
source for its operations.

The majority of user charges are fees for installment agreements, rulings
and determinations of tax- exempt status. Installment agreement fees are
set at an amount below full cost. Fees for certain rulings and
determinations are also set below full cost. Additionally, reimbursable
fees are set below full cost; these fees are based on incremental costs
incurred to provide services to other federal agencies.

Pre- Filing Taxpayer Assistance and Education Provides services to
taxpayers before returns are filed, to assist taxpayers in preparing
correct returns. Primary activities include interpretations, preparing and
disseminating tax publications and information, taxpayer education
programs, researching customer needs, pre- filing agreements and
determinations, and initiatives to promote electronic tax filing. Exchange
revenues include user fees from the pre- filing agreements and
determinations, letter rulings, and enrolled agent fees.

Filing and Account Services Performs accounts maintenance functions of
processing tax returns, recording tax payments, issuing refunds, and
maintaining taxpayer accounts. The scope extends to all tax returns and
taxpayer accounts regardless of type and method of filing. Program
activities also include providing field assistance in preparing tax
returns and supplying tax forms to the public.

Compliance Services Administers compliance activities after a return is
filed in order to identify and correct possible errors or underpayments.
This program includes field collection activities, document matching,
examination of returns, criminal investigation, and tax litigation.
Exchange revenues include installment agreement fees.

Administration of Earned Income Tax Credit ( EITC) Administers the EITC
program. It includes expanded customer service, public outreach,
enforcement, and research efforts to reduce claims and erroneous filings
associated with EITC. It comprises pre- filing, filing and account
services, and compliance activities. EITC payments actually refunded to
individuals or credited against other tax liabilities are not included in
program costs. - 8 -

Internal Revenue Service Notes to the Financial Statements For the Years
Ended September 30, 2002 and 2001

Statement of Budgetary Resources

The statement of budgetary resources is presented using the budgetary
basis of accounting. Budgetary accounting facilitates compliance with
legal constraints and controls over the use of federal funds. This
financial statement is in addition to the reports prepared by the Service
throughout the year pursuant to OMB directives for purposes of monitoring
and controlling the Service' s obligation and expenditure of budgetary
resources.

Statement of Financing

The statement of financing is presented using both an accrual and a
budgetary basis of accounting as a means to facilitate understanding of
the differences between the two accounting bases.

Statement of Custodial Activity

The statement of custodial activity is presented on the modified cash
basis of accounting. This method initially reports revenue in the
financial statements on the cash basis, which is then adjusted by the
change in net federal taxes receivable - - net of the change in refunds
payable- - during the current fiscal year. This adjustment effectively
converts the cash basis revenue and refunds to a full accrual amount. The
related distribution of all such collections to the Treasury is similarly
reported on the cash basis. It is then adjusted to the accrual basis by
the net change during the fiscal year in uncollected amounts due to
Treasury.

Refunds of taxes and interest are reported on the cash basis. Refunds
include payments of earned income tax credits ( EITC) and child care
credits, as well as overpayments of taxes.

D. Financing Sources and Exchange Revenue

The Service receives the majority of its funding through annual, multi-
year, and no- year appropriations that are available for use within
statutory limits for operating and capital expenditures. Appropriations
are recognized as financing sources when the related expenses are
incurred. The following are the different types of operating
appropriations:

Processing, Assistance, and Management

This appropriation provides funds for processing tax returns and related
documents; assisting taxpayers in the filing of their returns and in
paying taxes that are due; matching information returns with tax returns;
conducting internal audit reviews and internal security investigations;
and managing financial resources, rent, and utilities.

Tax Law Enforcement

The purpose of this appropriation is to provide funds for the examination
of tax returns, and the administrative and judicial settlement of taxpayer
appeals of examination findings. It also provides for issuing technical
rulings, monitoring employee pension plans, determining qualifications of
organizations seeking tax- exempt status, examining tax returns of exempt
organizations, enforcing statutes relating to detection and investigation
of criminal violations of the internal revenue laws, collecting unpaid
accounts, compiling statistics of income and compliance research, and
securing unfiled tax returns and payments.

Information Systems

This appropriation funds costs for data processing and information and
telecommunication support for the Service s activities, including
developmental information systems and operational information systems. The
operational systems are located in a variety of sites including the
Martinsburg Computing Center, the Detroit Computing Center, the Tennessee
Computing Center, and in district offices and service centers. - 9 -

Internal Revenue Service Notes to the Financial Statements For the Years
Ended September 30, 2002 and 2001

Other

These budgetary accounts consist of an aggregate of smaller multi-
functional funds that support the Service s mission to collect the proper
amount of tax and provide improved customer service to the taxpayer. The
Business Systems Modernization ( BSM) appropriation is the largest of
these funds and may be obligated as Congress approves expenditure plans.
Also included is the Earned Income Tax Credit appropriation that funds the
administration of the EITC program.

In addition, the Service incurs certain costs that are paid in total or in
part by other federal entities, such as pension costs administered by the
Office of Personnel Management and legal judgments paid by the Treasury
Judgment Fund. These constitute subsidized costs and are recognized by the
Service on its statement of changes in net position and statement of
financing as imputed financing sources equal to the cost paid by other
federal entities.

E. Fund Balance with Treasury and Cash

The fund balance with Treasury is the aggregate amount of funds in the
Service s accounts including appropriated funds from which the Service is
authorized to make expenditures and pay liabilities; as well as funds in
deposit, suspense, and clearing accounts. Generally, cash receipts and
disbursements are processed by the Treasury. Imprest funds are maintained
by Headquarters and field offices in commercial bank accounts.

F. Accounts Receivable, Net

Accounts receivable consists of amounts due from federal agencies, state
and local governments, and the public. The balance of accounts receivable
for reimbursable services includes both billed and unbilled receivables.
Unbilled accounts receivable are recorded, and reimbursable revenues are
recognized, as the services are performed and costs are incurred. The
unbilled receivables are later transferred to billed accounts receivable
when bills are rendered to the buying agencies. The allowance for
uncollectible accounts is based on an annual review of groups of accounts
by age and includes accounts receivable balances older than one year.

G. Advances

Advances to government agencies primarily represent funds paid to the
Treasury Working Capital Fund ( WCF) . Amounts in the fund are available
for expenses of operating and maintaining common administrative services
of Treasury that can be performed more economically as a centralized
service. Centralized services funded through the WCF for the Service
consist primarily of telecommunications services, payroll processing, and
depreciation of property and equipment owned by the WCF. Each quarter the
WCF allocates charges for these services to the Service based on its pro
rata share of usage. In accordance with established WCF procedures,
Treasury collects funds for these services in advance from Treasury
bureaus. The Service records the initial payments as advances and
subsequently recognizes expenses as quarterly statements are received.

In FY 1999 the Service recorded a one- time accounting adjustment to
capitalize telecommunications equipment owned by the WCF. These costs are
included in advances to government agencies as of September 30, 2002 and
September 30, 2001, and are amortized over the seven- year life of the
equipment. After FY 1999, further capitalization of WCF equipment was
discontinued. Subsequently, all WCF costs- - including depreciation of
equipment- - are reported as current year expenses.

The majority of advances to the public are for investigations and employee
travel advances, which are expensed upon receipt of employees expense
reports. - 10 -

Internal Revenue Service Notes to the Financial Statements For the Years
Ended September 30, 2002 and 2001

H. Property and Equipment

The net book values of Property and Equipment as of September 30, 2002 and
2001, consist of the following components:

General Property and Equipment acquired before October 1, 1999

The estimated net book value of ADP equipment, telecommunication
equipment, office equipment and furniture, investigative equipment, and
vehicles as of September 30, 1999, was derived based upon estimates of the
net book value of a statistically selected sample of assets, using
techniques prescribed by the Uniform Standards of Appraisal Practice.
These estimated net book values were then projected to the entire
population of assets. With the exception of small expendable computer
peripherals such as keyboards and cables, all property and equipment in
the categories described above and acquired before October 1, 1999 is
capitalized regardless of the dollar amount of individual assets.
Depreciation on these assets is calculated using the straight line method
and is based on the estimated net book values and projected remaining
useful lives of the assets as of September 30, 1999.

ADP and Telecommunication Equipment acquired after September 30, 1999

The method used by the Service to report the capitalized ADP and
telecommunication assets acquired after September 30, 1999 is described as
pooling. Under pooling, , all ADP and telecommunication equipment is
recorded at cost. Each fiscal year separate pools are established for each
class of ADP and telecommunication assets, as distinguished by the useful
lives of the assets. In FY 2002 and FY 2001, there are two pools- - one
for equipment with a useful life of three years, consisting of
microcomputers, related equipment, and software; the other for assets with
a useful life of seven years, consisting of supercomputers, mainframes,
minicomputers, telecommunications equipment and all related equipment and
software. ADP and telecommunications equipment includes all related
software, including commercial off- the- shelf software, except as
separately stated under Internal Use Software, discussed below. Small
computer peripherals are excluded from the pools. With these exceptions,
all other costs of ADP and telecommunication equipment acquired after
September 30, 1999 are accumulated regardless of the dollar value of
individual assets.

Depreciation on these assets is calculated using the straight- line method
over the estimated useful lives with a halfyear of depreciation taken in
the first and final years. Under the pooling concept, only disposals that
are material to the financial statements are recognized. The Service
performed an analysis of the FY 2002 and 2001 pools and determined that
disposals were not material to the financial statements.

Office Equipment and Furniture, Investigative Equipment, and Vehicles
acquired after September 30, 1999

The Service capitalizes office equipment and furniture, investigative
equipment, and vehicles acquired after September 30, 1999, with an
individual- asset acquisition cost of $ 5, 000 or more. Depreciation on
these assets is calculated using the straight- line method over the
estimated useful lives with a half- year of depreciation taken in the
first and final years. Useful lives are established as ten years for
office equipment and investigative equipment, eight years for furniture,
and five years for vehicles. Only disposals that are material to the
financial statements are recognized. The Service performed an analysis of
the FY 2002 and 2001 property and determined that disposals were not
material to the financial statements. - 11 -

Internal Revenue Service Notes to the Financial Statements For the Years
Ended September 30, 2002 and 2001

Major Systems

Prior to FY 2001 the Service capitalized certain costs of large- scale
computer software systems as major systems. Due to implementation of
Statement of Federal Financial Accounting Standards No. 10, Accounting for
Internal Use Software , the Service discontinued accumulation of costs in
the major systems category after September 30, 2000. Subsequently, such
costs are included in internal use software. Costs capitalized prior to
September 30, 2000 continue to be depreciated over the remaining useful
lives of the major systems.

The Service has ten systems it considers major systems as of September 30,
2002 and September 30, 2001. As of September 30, 2002 major systems
consisted largely of costs associated with re- engineering the Martinsburg
and Tennessee Computing Centers, known as the Mainframe Consolidation
project, and a system to convert paper tax documents and remittances into
electronic records, known as the Integrated Submission and Remittance
Processing System.

Major systems are defined as any system where the estimated development
costs are expected to exceed $ 20 million. Costs included in the major
systems category include direct operating costs for the design,
development, acquisition, and implementation of the major systems
software. Other costs associated with these major systems, such as
hardware, transportation and installation of hardware are included in the
property and equipment categories previously described. Costs associated
with preparation of facilities to house the systems are classified as
leasehold improvements.

Major systems are depreciated using the straight- line method over an
estimated useful life of seven years with a half- year of depreciation
taken in the first and final years. Major systems are disposed or net book
value is reduced to the extent they are considered impaired. During the
years ended September 30, 2002 and September 30, 2001 there were no
disposals of assets included in major systems. - 12 -

Internal Revenue Service Notes to the Financial Statements For the Years
Ended September 30, 2002 and 2001

Internal Use Software

In accordance with Statement of Federal Financial Accounting Standards No.
10 ( SFFAS No. 10 ) , Accounting for Internal Use Software , beginning in
FY 2001, the Service capitalizes all internal use software projects
recognized and authorized by management as major development projects.
Only projects with a projected lifetime design and development cost
greater than $ 7 million, and useful lives greater than one year, are
capitalized. In addition, projects must be recognized as major efforts by
the Core Business System Executive Steering Committee to be eligible for
capitalization.

As of September 30, 2002, the Service has 13 internal use software
projects, including deployed and work in process. Major deployed projects
include Customer Communications, a project to improve the customer service
telephone system. Major systems in process include Customer Account Data
Engine ( CADE) , a project to replace the IRS s master file for taxpayer
accounts, and Security and Technology Infrastructure Release ( STIR) , a
project to modernize and standardize the technical infrastructure
throughout the Service.

IRS capitalizes direct and indirect costs of internal use software
incurred in the development phase of a project as defined in the SFFAS No.
10 . Direct costs include direct salaries and benefits of IRS employees
assigned to the projects, consultant fees, and contracting costs. Direct
costs exclude maintenance contracts in effect at any time during
development or thereafter.

IRS applies overhead to internal use software projects using a three- year
average rate of overhead costs. In FY 2002 and prospectively, the overhead
rate is applied only to salaries and benefits of IRS employees directly
assigned to the internal use software projects. In accordance with SFFAS
No. 10 , costs incurred for the development phase of a project are
capitalized, while

costs incurred for design ( prior to the development phase) and operations
( after the development phase) are expensed. The design phase, defined by
Standard No. 10, includes conceptual formulation of alternatives,
determination and testing of alternatives, determination of existence of
needed technology, and final selection of alternatives. The development
phase includes developing the software configuration and interfaces,
coding, installation of hardware and software, and testing. The
operational phase begins upon successful completion of testing.

Internal use software s capitalized costs are accumulated in work in
process until final acceptance and testing have been successfully
completed. Once completed, the costs are transferred to depreciable
property. Internal use software has an estimated useful life of 7 years
with no residual value, and is depreciated using the straight- line method
with a half- year convention in the first and final years.

In accordance with SFFAS No. 10 , disposals are recognized when software
is determined to be obsolete or nonfunctional. The IRS treats terminated
projects and or subprojects as 100% obsolete. Obsolete projects are
adjusted to reduce both the asset and accumulated depreciation accounts,
and record any losses as the result of the disposal.

Leasehold Improvements

This category of assets is shown at historical cost less depreciation.
Depreciation on these assets is calculated using the straight- line method
with ten years as the estimated useful life of the improvements with a
half- year of depreciation taken in the first and final years. For
projects initiated before October 1, 1999, a $ 50,000 threshold was used
to identify projects capitalized as leasehold improvements; all leasehold
improvement projects initiated after September 30, 1999 are capitalized
regardless of cost. Disposals are not recorded for leasehold improvements.
- 13 -

Internal Revenue Service Notes to the Financial Statements For the Years
Ended September 30, 2002 and 2001

I. Capital Lease Liability

Certain computer equipment, mail sorters, copiers and other equipment are
leased under Lease- To- Ownership- Plans ( LTOP) . The original terms of
these LTOPs provide for 36 monthly payments for computers, and from 36 to
60 months for other equipment. Under each LTOP, the equipment is owned as
of the last monthly payment. These LTOP leases are classified as capital
leases. The liability reported represents the lesser of the net present
value of future lease payments required by the terms of the capital leases
or fair market value. The capital lease liability for computers and other
equipment is included in funded liabilities.

In fiscal year 2002, the Service exercised its option to purchase computer
servers and retired all remaining capital lease liabilities on this
equipment.

In accordance with SFFAS No. 10 , capital lease liability also includes
amounts for computer software leased under software licensing agreements.
These licensing agreements provide for payments over periods ranging from
three to six years. The liability reported represents the net present
value of future lease payments. The capital lease liability for software
licenses is generally included in Liabilities Not Covered by Budgetary
Resources. There is an exception for lease agreements subject to a
cancellation clause in the lease. The liability is treated as fully funded
up to the amount of the cancellation penalty. As of September 30, 2002 and
2001, there were no capital leases with cancellation clauses.

J. Permanent and Indefinite Funds

The Service uses a special class of funds, designated as permanent and
indefinite, to disburse tax refund principal and related interest. These
permanent and indefinite funds are not subject to budgetary ceilings set
by Congress during the annual appropriation process. Because Congress
permanently funds tax refunds from a budgetary standpoint, tax refunds
payable at year- end are fully funded. The asset Due from Treasury
designates this approved funding to pay year- end tax refund liabilities,
which are reflected in the funds used for refund of federal taxes on the
statement of custodial activity along with tax refund payments for the
year.

Although funded through the appropriation process, refund activity is
reported as a custodial activity of the Service. This presentation is
appropriate because refunds are, in substance, a custodial revenue-
related activity in that they are a direct result of taxpayer overpayments
of their tax liabilities. Federal tax revenue received from taxpayers is
not available for use in the operation of the Service and is not reported
on the statements of net cost. Likewise, the resultant refunds of
overpayments are not available for use by the Service in operations.
Consequently, to present refunds as an expense of the Service on the
statements of net cost with related appropriations used would be
inconsistent with the reporting of the related federal tax revenue and
would materially distort the costs incurred by the Service in meeting its
strategic objectives. - 14 -

Internal Revenue Service Notes to the Financial Statements For the Years
Ended September 30, 2002 and 2001

K. Tax Assessments and Abatements

Under the Internal Revenue Code Section 6201, the Commissioner of the IRS,
as delegated by the Secretary of the Treasury, is authorized and required
to make inquiries, determinations, and assessments of all taxes that have
been imposed and accruing under any internal revenue law but have not been
duly paid ( including interest, additions to the tax, and assessable
penalties) . Unpaid assessments result from taxpayers filing returns
without sufficient payments; as well as from the Service s enforcement
programs, such as examination, under- reporter, substitute for return, and
combined annual wage reporting.

The Commissioner of the IRS also has authority to abate the paid or unpaid
portion of an assessed tax, interest, and penalty. Abatements occur for a
number of reasons and are a normal part of the tax administration process
( Abatements may be allowed for a qualifying corporation that claimed a
net operating loss that created a credit that can be carried back to
reduce a prior year s tax liability, amended tax returns, correction of an
assessment from an enforcement program, taxes discharged in bankruptcy,
accepted offers in compromise, penalty abatements for reasonable cause,
contested assessments made due to mathematical or clerical errors, and
assessments contested after the liability has been satisfied) . Abatements
may result in claims for refunds or a reduction of the unpaid assessed
amount.

L. Federal Taxes Receivable

Federal taxes receivable and the corresponding liability, Due to Treasury,
are not accrued until related tax returns are filed or assessments made by
IRS and agreed to by either the taxpayer or the court and prepayments
netted against liabilities. Accruals are made to reflect penalties and
interest on taxes receivable through the balance sheet date.

Taxes receivable consist of unpaid assessments ( taxes and associated
penalties and interest) due from taxpayers for which the Service can
support the existence of a receivable through taxpayer agreement, such as
filing of a tax return without sufficient payment, or a court ruling in
favor of the Service. Taxes receivable are shown on the balance sheet net
of an allowance for doubtful accounts. The allowance for doubtful accounts
reflects an estimate of the portion of total taxes receivable deemed to be
uncollectible.

Compliance assessments are unpaid assessments, for which neither the
taxpayer nor a court has affirmed that the taxpayer owes amounts to the
Federal Government. Examples include assessments resulting from an IRS
audit or examination in which the taxpayer does not agree with the
results. These amounts are not reported on the balance sheet; however,
statutory provisions require that these accounts be maintained until the
statute for collection expires.

Write- offs consist of unpaid assessments for which the Service does not
expect further collections due to factors such as taxpayers bankruptcy,
insolvency, or death. These amounts are also not reported on the balance
sheet; however, statutory provisions require that these accounts be
maintained until the statute for collection expires. - 15 -

Internal Revenue Service Notes to the Financial Statements For the Years
Ended September 30, 2002 and 2001

Note 2. Fund

Fund balance with Treasury and cash as of September 30, 2002 and 2001,
consist of the following:

Balance with Treasury and

Fund Balance and Cash 2002 2001 Cash

( In Millions)

Appropriated and other funds $ 1, 648 $ 2, 067 Imprest funds 4 3

Fund Balance with Treasury and Cash $ 1, 652 $ 2, 070

Status of Fund Balance with Treasury 2002 2001

Unobligated balances - Available $ 217 $ 196 - Unavailable 225 245
Obligated balances not yet disbursed 1,225 1,635 Other funds ( 19) ( 9)

Fund Balance with Treasury $ 1, 648 $ 2, 067 Available unobligated
balances represent no- year and multi- year appropriations that can be
obligated after September 30, 2002 and September 30, 2001. Unavailable
unobligated balances are expired appropriations no longer available to
incur new obligations. Obligated balances not yet disbursed include
undelivered orders unpaid of $ 594 million and $ 921 million as of
September 30, 2002 and 2001, respectively, as shown in note 12, Obligated
balances. Other funds primarily consist of suspense, deposit, and clearing
funds.

In FY 2002 and FY 2001, the $ 1,036 million and $ 1, 362 million totals of
unobligated balances and undelivered orders are different than the $ 1,039
million and $ 1, 380 million balances of unexpended appropriations,
respectively, as shown on the balance sheet. These differences result from
user fees, undelivered orders paid,

, and receivables with the public. User fees that have not yet been
transferred to appropriations are included in fund balance but do not
represent unexpended appropriations. Undelivered orders paid and
receivables from the public are included in unexpended appropriations but
not in fund balance.

The Business Systems Modernization ( BSM) fund represents $ 354 million
and $ 270 million of the appropriated fund balance as of September 30,
2002 and 2001, respectively. BSM funds can only be obligated pursuant to
an expenditure plan approved by Congress. As of September 30, 2002,
Congress has approved a cumulative amount of $ 968 million in BSM
appropriations received, of which $ 811 million has been obligated.
Unobligated balances include $ 171 million and $ 78 million of the BSM
fund as of September 30, 2002 and 2001, respectively. As of September 30,
2002, $ 157 million was approved for expenditure. As of September 30,
2001, the entire $ 78 million was approved for expenditure.

Note 3.

Accounts receivable and allowances for uncollectible accounts as of
September 30, 2002 and 2001, consist of the

Accounts

following:

Receivable, 2002 2001

Net Intra-

With the Intra

With the

( In Millions)

Governmental Public

Governmental Public

Accounts receivable $ 7 $ 2 $ 35 $ 5 Allowance for uncollectible accounts
- ( 1) ( 2) ( 2)

Accounts Receivable, Net $ 7 $ 1 $ 33 $ 3 - 16 -

Internal Revenue Service Notes to the Financial Statements For the Years
Ended September 30, 2002 and 2001

Note 4.

Other assets, as of September 30, 2002 and 2001, consist of the following:

Other Assets

( In Millions)

2002 2001 Intra-

With the Intra-

With the Governmental

Public Governmental

Public

Other custodial assets $ - $ 74 $ - $ 191 Federal tax lien revolving fund
- 4 - 4

Total Other Assets $ - $ 78 $ - $ 195 Other custodial assets primarily
represent voluntary deposits received from taxpayers, pending application
of the funds to unpaid tax assessments. This category also includes seized
monies of $ 1 million and $ 2 million as of September 30, 2002 and 2001,
respectively, which are held pending the results of criminal
investigations. As described in Note 13, other custodial assets are
classified as Non- Entity Assets and are offset by an equal liability in
other custodial liabilities.

The Federal tax lien revolving fund primarily consists of real property
held for resale to the public. In accordance with Section 7425 of the
Internal Revenue Code and Section 2410 of Title 28, the revolving fund can
be used to redeem real property foreclosed upon by a holder of a lien,
which is superior to the tax lien. Real property is redeemed when the
Service pays the lien holder the amount bid at sale plus interest and
certain post- sale expenses. The Service may then sell the property,
reimburse the fund, and apply the net proceeds to the outstanding tax
obligation.

Note 5.

Federal taxes receivable ( gross) was $ 87 billion and $ 80 billion as of
September 30, 2002 and 2001, respectively,

Federal Taxes

and consisted of tax assessments, penalties, and interest that were not
paid or abated, and which were agreed to by

Receivable,

the taxpayer and the Service, or upheld by the courts.

Net

Federal taxes receivable ( net) equaled $ 20 billion and $ 20 billion as
of September 30, 2002 and 2001, respectively, and is the portion of
federal taxes receivable ( gross) estimated to be collectible. It is based
on projections of collectibility from a statistical sample of taxes
receivable. An allowance for doubtful accounts of $ 67 billion and $ 60
billion was established in FY 2002 and FY 2001, respectively, for the
difference between the gross federal taxes receivable and the portion
estimated to be collectible. Due to Treasury is the offsetting liability
to federal taxes receivable, representing amounts to be transferred to
Treasury when collected. - 17 -

Internal Revenue Service Notes to the Financial Statements For the Years
Ended September 30, 2002 and 2001

Note 6.

Property and equipment as of September 30, 2002 and 2001 is shown in the
schedule below. Net Book Value is

Property and

stated net of accumulated depreciation. The cost basis for fiscal years
2002 and 2001 is $ 2, 648 and $ 2, 095,

Equipment

respectively. Accumulated depreciation for fiscal years 2002 and 2001 is $
1, 102 and $ 714, respectively.

( In Millions)

Net Net Book

Net Book Useful

Book Value/ Accumulated

Value Value

Category Life

Cost Depreciation

9/ 30/ 2002 9/ 30/ 2001

ADP assets 3 to 7 Years $ 1, 521 $ ( 759) $ 762 $ 681 Furniture and non-
ADP equipment 8 to 10 Years 55 ( 21) 34 42 Investigative equipment 10
Years 11 ( 6) 5 7 Vehicles 5 Years 81 ( 53) 28 31

1, 668 ( 839) 829 761 Major systems 7 Years 422 ( 152) 270 331 Internal
use software 7 Years 36 ( 6) 30 24 Internal use software work in process
181 - 181 52 Leasehold improvements 10 Years 341 ( 105) 236 213

Total Property and Equipment $ 2,648 $ ( 1, 102) $ 1, 546 $ 1, 381

Prior to Fiscal Year 2001, the Service captured the costs of major systems
consulting and contractual services in the category Major systems . These
costs consist largely of the Mainframe Consolidation project the
Integrated Submission and Remittance Processing System ( ISRP) . Mainframe
Consolidation is a project to re- engineer mainframe computer systems at
Martinsburg and Tennessee Computing Centers. ISRP is a system to convert
paper tax documents and remittances into electronic records.

Beginning in Fiscal Year 2001, the costs of major software projects are
captured in Internal Use Software and Internal use software work in
process . As of September 30, 2002, major projects in Internal use
software included Customer Communications, a project to improve the
customer service telephone system. As of September 30, 2002, Internal use
software work in process, , includes Customer Account Data Engine ( CADE)
and Security and Technology Infrastructure Release ( STIR) . CADE is a
project to replace the Service s master file for taxpayer accounts. STIR
is a project to modernize and standardize the technical infrastructure
throughout the Service.

In FY 2002, internal use software - work in process has been reduced for
impairment in the amount of $ 6 million. This represents 100% of the costs
of the Customer Relationship Management Exam project due to
discontinuation of the project. - 18 -

Internal Revenue Service Notes to the Financial Statements For the Years
Ended September 30, 2002 and 2001

Note 6.

The Net Book Value/ Cost column for property and equipment represents the
combination of ( 1) net book value of

Property and

certain property and equipment acquired before October 1, 1999, derived
from estimates, as discussed in Note 1;

Equipment

and ( 2) the actual cost of other property and equipment. The net book
value of property and equipment derived

( In Millions)

from estimates- - item ( 1) above- - consists of the following: (
Continued)

Net Book Net Book

Useful Net

Accumulated Value

Value Category

Life Book Value

Depreciation 9/ 30/ 2002

9/ 30/ 2001

ADP assets 3 to 7 Years $ 668 $ ( 502) $ 166 $ 263 Furniture and non- ADP
Equipment 8 to 10 Years 16 ( 7) 9 11 Investigative equipment 10 Years 11 (
6) 5 7 Vehicles 5 Years 48 ( 44) 4 15

Total Property and Equipment $ 743 $ ( 559) $ 184 $ 296 - 19 -

Internal Revenue Service Notes to the Financial Statements For the Years
Ended September 30, 2002 and 2001

Note 6.

Property and equipment acquired through capital leases are included in the
categories below. Disclosures

Property and

concerning associated capital lease liabilities are provided in Note 9.

Equipment

( In Millions)

Net Book Net Book

Useful Accumulated

Value Value

( Continued)

Category Life Cost

Depreciation 9/ 30/ 2002

9/ 30/ 2001

ADP assets Mainframe Consolidation 7 years - - - 52 ADP Equipment 7 years
- - - 7 Software licenses 3 to 7 Years 215 ( 59) 156 108

$ 215 $ ( 59) $ 156 $ 167 Equipment Mail sorters 10 Years 14 ( 5) 9 14
Photocopiers 10 Years 6 ( 1) 5 3

20 ( 6) 14 17

Totals $ 235 $ ( 65) $ 170 $ 184 Note 7.

Accounts payable and accrued expenses as of September 30, 2002 and 2001,
consist of the following:

Accounts Payable and

2002 2001 Accrued

Intra- With the

Intra- With the

Expenses Governmental

Public Governmental

Public

( In Millions)

Accounts payable $ - $ 51 $ - $ 27 Accrued expenses 120 295 43 301 Accrued
payroll and benefits 22 129 46 307

Total Accounts Payable and Accrued Expenses $ 142 $ 475 $ 89 $ 635 - 20 -

Internal Revenue Service Notes to the Financial Statements For the Years
Ended September 30, 2002 and 2001

Note 8.

Other liabilities as of September 30, 2002 and 2001, consist of the
following:

Other Liabilities

2002 2001

( In Millions) Intra- With the

Intra- With the

Governmental Public

Governmental Public

Workers compensation $ 89 $ 506 $ 85 $ 513 Accrued annual leave - 382 -
367 Suspense 1 - ( 4) - Other custodial liabilities - 74 - 191

Total Other Liabilities $ 90 $ 962 $ 81 $ 1,071 Workers compensation is
paid to employees injured on the job or incurring work- related illnesses,
as required by the Federal Employees Compensation Act ( Act) . The Act
provides income, medical cost protection, and death benefits to covered
federal civilian employees and their beneficiaries. The program is
administered by the U. S. Department of Labor, which initially pays valid
claims and subsequently seeks reimbursement from federal agencies. The
liability of $ 595 million at September 30, 2002 includes a current
portion of $ 89 million and estimated future costs of $ 506 million. As of
September 30, 2001, the liability of $ 598 million includes a current
portion of $ 85 million and estimated future costs of $ 513 million.
Estimated future costs have been actuarially determined, and are regarded
as a liability to the public because neither the costs nor reimbursement
have been recognized by the Department of Labor. Workers Compensation is
included in Liabilities Not Covered by Budgetary Resources, as described
in Note 14.

Accrued annual leave consists of employees unpaid leave balances at
September 30, 2002 and 2001, and reflects wage rates in effect at fiscal
year end. Accrued annual leave is included in Liabilities Not Covered by
Budgetary Resources, as described in Note 14.

Other custodial liabilities ( the offsetting liability to other custodial
assets) primarily consist of liabilities to taxpayers for deposits pending
application of the funds to outstanding tax deficiencies and liability for
seized monies. - 21 -

Internal Revenue Service Notes to the Financial Statements For the Years
Ended September 30, 2002 and 2001

Note 9.

The capital lease liability as of September 30, 2002, is as follows:

Leases

( In Millions)

2006 and Total 2003 2004 2005

Beyond

Copiers and other 3 1 1 1 Software licenses 166 60 54 30 22

Total Lease Obligations $ 169 $ 61 $ 55 $ 31 $ 22 Less: Interest ( 11)

Present Value of Lease Payments $ 158 The capital lease liability as of
September 30, 2001, is as follows:

2005 and Total 2002 2003 2004

Beyond

Mail sorters 11 6 5 - Copiers and other 10 4 3 3 Software licenses 124 39
40 33 12

Total Lease Obligations $ 145 $ 49 $ 48 $ 36 $ 12 Less: Interest ( 20)

Present Value of Lease Payments $ 125 In fiscal years 2002 and 2001,
certain computer equipment, mail sorters, copiers and other equipment are
leased under Lease- To- Ownership- Plans ( LTOPs) . The original terms of
these LTOPs provide for 36 monthly payments for computers, and from 36 to
60 monthly payments for other equipment. Under each LTOP, the equipment is
owned as of the last monthly payment. Interest rates range from 3 to 10
percent. In fiscal year 2002, the Service exercised its option to purchase
computer servers in the amount of $ 5 million and retire all remaining
capital lease liabilities on this equipment.

Capital lease liabilities for equipment is included in funded liabilities.
Prior to fiscal year 2001, capital lease liabilities for equipment was
included in Liabilities Not Covered by Budgetary Resources. As of
September 30, 2002, the Service had $ 2 million in funded capital lease
liabilities and $ 156 million in Liabilities Not Covered by Budgetary
Resources. As of September 30, 2001, the Service had $ 10 million in
funded capital lease liabilities and $ 115 million in Liabilities Not
Covered by Budgetary Resources.

Capital lease treatment is accorded to computer software leased under
software licensing agreements. These licensing agreements provide for
payments over periods ranging from three to six years. The liability
reported represents the net present value of future lease payments, and is
generally included in Liabilities Not Covered by Budgetary Resources, with
the exception of software lease agreements subject to a cancellation
clause in the lease. Cancellation clauses are treated as fully funded
liabilities. As of September 30, 2002, the Service had no funded
cancellation clauses on software licenses.

The Service leases office space, vehicles and equipment under annual
operating leases. These leases are cancelable or renewable on an annual
basis at the option of the Service. They do not impose binding commitments
on the Service for future rental payments on leases with terms longer than
one year. - 22 -

Internal Revenue Service Notes to the Financial Statements For the Years
Ended September 30, 2002 and 2001

Note 10.

As of September 30, 2002 and 2001, the Service provided an accrual for
contingent losses of $ 9 million and

Contingencies

$ 6 million, respectively, for pending and threatened legal matters, that,
in the opinion of Chief Counsel, are considered probable. No additional
losses are considered probable by Chief Counsel. Of these amounts, certain
settlements and awards may be payable from the Treasury Judgment Fund in
accordance with 31 U. S. C. 1304. For fiscal years 2002 and 2001, of the $
9 million and $ 6 million, respectively, accrued by the Service, all is
estimated to be payable from the Treasury Judgment Fund for settlements
and awards relating to these claims.

The Service does not have contractual commitments for payments on
obligations related to canceled appropriations.

Note 11.

Appropriations received reported in the statement of budgetary resources
include $ 73 million in user fees

Appropriations

received from the public for services provided and retained by the agency
to reduce its net cost of operations.

Received

These amounts are also reported in the statement of financing as part of
exchange revenue not in the budget.

Note 12.

Obligated balances as of September 30, 2002 and 2001 in the Statements of
Budgetary Resources and

Obligated

Financing are as follows:

Balances

( In Millions)

2002 2001

Budgetary accounts receivable 6 31 Budgetary accounts payable ( 637) (
745) Undelivered orders unpaid ( ( 594) ( 921)

$ ( 1, 225) $ ( 1, 635)

Note 13.

Non- entity assets arise from the Service s custodial duty to collect
taxes, disburse tax refunds and maintain

Non- entity

proper accounting for these activities in the books and records of the
Service. Non- entity assets as of

Assets

September 30, 2002 and 2001, consist of the following: ( In Millions)

2002 2001 Intra-

With the Intra-

With the Governmental

Public Governmental

Public

Due from Treasury $ 1, 287 $ - $ 1, 419 $ - Federal taxes receivable, net
of allowance for doubtful accounts - 20, 000 - 20, 000 Other custodial
assets - 74 - 191

Due from Treasury represents tax refunds due to taxpayers but not
disbursed as of September 30, 2002 and 2001.

Federal taxes receivable are transferred to Treasury upon receipt. An
amount equal to federal taxes receivable has been recognized as an
offsetting intragovernmental liability Due to Treasury. Federal taxes
receivable is described in more detail in Note 5.

Other custodial assets, also discussed in Note 4, primarily relate to the
deposits received from taxpayers, pending application of the funds to
unpaid tax assessments and seized monies. - 23 -

Internal Revenue Service Notes to the Financial Statements For the Years
Ended September 30, 2002 and 2001

Note 14.

Liabilities not covered by budgetary resources as of September 30, 2002
and 2001, consist of the following:

Liabilities Not Covered by

2002 2001 Budgetary

Intra- With the

Intra- With the

Resources Governmental

Public Governmental

Public

( In Millions)

Workers compensation $ 89 $ 506 $ 85 $ 513 Accrued annual leave - 382 -
367 Contingencies - 9 - 6 Capital lease liability - 156 - 115

Liabilities not covered by budgetary resources are liabilities that are
not funded by direct budgetary authority and result from the receipt of
goods and services, or the occurrence of eligible events, for which
appropriations, revenues, or other financing sources necessary to pay the
liabilities have not yet been made available through Congressional
appropriation. See Note 8 for further description of workers compensation
and accrued annual leave, Note 9 for capital lease liability and Note 10
for contingencies.

Note 15.

Statement of Federal Financial Accounting Standards No. 7 ( SFFAS No. 10 )
, Accounting for Revenue and Other

Comparison of

Financing Sources and Concepts for Reconciling Budgetary and Financial
Accounting, calls for explanations of

Statement of

material differences between budgetary resources available, status of
those resources and outlays as presented in

Budgetary

the statement of budgetary resources to the related actual balances
published in the Budget of the United States

Resources and

Government . However, the Budget of the United States Government has not
yet been published. The Budget of

the President s

the United States Government is scheduled for publication in January 2003
and will be available through OMB.

Budget

Accordingly, information required for such disclosure is not available at
the time of publication of these financial statements. - 24 -

Internal Revenue Service Notes to the Financial Statements For the Years
Ended September 30, 2002 and 2001

Note 16.

The Service transfers total tax collections to the U. S. Treasury.
Collection activity, by financial statement line

Collections of

item for the fiscal year ended September 30, 2002 and 2001, and by tax
year for fiscal year ended September 30,

Federal Tax

2002:

Revenue

( In Billions)

Collections Collections

Tax Year Received

Received 2002 2001 2000 Prior Years

FY 2002 FY 2001

Individual income, FICA/ SECA, and other

$ 1, 105* $ 584

$ 15 $ 10

$ 1, 714 $ 1, 844 Corporate income

113* * 89

1 8

211 187 Excise

38 14

1 2 52

52 Estate and gift

4 24

27 29 Railroad retirement

1 5

5 Federal unemployment

5 2

- -

7 7

Total $ 1, 265 $ 714 $ 17 $ 20 $ 2, 016 $ 2, 124

63% 35% 1% 1% 100% * Includes other collections of $ 538 million. * *
Includes tax year 2003 corporate income tax receipts of $ 5 billion.

In FY 2002, Individual income, FICA/ SECA, and other taxes include $ 55
billion in payroll taxes collected from other federal agencies. Of this
amount, $ 11 billion represents the portion paid by the employers.

Note 17.

Refund activity, broken out similarly to collection activity by financial
statement line item for the fiscal years

Federal Tax

ended September 30, 2002 and 2001, and by tax year for fiscal year ended
September 20, 2002:

Refund Activity

Refunds Refunds

( In Billions)

Tax Year Disbursed

Disbursed 2002 2001 2000 Prior Years

FY 2002 FY 2001

Individual income, FICA/ SECA, and other

$ 1 $ 194

$ 12 $ 5

$ 212 $ 211

Corporate income 2

16 14

35 67

38 Excise

1

1

1 Estate and gift

1

1

1 Railroad retirement

Federal unemployment -

- -

- -

-

Total $ 3

$ 211 $ 27

$ 40 $ 281

$ 251

1% 75% 10% 14% 100% Individual income, FICA/ SECA, and other refund
amounts include EITC and child tax credit refunds. In FY 2001, Refunds
Disbursed included $ 36 billion in special tax rebates as required by the
Economic Growth and Tax Relief Reconciliation Act ( Public Law 107- 16) .
- 25 -

Internal Revenue Service Notes to the Financial Statements For the Years
Ended September 30, 2002 and 2001

Note 18. Budget Functional Classification

Budget

Gross cost and earned revenue for the Service are classified under the
budget functional classification of General

Functional

Government under the President s budget. Gross cost and earned revenue are
categorized as follows:

Classification

( In Millions)

Intragovernmental With the Public Total 2002 2001 2002 2001 2002 2001

Gross Cost $ 2, 995 $ 2, 161 $ 7, 305 $ 7, 373 $ 10, 300 $ 9, 534 Earned
Revenue ( 103) ( 109) ( 160) ( 127) ( 263) ( 236) Net Cost

$ 2, 892 $ 2, 052 $ 7, 145 $ 7, 246 $ 10, 037 $ 9, 298

Note 19.

Permanently not available in the Budgetary Resources section of the
Statement of Budgetary Resources comprises

Budgetary

rescissions of budget authority of $ 42 million and canceled
appropriations of $ 61 million. Rescissions and

Rescissions

canceled appropriations are also reported in the statement of changes in
net position. Rescissions include $ 17 million under Public Law 107- 206,
$ 22 million under Public Law 106- 554, and $ 3 million under Public Law
103- 329. Public Law 106- 554 and Public Law 103- 329 reappropriated $ 24
million to current multi- year and no- year appropriations.

Note 20.

The Office of Management and Budget apportions the Service s budgetary
resources by fiscal year under

Obligations

apportionment Category B. In fiscal year 2002, the Service incurred $ 9,
614 million in obligations funded by direct

Incurred

appropriations and $ 137 million funded by reimbursable revenue and
transfers from the Treasury Asset Forfeiture Fund.

Note 21.

Spending authority from offsetting collections as of September 30, 2002 in
the Statements of Budgetary Resources

Spending

and Financing is as follows:

Authority from

Reimbursable revenue $ 126

Offsetting

Receipts for Tax Lien Revolving Fund 5

Collections

Refunds from vendors 22

( In Millions)

Treasury Asset Forfeiture Fund 11

$ 164 - 26 -

Supplemental and Other Accompanying Information

Internal Revenue Service Supplemental Information - Unaudited For the
Years Ended September 30, 2002 and 2001

Other Claims

Management has estimated amounts that may be paid out as other claims for
tax refunds. This estimate

for Refund

represents an amount ( principal and interest) that may be paid for claims
pending judicial review by the Federal courts or, internally, by Appeals.
In FY 2002, the total estimated payout ( including principal and interest)
for claims pending judicial review by the Federal courts is $ 4. 7 billion
and by Appeals is $ 8. 4 billion. In FY 2001, the total estimated payout (
including principal and interest) for claims pending judicial review by
the Federal courts is $ 7. 7 billion and by Appeals is $ 13.6 billion.
Although these refund claims have been deemed to be probable, they do not
meet the criteria in SFFAS No. 5 for reporting the amounts in the balance
sheet or for disclosure in the notes to the financial statements. However,
they meet the criteria in SFFAS No. 7 for inclusion as supplemental
information. To the extent judgments against the government in these cases
prompt other similarly situated taxpayers to file similar refund claims,
these amounts could become significantly greater.

Federal Taxes

In accordance with SFFAS No. 7, some unpaid assessments do not meet the
criteria for financial statement

Receivable,

recognition as discussed in Note 1 to the financial statements. Although
compliance assessments and write- offs

Net

are not considered receivables under federal accounting standards, they
represent legally enforceable claims of

( In Billions )

the IRS - acting on behalf of the federal government. There is, however, a
significant difference in the collection potential of these categories.

The components of the total unpaid assessments and derivation of net
federal taxes receivable at September 30, 2002 and 2001 were as follows:

2002 2001

Total unpaid assessments $ 249 $ 239 Less: Compliance assessments ( 25) (
22)

Write- offs ( 137) ( 137) Gross Federal Taxes Receivable 87 80 Less:
Allowance for doubtful accounts ( 67) ( 60)

Federal Taxes Receivable, Net $ 20 $ 20 The Service cannot reasonably
estimate the amount of allowance for doubtful accounts pertaining to its
compliance assessments, and thus cannot determine their net realizable
value or the value of the pre- assessment work- in- process.

To eliminate double- counting, the compliance assessments reported above
exclude trust fund recovery penalties, totaling $ 13 billion and $ 14
billion as of September 30, 2002 and 2001, respectively, assessed against
officers and directors of businesses who were involved in the non
remittance of federal taxes withheld from their employees. The related
unpaid assessments of those businesses are reported as taxes receivable or
write- offs, but the Service may also recover portions of those businesses
unpaid assessments from any and all individual officers and directors
against whom a trust fund recovery penalty is assessed.

Earned

The EITC was originally authorized by the Tax Reduction Act of 1975 (
Public Law 94- 12) and made permanent

Income Tax

by the Revenue Act of 1978 ( Public Law 95- 600) . The EITC is a special
credit for taxpayers who work and

Credit

whose earnings fall below the established allowance ceiling. Qualified
taxpayers can receive partial credit in advance in each paycheck. In
fiscal year 2002, the Service issued $ 27. 8 billion in EITC refunds, of
which $ 66 million was applied to advance EITC. In fiscal year 2001, the
Service issued $ 26. 1 billion in EITC refunds, of which $ 72.0 million
was applied to advance EITC. An additional $ 4. 7 billion and $ 5. 1
billion of the EITC was applied to reduce taxpayer liability for fiscal
years 2002 and 2001, respectively. - 27 -

Internal Revenue Service Supplemental Information - Unaudited For the
Years Ended September 30, 2002 and 2001

Intra- Fiscal Year 2002

Governmental Assets

Advances to

( In Millions)

Fund Balance Due from

Accounts Government

Agency with Treasury

Treasury Receivable, Net

Agencies

Treasury $ 1, 648 $ 1, 287 $ 6 $ 126 Other - - 1

Total $ 1, 648 $ 1, 287 $ 7 $ 126

Fiscal Year 2001 Advances to Fund Balance

Due from Accounts

Government Agency

with Treasury Treasury

Receivable, Net Agencies

Treasury $ 2, 067 $ 1, 419 $ 27 $ 128 Other - - 6

Total $ 2, 067 $ 1, 419 $ 33 $ 128

Intra- Fiscal Year 2002

Governmental Liabilities

Accrued Payroll

( In Millions)

Accrued and

Other Agency Due to Treasury

Expenses Benefits

Liabilities

Treasury $ 20, 000 $ 6 $ - $ - U. S. Postal Service - 20 - - Department of
Labor - 11 - 89 Office of Pers. Mgmt - 2 18 - Other - 81 4 1

Total $ 20, 000 $ 120 $ 22 $ 90

Fiscal Year 2001 Accrued Payroll Accrued

and Other

Agency Due to Treasury Expenses

Benefits Liabilities

Treasury $ 20, 000 $ 6 $ - $ - U. S. Postal Service. - 20 - Department of
Labor - 8 - 85 Office of Pers. Mgmt - 1 46 Other - 8 - ( 4)

Total $ 20, 000 $ 43 $ 46 $ 81 - 28 -

Internal Revenue Service Supplemental Information - Unaudited For the Year
Ended September 30, 2002

Schedule of Budgetary Resources by

Business Major

Processing Systems

Budget Assistance &

Tax Law Information

Modernization Accounts

Management Enforcement

Services and Other Total

( In Millions)

Budgetary Resources

Budget authority :

Appropriations received $ 3, 828 $ 3, 549 $ 1, 579 $ 626 $ 9, 582 Net
transfers 17 20 33 ( 70) Unobligated balance beginning of period 174 64 92
111 441 Spending authority from offsetting collections 35 102 22 5 164
Recoveries of prior year obligations 42 24 25 18 109 Permanently not
available ( 42) ( 25) ( 33) ( 3) ( 103)

Total Budgetary Resources $ 4, 054 $ 3, 734 $ 1, 718 $ 687 $ 10,193 Status
of Budgetary Resources

Obligations incurred $ 3, 934 $ 3, 694 $ 1, 641 $ 482 $ 9, 751 Unobligated
balance - available 21 1 21 174 217 Unobligated balance not available 99
39 56 31 225

Total Status of Budgetary Resources $ 4, 054 $ 3, 734 $ 1, 718 $ 687 $
10,193

Relationship of Obligations to Outlays

Obligated balance, net, beginning of period 556 299 559 221 1,635
Obligated balance, net,

end of period ( 439) ( 164) ( 417) ( 205) ( 1, 225) Outlays: Disbursements
4,011 3,827 1,759 480 10, 077 Collections ( 36) ( 125) ( 23) ( 5) ( 189)

Net Outlays $ 3, 975 $ 3, 702 $ 1, 736 $ 475 $ 9, 888 - 29 -

Internal Revenue Service Other Accompanying Information - Unaudited For
the Years Ended September 30, 2002 and 2001

Child Tax

The child tax credit was originally authorized by the Taxpayer Relief Act
of 1997 ( Public Law 105- 34) . The

Credit

child tax credit is a special credit for taxpayers who work, whose
earnings fall below the established allowance ceiling, and who have a
qualifying child. In fiscal year 2002, the Service issued $ 5 billion in
child tax credit refunds. An additional $ 22 billion of child tax credits
were applied to reduce taxpayer liability. In fiscal year 2001, the
Service issued $ 972 million in child tax credit refunds. An additional $
19. 6 billion of child tax credits were applied to reduce taxpayer
liability.

Tax Gap The tax gap is the aggregate amount of tax imposed by the tax laws
for any given tax year that is not paid voluntarily and timely, excluding
interest and penalties. The Service currently projects, based on
compliance data from the 1980 s, that the nation s gross tax gap ( i. e. ,
Federal taxes owed but not paid voluntarily and timely) is somewhere
between $ 250 billion and $ 300 billion.

The collection gap is the cumulative amount of assessed taxes, including
penalties and interest, which the Service expects to remain uncollectible.
In essence, it represents the difference between the total balance of
unpaid assessments and the net taxes receivable reported on the Service s
balance sheet. The tax gap and the collection gap are related and
overlapping concepts. The collection gap includes all of the uncollectible
taxes for a particular tax year of the tax gap, and uncollectible taxes
from prior years.

Tax Burden

The Internal Revenue Code provides for progressive rates of tax, whereby
higher incomes are generally subject to

and Tax

higher rates of tax. The bar charts and pie graphs below present the
latest available information on income tax

Expenditures

and on related income, deductions, and credits for individuals by income
level and for corporations by size of assets. The information illustrates
the tax burden borne by different income and asset brackets. The bar
charts and pie graphs are only representative of more detailed data and
analysis available from the Statistics of Income ( SOI) office.

Total tax expenditures are the foregone federal revenue resulting from
deductions and credits provided in the Internal Revenue Code. Since tax
expenditures directly affect funds available from government operations,
decisions to forego federal revenue are as important as decisions to spend
federal revenue. - 30 -

Returns

Internal Service

Total Tax Per Return

Revenue Other Accompanying Information - Unaudited Years Ended September
Percent of Gross

and 2001

Income

30, For the 2002 ( All figures are estimates based on samples provided by
the Statistics of Income office)

Individual Income Tax Returns ( Tax Year 2000 Data)

Total Number of Returns Tax Burden % of Gross Income

68, 887, 198 25%

70,000,000 25%

60,000,000 50,000,000

20% 15% 41,037,927

40,000,000 15%

11% 30,000,000

10% 14,743,707

6% 20,000,000

10,000,000 4,708,696

5% 0

0% under $ 30K $ 30K under

$ 75K under greater than

under $ 30K $ 30K under $ 75K under

greater than $ 75K $ 150K

$ 150K $ 75K $ 150K

$ 150K

Size of Adjusted Gross Income Size of Adjusted Gross Income

Average Tax Per Return

$ 120,000 $ 110, 320

$ 100,000 $ 80,000 $ 60,000 $ 40,000

$ 15, 368 $ 20,000

$ 793 $ 5, 301 $ 0 under $ 30K $ 30K under

$ 75K under greater than

$ 75K $ 150K $ 150K

Size of Adjusted Gross Income Percent of Total Deductions on Taxable
Income

Percent of Total Credits Against Tax Liability

19% under $ 30K 30%

$ 30K under $ 75K $ 75K under $ 150K 20%

greater than $ 150K 19%

22% under $ 30K 31%

$ 30K under $ 75K 17% $ 75K under $ 150K greater than $ 150K 42% - 31 -

Tax Per Return

Internal Revenue Service Other Accompanying Information - Unaudited For
the Years Ended September 30, 2002 and 2001

( All figures are estimates based on samples provided by the Statistics of
Income office)

Corporation Income Tax Returns ( Tax Year 1999 Data)

Average Tax Per Return

$ 14,844,845 $ 16,000, 000

$ 14,000, 000 $ 12,000, 000 $ 10,000, 000

$ 8,000, 000 $ 6,000, 000 $ 4,000, 000 $ 2,000, 000

$ 759, 184 Tax Burden % of Gross Income

$ 3,561 $ 168,393 $ 0 under $ 10M $ 10M under $ 50M $ 50M under

greater than $ 250M

$ 250M 2%

Size of Total Assets

1.00% 1%

0.50% 0.37% 0.10%

0% under $ 10M $ 10M under

$ 50M under greater than

$ 50M $ 250M

$ 250M

Size of Total Assets Percent of Total Credits Against Tax Liability

under $ 10M 4%

1% 2% $ 10M under $ 50M $ 50M under $ 250M $ 250M or more

on Taxable Income

Percent of Gross Total Receipts

Percent of Total Deductions 93% under $ 10M 26%

$ 10M under $ 50M $ 50M under $ 250M

59% 8%

$ 250M or more 7% - 32 -

Appendi xes Material Weaknesses, Reportable Conditions,

Appendi x I

and Compliance Issues Material Weaknesses During our audits of the
Internal Revenue Service*s (IRS) fiscal year 2002 and 2001 financial
statements, we identified five material weaknesses in internal controls.
These material weaknesses have given rise to significant management
challenges that have (1) impaired management*s ability to prepare
financial statements and other financial information without extensive
compensating procedures, (2) limited the availability of reliable
information to assist management in effectively managing operations on an
ongoing basis, (3) reduced IRS*s effectiveness in enforcing the Internal
Revenue Code, (4) resulted in errors in taxpayer accounts, and (5)
increased taxpayer burden. The issues that we have identified and discuss
in this report relate to IRS*s controls over (1) financial reporting, (2)
unpaid assessments, (3) federal tax revenue and refunds, (4) property and
equipment, and (5) computer security. We reported on each of these issues
last year. 7 We also reported a material weakness in controls over IRS*s
budgetary activity in prior years. However, as a result of

improvements in IRS*s controls over its budgetary transactions, we have
reassessed this as a reportable condition. We highlight these issues in
the following sections. Less significant matters involving IRS*s system of
internal controls and its operations will be reported to IRS separately.

Financial Reporting In fiscal year 2002, as in prior years, IRS did not
have financial management systems adequate to enable it to timely,
routinely, and reliably generate and report the information needed to
prepare financial statements and manage operations on an ongoing basis. To
overcome these systemic deficiencies, IRS was compelled to rely on
extensive compensating procedures that were costly, labor intensive, and
not always effective. During fiscal year 2002, IRS (1) did not have an
adequate general ledger system for financial reporting and management
purposes, (2) did not always timely recognize material transactions in its
general ledger system, (3) could not determine and report on the specific
amount of revenue collected for each of several of the federal
government*s largest revenue sources, and (4) did not have a cost
accounting system capable of providing timely and reliable cost
information related to IRS*s activities and programs. In fiscal year 2002,
IRS

enhanced its procedures to more timely record certain types of
transactions and thereby improved the ongoing reliability of its financial
information. However, primarily because it continues to rely on the same

7 U. S. General Accounting Office, Financial Audit: IRS*s Fiscal Year 2001
and 2000 Financial Statements, GAO- 02- 414 (Washington, D. C.: Feb. 27,
2002).

inadequate financial management systems as in prior years, material
financial reporting control weaknesses remain. To compensate for these
weaknesses, IRS continued to depend extensively on labor- intensive
compensating procedures to enable it to generate reliable information for
the annual financial statements. Although this approach culminated in

financial statements that were fairly stated as of September 30, 2002 and
2001, it has not produced the current data needed to assist in managing
operations on an ongoing basis, such as cost- based performance
information to assist in making resource allocation decisions. As in
previous years, 8 during fiscal year 2002, IRS*s general ledger system

(1) comprised two independent general ledgers that were not integrated
with each other or with their supporting records for material balances,
and (2) was not supported by adequate audit trails for federal tax
revenue, federal tax refunds, taxes receivable, or property and equipment.
IRS*s use of two separate general ledgers to account for its tax
collection activities and the costs of conducting those activities,
respectively, greatly complicates efforts to measure the cost of IRS*s tax
collection efforts. In addition, IRS*s general ledger for its custodial
activities does not use the standard federal accounting classification
structure. Because of these deficiencies, IRS*s general ledger system does
not conform to the U. S. Government Standard General Ledger (SGL) as
required by the Core Financial System Requirements of the Joint Financial
Management

Improvement Program (JFMIP) 9 or the requirements of the Federal Financial
Management Improvement Act of 1996 (FFMIA). In its Management Discussion
and Analysis, IRS discusses its plans to implement a single, integrated
general ledger that will be fully compliant with FFMIA. 10 However, it is
unclear when this will be accomplished, and thus when IRS

will have a functional general ledger that is fully compliant with FFMIA,
including being supported by detailed subsidiary records for its
administrative and custodial accounts. 8 GAO- 02- 414.

9 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. 10 IRS*s integrated financial
system is planned to include the core financial system defined by JFMIP,
including an SGL- compliant general ledger, accounts payable, accounts
receivable, fund and cost management, budget formulation, and financial
reporting.

Also, during fiscal year 2002, IRS did not always timely record material
transactions in its general ledger. As a result, affected balances were
not always current and accurate on an ongoing basis. In fiscal year 2002,
IRS implemented procedures to more timely record material activity, such
as quarterly recording of property and equipment acquisitions and related
depreciation and monthly recognition of imputed financing costs, which
have significantly improved the reliability of related balances during the
year. However, IRS did not record accruals to recognize nonpayroll-
related

expenses, such as rent and utilities, during the year. As a result,
transactions totaling more than $156 million and more than $95 million
remained in IRS*s suspense account as of March 31 and June 30,

respectively. 11 Thus, affected accounts in IRS*s general ledger continued
to be materially misstated during the year. At interim periods, these
problems also resulted in the understatement of the cost of IRS*s
operations and outlays in the Statements of Net Cost and Budgetary
Resources, respectively. Additionally, as discussed in the material
weakness over

unpaid assessments, IRS requires months of effort and compensating
procedures to produce a balance for taxes receivable, the single largest
item on its balance sheet. This number is only derived on an annual basis.
During fiscal year 2002, IRS continued to be unable to determine the
specific amount of revenue it actually collects for three of the federal
government*s four largest revenue sources* Social Security, hospital
insurance, and individual income taxes. In addition, IRS continued to be
unable to determine, at the time payments are received, collections for
the Highway Trust Fund or other trust funds that receive excise tax
receipts. 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 tax return
pertains only to the amount of the tax liability, not to how to distribute
the amount previously collected among the appropriate trust funds. IRS
does not require

taxpayers to submit information identifying the type of tax at the time of
payment because it believes that imposing such a requirement would create
an additional burden to taxpayers. In addition, IRS*s systems cannot

11 Suspense accounts are used to temporarily recognize certain
transactions until sufficient information is available to determine their
appropriate permanent account classification. As of September 30, 2002,
IRS recorded estimated nonpayroll expenses and in the process, reduced the
suspense balance to an immaterial amount by analyzing its content and
reclassifying most of it to the appropriate permanent accounts. However,
IRS did not perform this process during the year.

presently capture and report such information routinely. IRS is working on
systems improvements to accommodate this type of information. IRS will
continue to be unable to timely report the specific amount of revenue it
actually collects for these large revenue sources until it has the systems

capability to record, and requires taxpayers to provide, this information.
This condition also makes the federal government rely on a complex,
multistep process to distribute excise taxes to the recipient trust funds
that continues to be susceptible to error.

During fiscal year 2002, IRS continued to lack a cost accounting system
(1) capable of accurately and timely tracking and reporting the costs of
IRS*s programs and projects to assist it in managing its costs and

(2) meeting the JFMIP Systems Requirements for Managerial Cost Accounting.
12 This condition also renders IRS unable to produce reliable cost- based
performance information. IRS officials have indicated that IRS*s records
contain information necessary to enable them to determine the cost of
various activities, such as conducting investigations. However, this
information is widely distributed among a variety of information systems,
which are not linked and therefore cannot share data. This makes the
accumulation of cost information time consuming, labor intensive, and not
readily available as a tool to manage costs. For example, IRS has a
variety of workload management systems that staff in different units use
to track how their time is spent on specific tasks. However, these systems
are not integrated with IRS*s general ledger or each other to allow IRS to
readily

identify and accumulate the total costs for time spent by all units
involved in any specific activity. In addition, IRS*s workload management
systems are not designed to track certain material forms of nonpersonnel
costs by project and subproject, such as equipment depreciation, rent, and
utilities. Without a cost accounting system to centrally accumulate,
organize, and timely report cost data in a format that meets management*s
current needs,

such information is not readily available for use by managers to aid in
routinely managing costs and in decision making. Instead, IRS often finds
it necessary to conduct special research efforts tailored to determine the
cost

of a specific task or project. In its Management Discussion and Analysis,
IRS stated that the new cost management system, which includes a cost
accounting module, is scheduled for deployment on October 1, 2003. IRS

12 Joint Financial Management Improvement Program, Systems Requirements
for Managerial Cost Accounting (Washington, D. C.: Feb. 1998).

expects this system to provide and reliably report cost information that
it can use to manage its operations. As a result of these pervasive
financial reporting weaknesses, IRS was compelled to expend far more time
and effort to maintain its accounting records and generate financial
management information than would otherwise have been necessary, and
despite these monumental efforts, continued to lack current, reliable
financial information available to assist in managing operations
throughout fiscal year 2002. During fiscal year

2002, as part of its strategic planning process, IRS conducted a
comprehensive assessment of its strategic priorities. A major goal of this
exercise was to prioritize IRS*s programs relative to its mission in light
of its available resources. IRS is using the outcome of this process as a
basis for resource allocation decisions intended to reduce the difference
between the aggregate amount of taxes assessed by federal tax laws in any
given year and the amount that is paid voluntarily and timely (known as
the tax gap). This initiative represents a major step forward in IRS*s
efforts to ensure that it is utilizing its resources as efficiently and
effectively as possible. Addressing the financial reporting deficiencies
discussed above

would enhance this process by providing sound, reliable, and timely
information to assist in evaluating the impact of these decisions in terms
of both the costs incurred and the benefits derived. Unpaid Tax
Assessments During fiscal year 2002, we continued to find serious internal
control issues that affected IRS*s management of unpaid assessments.
Specifically, we

found (1) IRS continued to lack a subsidiary ledger for unpaid assessments
that would allow it to produce timely and useful information with which to
manage and report externally and (2) errors and delays in recording
taxpayer information, payments, and other activities that continued to
hinder IRS*s ability to effectively manage its unpaid assessments. 13

13 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, 2002,
IRS reported $20 billion (net of an allowance for doubtful accounts of $67
billion), $25 billion, and $137 billion in these three categories,
respectively.

IRS*s management of unpaid assessments is hindered by a lack of effective
supporting systems. IRS lacks a detailed listing, or subsidiary ledger,
that tracks and accumulates unpaid assessments and their status on an
ongoing

basis. As a result, IRS must rely on a costly, labor- intensive manual
compensating process for external reporting. Specifically, to report
balances for taxes receivable and other unpaid assessments in its
financial statements and supplemental information, IRS must apply
statistical sampling and projection techniques to data in its master files
14 to estimate

the balances at year end. While refinements were made to this process
during fiscal year 2002, it continued to take several months to complete,
required adjustments totaling tens of billions of dollars, and produced
amounts that were only reliable as of the last day of the fiscal year.
Consequently, this information is not useful for ongoing management
decisions. In addition, the lack of a subsidiary ledger renders IRS unable
to timely develop reliable financial and management reports and promptly
identify and focus collection efforts on accounts most likely to prove

collectible. IRS*s management of unpaid assessments also continued to be
hindered by inaccurate tax records. We continued to find errors and
omissions in taxpayer records resulting from IRS*s failure to accurately
and timely record information. As in prior years, the most prevalent
errors we found involved IRS*s failure to record payments to all related
taxpayers associated with unpaid payroll taxes. 15 IRS*s current systems
continued to be unable to automatically link each of the multiple
assessments made for

the one tax liability. Consequently, if the business or an officer pays
some or all of the outstanding taxes, IRS*s systems are unable to
automatically reflect the payment as a reduction in the related account or
accounts. In

reviewing unpaid payroll tax cases where one or more individuals were
assessed a trust fund recovery penalty, we found 23 cases in which 14
IRS*s master file contains detailed records of taxpayer accounts. However,
the master files do not contain all the details necessary to properly
classify or estimate collectibility for unpaid assessment accounts. 15
When a company does not pay the taxes it withholds from employees* wages,
such as Social Security or individual income tax withholdings, IRS has the
authority to assess all responsible officers individually for the taxes
withheld from employees. Although assessed to multiple parties, the
liability need only be paid once. Thus, IRS may record assessments against
each of several individuals for the employee- withholding component of the
payroll tax liability of a given business in an effort to collect the
total tax liability of the business. The assessments made against business
officers are known as trust fund recovery penalties.

payments were not recorded in all related taxpayer accounts. We are 95
percent confident that the error rate in the population could be as high
as 20 percent. IRS has recognized the seriousness of this issue and has
attempted to compensate for the lack of an automated link between related
accounts by manually inputting a code in each account that crossreferences

it to other related accounts. However, our work in fiscal year 2002
indicates that this compensating control has not been fully effective: of
the 23 cases with unrecorded payments, 21 had the manual crossreferences

and in 9 of those cases, the unposted payments were made after the cross-
references had been added to the accounts.

We found other errors in taxpayer accounts that were caused by IRS input
errors. For example, in two different cases involving the estates of
deceased taxpayers, IRS erroneously input the deceased taxpayer*s date of
birth as the date of death. This input error caused the IRS system to
automatically generate interest and penalties of almost $50 million in one

case and $1.8 million in another. IRS sent out tax notifications to both
estates and, at the time of our testing, these amounts were recorded as
valid unpaid tax assessments. Delays and errors in recording activity in
taxpayer accounts complicate IRS*s efforts to derive a reliable balance
for taxes receivable and other unpaid assessments for its financial
statements and other accompanying information. Additionally, failure to
record

payments and other activity timely could result in a burden on taxpayers,
including having enforcement actions taken against them for taxes they do
not owe or that have already been paid.

We have reported on these issues in previous audits. 16 IRS has
acknowledged the seriousness of these issues and continues to take
remedial steps to address their impact. For example, IRS has convened a
task group to design an automated trust fund recovery penalty system that
can properly cross- reference payments received and thus eliminate the
opportunity for errors that plague the current manual process. However,

the ultimate solution to many of these issues continues to be the
successful modernization of IRS*s systems, which IRS acknowledges will
take several years to complete.

16 GAO- 02- 414.

Tax Revenue and Refunds During fiscal year 2002, we continued to find that
IRS*s controls were not fully effective in maximizing the government*s
ability to collect what is owed and in minimizing the risk of payment of
improper refunds. IRS recognized this in its fiscal year 2002 Federal
Managers* Financial Integrity Act (FIA) assurance statement to the
Treasury, in which it reported a material weakness in Earned Income Tax
Credit (EITC) noncompliance. IRS*s taxpayer compliance programs identify
billions of dollars of potentially underreported taxes and invalid EITCs
each year. However, due in large part to perceived resource constraints,
IRS selects only a portion of the questionable cases it identifies for
follow- up investigation and action.

In addition, IRS often does not initiate follow- up on the cases it
selects until months after the related tax returns have been filed and any
related refunds disbursed, affecting its chances of collecting amounts due
on these cases. Consequently, the federal government is exposed to
potentially significant losses from reduced revenue and disbursements of
improper refunds. The options available to IRS in its efforts to identify
and pursue the correct amount of taxes owed and to ensure that only valid
refunds are disbursed continue to be limited. For example, third- party
information such as form 1099s 17 that can corroborate the amount of
income reported by taxpayers are not required to be filed until after the
start of the tax filing season. 18 Consequently, comparison of such
information with tax return data is problematic because IRS does not have
time to prepare the third- party data

for matching prior to the receipt of individual tax returns. Additionally,
while it processes hundreds of millions of tax returns each filing season,
IRS must issue refunds within statutory time constraints or be subject to

interest charges. 19 17 IRS 1099 forms are used by third parties, such as
financial institutions, to report taxpayers* interest income, dividend
distributions, and other miscellaneous income. 18 The peak tax filing
season primarily occurs from January 1 to April 15 of each year.

19 By statute, IRS must pay interest on refunds not paid within 45 days of
receipt or due date, whichever is later (26 U. S. C. S:6611).

IRS has some preventive controls that help to reduce the magnitude of
underreported taxes owed and improper refunds issued. For example, IRS*s
Examination Branch is responsible for performing examinations on

tax returns with potentially invalid EITC claims 20 to determine the
validity of the claim. When performed before refunds are disbursed, these
examinations are an important control to prevent disbursement of improper
refunds. However, these examinations are often performed after

any related refunds are disbursed, which reduces their effectiveness as a
preventive control. In February 2002, IRS estimated that of about $31.3
billion in EITC claims filed by taxpayers for tax year 1999, at least $8.
5 billion (27 percent) should not have been paid. 21 Of this amount, only

$1. 2 billion (14 percent) was either recovered or expected to be
recovered through compliance efforts. The dollar amount of improper
refunds disbursed related to these invalid EITCs is unknown. However,
based on the fiscal year 2000 refund rate, which was about 84 percent, 22
IRS may have disbursed about $7.1 billion in EITC- related improper
refunds in tax

year 1999, of which about $6.1 billion (86 percent) may never be
recovered. The full magnitude of improper refunds disbursed annually due
to invalid EITCs is unknown. 20 Because it is a tax credit, an EITC claim
always results in a reduction of the taxpayer*s calculated tax liability.
However, depending on the taxpayer*s amount of taxes withheld, it may or
may not result in a refund for a particular tax year. 21 Internal Revenue
Service, Compliance Estimates for Earned Income Tax Credit Claimed on 1999
Returns (Washington, D. C.: Feb. 28, 2002). 22 We used the fiscal year
2000 refund rate because most of the tax year 1999 refunds were paid in
fiscal year 2000.

Due to time and other constraints, IRS relies extensively on detective
controls, such as automated matching of returns with third- party data
such as W- 2s (wage and tax statements) to identify for collection
underreported taxes and improper refunds. However, these programs are not
run until months after the returns have been filed. As a result, they are
used too late to prevent improper refunds from being disbursed. In
addition, although IRS*s matching program for individual tax returns
identifies billions of dollars of potentially underreported taxes each
year, IRS only follows up on a portion of these cases to determine how
much tax is actually due and to pursue collection of those amounts. For
example, for tax year 2000, 23 IRS*s

matching program for individuals identified 16. 2 million individual tax
returns with potential underreported taxes totaling $19.2 billion. IRS
investigated 3 million (18.5 percent) of these returns accounting for
about $9 billion (47 percent) of the total potential underreported taxes.
There are factors that affect IRS*s ability to accelerate the timing of
its automated matches, such as the limitations of its current automated
systems and the timing of filing requirements for preparers of third-
party documents, which are beyond IRS*s control. Nonetheless, the
information from IRS*s automated matching program suggests that a
substantial amount of additional revenue might be realized if additional
resources were devoted to follow- up efforts. At present, billions of
dollars in underreported taxes could remain uncollected and improper
refunds could be disbursed. This, in turn, could further erode taxpayer
confidence in the equity of the tax system and reduce compliance with the
tax laws.

Property and Equipment In fiscal year 2001, we reported that material
weaknesses in IRS*s property and equipment (P& E) systems and controls
prevented it from having (1) current, reliable P& E information available
on an ongoing basis and (2) reasonable assurance that its assets were
properly safeguarded and used

only in accordance with management policy. 24 During fiscal year 2002, IRS
continued efforts to compensate for these longstanding deficiencies in
systems and controls over its P& E. Specifically, IRS implemented

procedures to improve the (1) timeliness of recording P& E transactions in
accounting records and (2) accuracy and reliability of its P& E inventory
23 Individual tax returns are not due until April 15 of the following year
(up to October 15 if extensions are filed), and the underreporter
screening programs cannot be run until after the returns are filed.
Consequently, tax year 2000 is the most recently completed tax year for

which the cited data are available. 24 GAO- 02- 414.

records. Nonetheless, fundamental deficiencies in IRS*s financial
management system continued to exist, which precluded IRS from having
ongoing information on its balance of P& E and assurance that its assets
were properly safeguarded. However, through the use of compensating
procedures, IRS was able to report a balance for P& E on its financial
statements at September 30, 2002, that was fairly stated in all material
respects. IRS has reported a material weakness in its controls over P& E
in its FIA assurance statement to Treasury every year since 1983.

As we previously reported, IRS does not have an integrated property
management system that appropriately records P& E additions and disposals
as they occur and links costs on the accounting records to property
records. Instead, IRS expenses property purchases as they occur, and then
later extracts the costs of property acquisitions from operating

expenses and records adjustments to remove property purchases from
expenses and capitalize them as P& E. Consequently, IRS does not have
reliable P& E data available on an ongoing basis that it can use to make
operational decisions related to the acquisition and use of P& E, and its
property management system does not provide timely and reliable
information to facilitate the preparation of financial statements.

In fiscal year 2002, IRS improved the timeliness of extracting and
recording P& E financial information. Beginning in mid- fiscal year 2002,
IRS was able to produce, with contractor assistance, P& E information
within a few weeks after the end of the quarter. This is a significant
improvement over fiscal year 2001, when reliable P& E information was not
available until 3 months after the end of the fiscal year. Although IRS
was able to produce P& E financial information on a more timely basis in
fiscal year 2002, the fundamental deficiencies in its property management
system remain. IRS did not properly record P& E transactions in P& E
accounts as they occurred, and it was necessary for IRS to hire a
contractor to extract,

analyze, and compile the data needed to report a reliable P& E balance. In
addition, IRS could not always link the property acquisitions eventually
recorded on IRS*s accounting records to assets recorded on IRS*s property
records. In transactions selected from IRS*s accounting records that we
tested, some or all of the assets acquired could not be linked to
inventory records. 25 For example, one of the transactions we tested was
for the purchase of 39 desktop computers. IRS had recorded this
transaction in the 25 Each transaction can involve multiple assets.

accounting records in November 2001 but had not recorded 38 of the 39
computers on the inventory records as of September 2002. Accurate records
are essential for maintaining control over P& E to ensure that assets are
properly accounted for and safeguarded. In prior years, we reported that
IRS*s procedures for recording P& E transactions in its inventory records
were not effective in ensuring that acquisitions, disposals, and transfers
were promptly and accurately recorded in its P& E

inventory records. In fiscal year 2002, IRS made a concerted effort to
improve procedures and practices used to account for its assets. Our
testing indicates that IRS continued to make significant progress on this
issue, but that nonetheless, transactions were not always promptly and
accurately recorded. Specifically, we found that 22 of 220 P& E items,
including computers and printers, selected at 22 sites could not be
located at the time of our review. 26 Based on our work, we estimate that
10 percent of the items in IRS*s P& E inventory records were erroneously
included as assets. 27 This year, however, we found that the majority of
the errors we identified in our sample were attributable to a system
limitation.

Specifically, 16 of the 22 assets we could not locate had been disposed
of, but the inventory records had not been updated to reflect these
disposals due to a system problem that prevented personnel responsible for
updating the inventory records for disposals from having access to the
records. At the time of our testing, IRS was aware of the system problem
and had

identified 13 of the 16 disposed item records for review but had not yet
corrected its inventory records. Despite these findings, we believe IRS is
making clear progress in improving accountability over P& E. For example,
in our fiscal year 2001 audit, we estimated that 12 percent of the items
in

IRS*s P& E inventory records were erroneously included as assets, 28 and
the reasons for the errors we identified last year were not primarily
attributable to a single cause. Additionally, individual sites we tested
showed significant improvement over previous years: at one location where
we found that 5 of 10 assets we tested in fiscal year 2001 could not be
located, all 10 assets we tested were accounted for in fiscal year 2002.
26 For our book- to- floor sample, we obtained a sample of P& E items with
a two- stage cluster sample. In the first stage, we selected a sample of
22 buildings. In the second stage, we selected a sample of 10 assets
located at each of the 22 buildings from IRS*s asset records. 27 We are 95
percent confident that the error rate does not exceed 18 percent.

28 In our fiscal year 2001 audit, we were 95 percent confident that the
error rate did not exceed 20 percent.

While further improvements are needed, there has been notable progress
made on this issue. During our fiscal year 2001 audit, we found that IRS*s
property management system did not capture information, such as licenser,
contract period, and number of authorized users, essential to ensure that
software and software licenses were controlled and utilized only in
accordance with software license contracts. In fiscal year 2002, IRS
initiated a process to identify and record software licenses and began
developing an action plan

that will set policies and procedures for review of and compliance with
the terms of the licenses. However, as of the completion of our fieldwork,
IRS had not completed this effort, and as a result continued to lack an
inventory record system that captured information essential to ensure that
software and software licenses were properly controlled and used only in
accordance with license agreements. Although we determined through
detailed tests of transactions and

analyses that IRS*s reported September 30, 2002, P& E balance was fairly
stated, longstanding weaknesses in IRS*s property and accounting systems
continue to affect IRS*s ability to account for its property and report a
reliable P& E balance on an ongoing basis. These weaknesses will continue
to exist until IRS has an integrated accounting and property system. In
March 2005, IRS plans to acquire and install an asset management module to
the integrated financial system. According to IRS, the system will be

capable of recording P& E as assets when purchased and generating detailed
records for P& E that reconcile to the financial records.

Computer Security IRS relies extensively on computer information systems
to perform basic functions, such as processing tax returns and payments,
maintaining sensitive taxpayer data, calculating interest and penalties,
and generating refunds. Although IRS has corrected or mitigated many of
the computer security weaknesses identified in our previous reports, much
remains to be done to resolve the significant control weaknesses that
continue to exist within IRS*s computing environment and to be able to
promptly address new security threats and risks as they emerge. Such
weaknesses can impair the agency*s ability to perform vital functions, and
can increase the risk of unauthorized disclosure, modification, or
destruction of taxpayer data.

IRS has continued to make progress improving computer security controls.
For example, IRS has revised its information technology security policy
and guidance, updated security standards for several of its computing

systems and devices, and improved certain physical security controls at
its data processing facilities. IRS is also consolidating several of its
geographically dispersed Unix computer systems and centralizing

responsibility for their operation and management, performing periodic
internal control reviews of its computer- processing environments, and
implementing an intrusion detection capability.

However, IRS continued to have serious weaknesses in fiscal year 2002 with
computer controls designed to protect computing resources such as
networks, computer equipment, software programs, data, and facilities

from unauthorized use, modification, loss, and disclosure. For example,
IRS did not always effectively configure and implement computer systems in
accordance with its computer security policies, monitor system
configuration and implementation, and provide sufficient technical
security- related training to key personnel. In addition, IRS has not
taken sufficient steps to ensure that internal control deficiencies
identified at one

facility are considered and addressed at other facilities. The following
examples illustrate the types of computer control weaknesses that affect
IRS*s financial and tax processing systems.

 IRS did not adequately restrict electronic access rights and permissions
on its servers, network devices, and mainframe computers. Inappropriate
access to sensitive files and directories can enable an intruder or user
to gain unauthorized access to computing resources.  IRS did not
sufficiently segregate system administration functions on its

servers from those related to security administration and system backup
operations, thereby increasing the risk that system administrators could
perform unauthorized system activities without detection.

 IRS did not securely control network services or configure system
software to minimize the risk of unauthorized access to and ensure the
integrity of system programs, files, and data. At one location, for
example, IRS did not secure its network against known vulnerabilities or
minimize the operational impact of a potential failure in a critical
network device.

 IRS did not sufficiently plan or test the activities required to restore
certain critical business systems when unexpected events occur. Disaster
recovery plans for some systems lacked essential information

to facilitate recovery operations and were not fully tested.

 IRS did not effectively monitor key systems and network devices to
identify unauthorized activities. Computer logs often did not record key
security- related events and pertinent data. Security specialists also did
not routinely or fully examine logs for unauthorized activity or usage
trends.

Collectively, these problems indicate material weaknesses in IRS*s
internal controls over information systems and data. These weaknesses
decreased the reliability and increased the vulnerability of data
processed by the systems. Until IRS can adequately mitigate these
weaknesses, unauthorized individuals could gain access to critical
hardware and software, and intentionally or inadvertently access, alter,
or delete sensitive data or computer programs. Such individuals could also
obtain personal taxpayer information and use it to commit financial crimes
in the taxpayers* names

(identity fraud), such as establishing credit and incurring debt.
Reportable Conditions In addition to the material weaknesses discussed
above, we identified two

reportable conditions. These concern weaknesses in IRS*s internal controls
over budgetary activity, which we have reported as a material weakness in
prior years, and weaknesses in internal controls over tax receipts and
taxpayer information, which we have reported as a reportable condition in
prior years. 29

29 GAO- 02- 414.

Budgetary Activity In prior years, we identified serious internal control
deficiencies that prevented IRS from ensuring that its budgetary authority
30 was routinely accounted for, reported, and controlled. Over the past
several years, IRS has made considerable progress in addressing internal
control deficiencies related to budgetary activity. In fiscal year 2002,
we noted further improvements in IRS*s controls and procedures that
enhanced its ability to account for and report on the status of its
budgetary resources.

Specifically, IRS (1) improved its reviews of outstanding obligations and
(2) performed more frequent analyses of certain general ledger accounts
containing transactions incorrectly recorded as adjustments to prior
years* obligations. 31 These further improvements allowed us to conclude
that the

remaining issues related to budgetary activity no longer constitute a
material internal control weakness. However, IRS did not implement these
improvements until after the first quarter of fiscal year 2002.
Additionally, we continued to find that IRS recorded invalid transactions
in its general ledger and instances in which IRS did not timely record
obligations and

expenditures. Over the past several years, IRS has issued numerous policy
memorandums and implemented procedures to deobligate funds 32 no longer
required for a specific purpose. IRS*s business units were required to
review outstanding obligation reports on a quarterly basis and identify
all obligations that were no longer active and thus would need to be
deobligated. Beginning in the

second quarter of fiscal year 2002, IRS improved its reviews of
outstanding obligations by (1) providing specific guidelines to the
business units that performed the reviews, (2) requiring the business
units to perform monthly reviews, and (3) providing more relevant and
timely information on the outstanding obligation reports to assist the
business units in their reviews. IRS*s improvements to its reviews of
outstanding obligations enabled it to identify on a more timely basis
obligated funds that could be deobligated 30 Budgetary authority is the
authority provided by law to enter into financial obligations that will
result in immediate or future outlays involving federal government funds.

31 An adjustment to a prior year*s obligation is recorded when the dollar
amount previously recorded is affected by a subsequent event, such as a
change in the price of goods or services.

32 Deobligations are downward adjustments of previously recorded
obligations. Deobligations can occur for a variety of reasons, such as if
the actual expense was less than the amount obligated, a project or
contract was cancelled, an initial obligation was determined to be
invalid, or previously recorded estimates were reduced.

and made available for future or existing obligations, thus improving its
management of budgetary resources. IRS*s accounting system records all
adjustments that affect a prior year*s appropriation, including those that
do not affect the obligated amount, as adjustments to prior years*
obligations. Many of the activities recorded as adjustments to prior
years* obligations are related to changes in accounting

codes, travel, and adjustments to doubtful accounts and are thus not valid
adjustments to prior years* obligations. For example, IRS records a change
in an internal accounting code as a new obligation and erroneously adjusts

the original obligation downward, thereby misstating its reported level of
adjustments to obligations. To identify valid adjustments to prior years*
obligations, IRS manually analyzes the adjustment activity recorded in its
accounting system. IRS then uses the results of this analysis to record
adjusting entries to the applicable general ledger accounts. For fiscal
year 2002, this analysis resulted in IRS making correcting entries to
remove $1. 2 billion of invalid

transactions from the $1.4 billion balance of adjustments to prior year
obligations in its general ledger. In prior years, IRS only performed this
analysis at fiscal year end to prevent its financial statements from being
misstated. This enabled the year- end financial statements to be correct,
but did not address the impact of these errors on interim internal and
external reporting. Beginning in mid- fiscal year 2002, however, IRS began
performing these procedures on a quarterly basis. By increasing the
frequency of its analysis of adjustment activity, IRS improved the
reliability of budgetary information it submits to OMB on a quarterly
basis through its SF133 Report on Budget Execution and Budgetary
Resources. 33 However, IRS*s compensating procedures only produce reliable
adjustment balances for the specific date covered by the analysis. Thus,
the existing deficiency in IRS*s accounting system with respect to
recording adjustments to prior years* obligations prevents IRS

from having accurate and reliable information on budgetary resources and
obligations on an ongoing basis. IRS plans to acquire and install, in
fiscal year 2004, an integrated financial system with the capability to
differentiate

between activities that are and are not valid adjustments to prior years*
obligations. 33 OMB requires that each agency submit SF133s on a quarterly
basis to report on each agency*s budget execution as well as the status of
its budgetary resources.

In prior audits, we found instances in which IRS received goods and
services during one fiscal year but did not record the applicable
expenditure to reduce the undelivered orders balance in its accounting
system until the following fiscal year. This resulted in IRS overstating
its balance of undelivered orders and understating its accrued expenses.

During fiscal year 2001, IRS developed a methodology to more reasonably
accrue expenditures at year end and thus recognize the associated
reduction in the balance of undelivered orders. By applying this
methodology, IRS was able to report reliable amounts for undelivered

orders and accrued expenses on its fiscal- year- end financial statements.
However, IRS*s balances of undelivered orders, expenses, and capital
expenditures were not accurate throughout fiscal year 2002 because of
delays in recording expenditures. Specifically, in our testing of
undelivered orders, we identified instances in which IRS took more than 30
days from the date it accepted the goods or services to record the
applicable expenditure in its accounting system. For example, in one
instance, IRS received telecommunication services that covered the month
of November 2001, at a cost of $1. 4 million. However, IRS did not record
the associated

expenditure in its accounting system until June 7, 2002* more than 6
months after the services were provided. Untimely recording of
expenditures affects IRS*s ability to efficiently manage its budgetary
resources by delaying the identification of obligated funds that (1) are
insufficient to cover the expenditure or (2) exceed amounts owed and thus
can be deobligated and made available for future or other existing
obligations.

We also found that IRS continued to experience delays in recording
obligations in its accounting system during fiscal year 2002. In our
testing of undelivered orders, we found instances in which IRS took more
than 30 days from the date the obligation document was established to
record the obligated amount in its accounting system and instances in
which IRS incurred costs prior to recording the obligation in its
accounting system. For example, in one instance, IRS established an
obligation on October 1, 2001, for armed security guard services totaling
$366, 000. However, IRS did

not record the obligation in its accounting system until April 22, 2002*
more than 6 months after the obligation was established. In another
instance, IRS received office equipment on October 9, 2001, at a cost of
$154,000. However, IRS did not generate the initial obligating document to
establish the obligation of funds until March 18, 2002, and recorded the

obligation in its accounting system on March 28, 2002* more than 5 months
after the equipment was received.

Delays in recording obligations affect the reliability of IRS*s financial
records used to track the status of its budgetary resources for day- to-
day decision making. Until the obligation of funds is recorded,
obligations reflected in IRS*s accounting system will be understated.
Understatement of obligations could lead IRS management to believe that
the agency has

more funding than is actually available. Consequently, IRS management and
staff might enter into obligations that exceed the budgetary authority
made available by Congress.

Hard- Copy Tax Receipts and IRS manually processes tax receipts and
taxpayer information at its service

Taxpayer Information center campuses and field offices. In addition,
commercial lockbox banks,

operating under contract with Treasury*s Financial Management Service,
process tax receipts and taxpayer information on behalf of IRS. During
fiscal year 2002, IRS*s controls over cash, checks, and related hard- copy
taxpayer data it received from taxpayers continued to be inadequate to
sufficiently limit the risk of theft, loss, or misuse of such funds and
data.

Recognizing its responsibility to protect taxpayer information and
receipts, IRS has taken action in the past several years to address a
number of its internal control deficiencies. For example, to improve the
safeguarding of taxpayer receipts and data, IRS began conducting periodic
security reviews of receipt processing areas, implemented many of its new
hiring and courier standards, and updated policies and procedures. In
fiscal year 2002, IRS issued the Lockbox Processing Guidelines to improve
the safeguarding of taxpayer receipts and data at lockbox facilities.
Nonetheless, internal

control deficiencies remain, primarily because of inconsistencies in the
establishment and implementation of, and compliance with, these policies
at IRS service center campuses, field offices, and commercial lockbox
banks.

We previously reported that IRS was hiring individuals and allowing them
access to cash, checks, and other taxpayer data before it had received
satisfactory results of their fingerprint checks. 34 Since establishing a
policy prohibiting new hires from entering on duty in any IRS offices
until their fingerprint checks are completed, IRS has worked aggressively
to enforce this policy and continued to make substantial progress in this
area in fiscal year 2002. As a result, IRS has significantly reduced its
exposure related to

this issue. 34 GAO- 02- 414.

We previously reported on weaknesses in internal controls to deter
unauthorized access to receipt processing areas. 35 In fiscal year 2002,
we continued to find significant security access issues at field offices
and lockbox banks, as well as at one of the two service center campuses we
visited. For example, IRS policy requires that all perimeter doors be
equipped with locks and alarms and that the doors must be locked and
alarms set. At lockbox sites, we found one perimeter door unlocked, one
without an alarm, and one where the alarm was not sufficiently audible.
Guards also failed to respond when we activated the perimeter door alarms
in two instances at a lockbox site and in one instance each at a field
office and a service center campus. The building perimeter is the first
line of defense in the effort to prevent unauthorized access to receipt
processing

areas. We also found other weaknesses in physical security at the service
center campus, such as a door to a receipts- processing area with a broken
lock that could be opened by an unauthorized individual, and a door with a
cipher lock that we were able to open because it had not been properly
closed. At field offices, we found that taxpayers visiting the taxpayer

assistance centers to make tax payments or obtain assistance with tax
questions could gain access to areas of the centers that are restricted to
authorized IRS personnel handling tax receipts and taxpayer information.
We further found that employees at IRS field offices had, or could have,
access to certain areas where tax receipts and taxpayer information are
handled, regardless of their need for access.

We continued to find other weaknesses and inconsistencies in controls over
taxpayer receipts and taxpayer data at service center campuses, field
offices, and lockboxes that have not been adequately addressed. For
example, we continued to find receipts stored in open, unlocked
containers, contrary to IRS policy. Another IRS policy limits personal
belongings that each worker can bring into receipt processing areas to
small items that can fit into a clear plastic bag, and specifically
prohibits large items such as purses and backpacks in which taxpayer
receipts could

be concealed. However, we found that at one service center campus personal
items were allowed in clear plastic bags of various sizes, with many of
the bags containing so many items that not all of the items could be
identified through the bag. In addition, at the same service center
campus, we found that employees carried CD cases, newspapers, and

35 U. S. General Accounting Office, Internal Revenue Service: Progress
Made, but Further Actions Needed to Improve Financial Management, GAO- 02-
35 (Washington, D. C.: Oct. 19, 2001).

magazines in the clear plastic bags* all objects in which taxpayer
receipts could be easily concealed. At another service center campus, we
noticed an employee leaving the processing area with a plastic bag that
was not clear. At a field office, we found that employees were allowed to
store personal belongings with taxpayer receipts and official receipt
certificate vouchers in desk drawers or cabinets. Additionally, at four
lockbox sites we visited, we were able to bring purses and fanny packs
into processing areas, and at several lockbox sites we saw employees
wearing bulky

clothing or bring in personal belongings, such as gift bags and purses. We
previously reported that checks made payable to *IRS* could easily be
altered and cashed and that returned refund checks were highly susceptible
to theft. 36 At field offices we visited during fiscal year 2002, we

continued to find that checks were not overstamped with *United States
Treasury,* and we continued to find instances at service center campuses,
field offices, and lockbox sites where returned refund checks were not
restrictively endorsed at the point of extraction.

We previously recommended that IRS develop policies and procedures to
reconcile logs of payments found during final candling to the related
receipts and documents. 37 During fiscal year 2002, we continued to find
that discovered items were not reconciled at both of the service center
campuses we visited and at two lockbox sites. At service center campuses,
we also found that discovered items were not immediately recorded and that
personnel who had overlooked items during candling were not always
identified.

36 U. S. General Accounting Office, Internal Revenue Service:
Recommendations to Improve Financial and Operational Management, GAO- 01-
42 (Washington, D. C.: Nov. 17, 2000). 37 U. S. General Accounting Office,
Internal Revenue Service: Status of Recommendations from Financial Audits
and Related Financial Management Reports, GAO- 02- 848 (Washington, D. C.:
July 30, 2002). Candling is a process that uses a light source to
determine if any contents remain in the open envelopes before their
destruction.

IRS procedures require that emptied envelopes be candled twice, and the
lockbox processing guidelines have this same requirement. Yet during
fiscal year 2002, we found instances at both service center campuses and
at lockbox sites where candling that should have been performed twice was
performed only once. Furthermore, at one service center campus, we

found that a single employee was performing final candling in a closed
room, thereby increasing the possibility of theft or destruction of
discovered remittances. 38 Standards for Internal Control in the Federal
Government requires agencies to establish physical controls to secure and

safeguard vulnerable assets. 39 IRS has made an effort to address courier
security weaknesses by adopting more stringent security standards for
couriers who transport IRS*s daily deposits to depository institutions.
However, IRS did not have effective

controls in place to ensure that the contract requirements were enforced.
In fiscal year 2002, we found that at one of the two IRS service center
campuses we visited, IRS failed to assure itself that the courier service
had met the insurance coverage requirements or that the courier service
employees had passed the required limited background investigation. In
fact, the courier service had failed to meet the insurance coverage
requirements, and IRS had performed no limited background investigation

of courier service employees. At a lockbox site, management of the site
had authorized three couriers to start transporting daily deposits prior
to receipt of their fingerprint check results. Furthermore, we noted
differing requirements for couriers depending on whether the couriers are
operating at IRS*s own service center campuses or at contractor- operated
lockbox banks, even though all couriers are entrusted with daily deposits.
For example, at lockbox banks, pursuant to the Lockbox Processing
Guidelines, couriers are only required to have a

fingerprint check. Requirements also differed among the service center
campuses: at the five service center campuses where couriers are under
IRS- negotiated contracts, they are required to have a background

investigation and a fingerprint check; at the other five service center
campuses, the couriers operate under FMS- negotiated contracts and are 38
Discovered remittances are cash or checks that were erroneously overlooked
during the extraction process. 39 U. S. General Accounting Office,
Standards for Internal Control in the Federal Government, GAO/ AIMD- 00-
21. 3. 1 (Washington, D. C.: Nov. 1999).

not required to have either a background investigation or a fingerprint
check. These weaknesses increase IRS*s vulnerability to theft or loss and
expose taxpayers to increased risk of losses from financial crimes
committed by individuals who inappropriately gain access to confidential
information

entrusted to IRS. Thus, it is important that IRS continue to work to
effectively address these matters because they are critical to IRS
successfully meeting its customer service goals.

Compliance Issues Our tests of compliance with selected provisions of laws
and regulations disclosed two areas of noncompliance that are reportable
under U. S.

generally accepted government auditing standards and OMB guidance. These
relate to the release of federal tax liens against taxpayers* property and
the structure of installment agreements IRS enters into with taxpayers to
satisfy the taxpayer*s outstanding tax liability. We also found that IRS*s

financial management systems do not substantially comply with the
requirements of FFMIA.

Release of Federal Tax The Internal Revenue Code grants IRS the power to
file a lien against the Liens

property of any taxpayer who neglects or refuses to pay all assessed
federal taxes. The lien becomes effective when it is filed with a
designated office, such as a courthouse in the county where the taxpayer*s
property is located. The lien serves to protect the interest of the
federal government and serves as a public notice to current and potential
creditors of the

government*s interest in the taxpayer*s property. For example, federal tax
liens are disclosed in credit reports of individuals. Under section 6325
of the Internal Revenue Code, IRS is required to release a federal tax
lien within 30 days after the date the tax liability is satisfied or has
become legally unenforceable or the Secretary of the Treasury has accepted
a bond

for the assessed tax.

In previous audits, we found that IRS did not always release the
applicable federal tax lien within 30 days of the tax liability being
either paid off or abated as required by the Internal Revenue Code. 40 We
found that this condition continued to exist in fiscal year 2002.
Specifically, in our testing of 59 tax cases with liens in which the
taxpayers* total outstanding tax liabilities were either paid off or
abated during fiscal year 2002, we found

20 instances in which IRS did not release the applicable federal tax lien
within the 30- day statutory requirement. The time between satisfaction of
the liability and release of the lien ranged from 46 to 1, 263 days. For

example, in one case we found that although the taxpayer satisfied the
outstanding tax liability in April 2000, IRS did not formally release the
lien against the taxpayer*s property until November of the following year*
578 days later. Based on the results of our work, we estimate that for 34
percent of unpaid tax assessment cases where IRS had filed a tax lien that
were resolved in fiscal year 2002, IRS did not release the lien within the
30day

requirement. 41 The failure to promptly release tax liens could cause
undue hardship and burden to taxpayers who are attempting to sell property
or apply for commercial credit. 40 GAO- 02- 414. 41 We are 95 percent
confident that the error rate could be as high as 44 percent. In our
fiscal year 2001 audit, we found five instances of noncompliance. At that
time, we estimated that for 8 percent of unpaid tax assessment cases where
IRS had filed a tax lien that were resolved in that fiscal year, IRS did
not release the lien within the 30- day requirement. We were 95 percent
confident that the error rate could be as high as 19 percent.

Structuring of Installment Section 6159 of the Internal Revenue Code
authorizes IRS to enter into

Agreements installment agreements with taxpayers to fully satisfy the
taxpayer*s tax

liability. While our fiscal year 2001 audit did not identify instances of
material noncompliance in a statistical sample of installment agreements,
42 audits for prior years showed that IRS had not always structured
installment agreements to ensure that they would satisfy the taxpayer*s
outstanding tax liability, including future interest accruals, before the
statutory collection period for the tax liability expired. 43 During our
fiscal year 2002 financial audit, we again found that installment
agreements were not always structured to provide for full payment of the
tax liability. Specifically, in our testing of 59 installment agreements,
we found 4 instances in which the terms of the installment agreements did
not require full satisfaction of the tax liability. Based on the results
of our work, we estimate that nearly 7 percent of new installment
agreements entered into during fiscal year 2002 had payment terms that
would not fully satisfy the tax liability within the statutory collection
period. 44 The presence of such cases in fiscal year 2002 indicates that
IRS was not in compliance with section 6159 of the Internal Revenue Code.

Financial Management In fiscal year 2002, we continued to find that IRS*s
financial management

Systems* Noncompliance systems did not substantially comply with the
requirements of FFMIA.

with FFMIA Specifically, IRS*s systems did not comply with Federal
Financial Management Systems Requirements (FFMSR), federal accounting

standards (U. S. generally accepted accounting principles), and the U. S.
Government Standard General Ledger (SGL) at the transaction level. We
found that IRS (1) cannot rely on information from its general ledger to
prepare its financial statements, (2) does not have a general ledger that
42 In last year*s audit, we found that based on a statistical sample of 59
installment agreements IRS entered into with taxpayers during fiscal year
2001, we were 95 percent confident that the rate of occurrence of
installment agreements entered into during fiscal year 2001 whose terms
did not require full satisfaction of the tax liability did not exceed 5

percent. However, we also pointed out that this did not mean that all
installment agreements IRS had entered into with taxpayers were structured
to provide for full satisfaction of the tax liability. 43 The statutory
collection period for taxes is generally 10 years from the date of the tax
assessment. However, this period can be extended by agreement between IRS
and the taxpayer.

44 We are 95 percent confident that the error rate could be as high as 15
percent.

conforms to the SGL, (3) lacks a subsidiary ledger for its unpaid
assessments, (4) lacks a reliable subsidiary ledger for its P& E, and (5)
lacks an effective audit trail from its general ledger back to subsidiary
detailed records and transaction source documents for material balances.
Other material weaknesses we discussed earlier* controls over unpaid
assessments, federal tax revenue and refunds, P& E, and computer

security* are also conditions indicating that IRS*s systems do not
substantially comply with the requirements of FFMIA.

As a result, IRS*s financial management systems cannot produce auditable
financial statements and related disclosures that conform with U. S.
generally accepted accounting principles without substantial compensating
processes and significant adjustments. These weaknesses also indicate that
IRS*s systems cannot routinely accumulate and report the full cost of its
activities. Since IRS*s systems do not comply with FFMSR, U. S. generally

accepted accounting principles, and the SGL, they also do not comply with
OMB Circular A- 127, Financial Management Systems. In its FIA assurance
statement to Treasury, IRS reported that its financial management systems

did not substantially comply with the requirements of FFMIA in fiscal year
2002. IRS has established a remediation plan to address the conditions
affecting its systems* ability to comply with the requirements of FFMIA.
This plan outlines the actions to be taken to resolve these issues,
designates resources to be devoted to implementing those actions, and
specifies time

frames for their completion. Due to the long- term nature of IRS*s systems
modernization efforts, which IRS expects will resolve many of the most
serious issues, many of the planned time frames exceed the 3- year
resolution period specified in FFMIA. However, for these instances IRS has
received a waiver from this requirement from OMB, as authorized by FFMIA.

Appendi x II

Details on Audit Methodology To fulfill our responsibilities as the
auditor of IRS*s financial statements, we did the following:  Examined,
on a test basis, evidence supporting the amounts and disclosures in the
financial statements. This included testing selected

statistical samples of unpaid assessment, revenue, refund, accounts
payable, accrued expenses, payroll, nonpayroll, P& E, and undelivered
order transactions. These statistical samples were selected primarily to

substantiate balances and activities reported in IRS*s financial
statements. Consequently, dollar errors or amounts can and have been
statistically projected to the population of transactions from which they
were selected. In testing these samples, certain attributes were
identified that indicated either significant deficiencies in the design or
operation of internal control or compliance with provisions of laws and

regulations. These attributes, where applicable, can be and have been
statistically projected to the appropriate populations.

 Assessed the accounting principles used and significant estimates made
by management.  Evaluated the overall presentation of the financial
statements.  Obtained an understanding of internal controls related to
financial

reporting (including safeguarding assets), compliance with laws and
regulations (including the execution of transactions in accordance with
budget authority), and performance measures reported in the

Management*s Discussion and Analysis.  Tested relevant internal controls
over financial reporting (including

safeguarding assets) and compliance, and evaluated the design and
operating effectiveness of internal controls.

 Considered the process for evaluating and reporting on internal controls
and financial management systems under FIA.

 Tested compliance with selected provisions of the following laws and
regulations: Anti- Deficiency Act, as amended (31 U. S. C. S:1341( a)( 1)
and 31 U. S. C. S:1517( a)); Agreements for payment of tax liability in
installments (26 U. S. C. S:6159); Purpose Statute (31 U. S. C. S:1301);
Release of lien or discharge of property (26 U. S. C. S:6325); Interest on
underpayment, nonpayment, or extensions of time for payment of tax (26 U.
S. C. S:6601); Interest on overpayments (26 U. S. C. S:6611);

Determination of rate of interest (26 U. S. C. S:6621); Failure to file
tax return or to pay tax (26 U. S. C. S:6651); Failure by individual to
pay estimated income tax (26 U. S. C. S:6654); Failure by corporation to
pay estimated income tax (26 U. S. C. S:6655); Prompt Payment Act (31 U.
S. C. S:3902 (a), (b), and (f), and 31 U. S. C. S:3904); Fair Labor
Standards Act of 1938, as amended (29 U. S. C. S:206); Civil Service
Retirement Act of 1930,

as amended (5 U. S. C. S:S: 5332, 5343); Federal Employees* Retirement
System Act of 1986, as amended (5 U. S. C. S:S: 8422 and 8423); Social
Security Act, as amended (26 U. S. C. S:S: 3101 and 3121, and 42 U. S. C.

S:430); and Federal Employees Health Benefits Act of 1959, as amended (5
U. S. C. S:S: 8905, 8906, and 8909).

 Tested whether IRS*s financial management systems substantially comply
with the three FFMIA requirements.

Comments from the Internal Revenue

Appendi x I II Service

(191023)

GAO*s Mission The General Accounting Office, the investigative arm of
Congress, exists to support Congress in meeting its constitutional
responsibilities and to help improve the performance and accountability of
the federal government for the American people. GAO examines the use of
public funds; evaluates federal programs and

policies; and provides analyses, recommendations, and other assistance to
help Congress make informed oversight, policy, and funding decisions.
GAO*s commitment to good government is reflected in its core values of
accountability, integrity, and reliability.

Obtaining Copies of The fastest and easiest way to obtain copies of GAO
documents at no cost is through the Internet. GAO*s Web site (www. gao.
gov) contains abstracts and fulltext GAO Reports and

files of current reports and testimony and an expanding archive of older
Testimony

products. The Web site features a search engine to help you locate
documents using key words and phrases. You can print these documents in
their entirety, including charts and other graphics.

Each day, GAO issues a list of newly released reports, testimony, and
correspondence. GAO posts this list, known as *Today*s Reports,* on its
Web site daily. The list contains links to the full- text document files.
To have GAO e- mail this list to you every afternoon, go to www. gao. gov
and select *Subscribe to GAO Mailing Lists* under *Order GAO Products*
heading.

Order by Mail or Phone The first copy of each printed report is free.
Additional copies are $2 each. A check or money order should be made out
to the Superintendent of Documents. GAO also accepts VISA and Mastercard.
Orders for 100 or more copies mailed to a single address are discounted 25
percent. Orders should be sent to:

U. S. General Accounting Office 441 G Street NW, Room LM Washington, D. C.
20548

To order by Phone: Voice: (202) 512- 6000 TDD: (202) 512- 2537 Fax: (202)
512- 6061

To Report Fraud, Contact: Waste, and Abuse in

Web site: www. gao. gov/ fraudnet/ fraudnet. htm E- mail: fraudnet@ gao.
gov

Federal Programs Automated answering system: (800) 424- 5454 or (202) 512-
7470

Public Affairs Jeff Nelligan, Managing Director, NelliganJ@ gao. gov (202)
512- 4800 U. S. General Accounting Office, 441 G Street NW, Room 7149

Washington, D. C. 20548

a

GAO United States General Accounting Office

In GAO*s opinion, IRS*s fiscal year 2002 financial statements were fairly
presented in all material respects. Because of serious financial systems
and control weaknesses, however, IRS again had to rely extensively on
various costly and resource- intensive processes to prepare its financial
statements.

IRS made notable progress in a number of areas in fiscal year 2002,
including addressing issues related to budgetary activity, accountability
over property and equipment, and computer security. The agency also laid
the groundwork for improvement in several other areas. Nevertheless, IRS
continues to be challenged by many of the same issues reported each year
since fiscal year 1992, when GAO began auditing IRS*s financial
statements. Serious problems continued to exist in the following five
areas: (1) financial reporting, (2) unpaid tax assessments, (3) tax
revenue and refunds, (4) property and equipment, and (5) computer
security. Additionally, IRS was not always in compliance with laws
concerning the structure of installment agreements IRS enters into with
taxpayers and the timing of the release of federal tax liens.

One of the largest obstacles facing IRS management is the agency*s lack of
a financial management system capable of producing information needed for
day- to- day decisions. Through compensating processes, extraordinary
efforts, and some fundamental changes in how it processed transactions,
maintained its records, and reported its financial results, IRS was able
to issue its financial statements 6 weeks after the end of the fiscal
year. Despite this, IRS*s compensating processes and approaches cannot
produce reliable, timely financial and cost- based performance information
useful for ongoing decision making or fully address the financial
management and operational issues that affect IRS*s ability to fulfill its
responsibilities as the nation*s tax collector, largely because IRS*s
financial management systems do not comply with FFMIA.

Total Federal Receipts

5% 95%

Non-IRS Collections IRS Collections

Source: IRS. IRS lacks an adequate, integrated financial system, although
the agency is responsible for collecting nearly all federal receipts.
IRS*s fiscal year 2002 financial statements show that IRS programs
collected more than $2 trillion in federal receipts; this constituted 95
percent of total federal receipts. FINANCIAL AUDIT

IRS*S FISCAL YEARS 2002 AND 2001 FINANCIAL STATEMENTS

www. gao. gov/ cgi- bin/ getrpt? GAO- 03- 243. For a fuller understanding
of GAO*s opinion on IRS*s 2002 financial statements, readers should refer
to the complete audit report, available by clicking the link above, which
includes information on audit objectives, scope, and methodology, as well
as audit findings. For additional information, contact Steven J. Sebastian
(202- 512- 3406). Highlights of GAO- 03- 243, a report to the

Secretary of the Treasury

November 2002

Because of the significance of IRS revenue collections to federal receipts
and, in turn, to the consolidated financial statements of the U. S.
government, which GAO is required to audit, and Congress*s interest in
financial management at IRS, GAO audits IRS*s financial statements
annually to determine whether (1) the financial statements IRS prepares
are reliable, (2) IRS management maintained effective internal controls,
and (3) IRS complies with selected provisions of significant laws and
regulations and its financial systems comply with the Federal Financial
Management Improvement Act (FFMIA).

In prior audits, GAO made numerous recommendations to IRS to address
issues raised again in this audit. GAO will continue to monitor IRS*s
progress in implementing the more than 60 recommendations that remain open
as of the date of this report. IRS agreed with the vast majority of GAO*s
recommendations and recognizes that only by implementing a new, integrated
financial system can it overcome many of its weaknesses. IRS agreed with
the report*s findings and cited a number of planned improvements and
initiatives to address some of the problems GAO identified.

Page i GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Contents

Contents

Page ii GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Page 1 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements
United States General Accounting Office

Washington, D. C. 20548 Comptroller General

of the United States A

Page 2 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Page 3 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Page 4 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Page 5 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements
United States General Accounting Office

Washington, D. C. 20548 Comptroller General

of the United States A

Page 6 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Page 7 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Page 8 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Page 9 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Page 10 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Page 11 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Page 12 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Page 13 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Page 14 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Page 15 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Management Discussion and Analysis Page 16 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 17 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 18 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 19 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 20 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 21 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 22 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 23 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 24 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 25 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 26 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 27 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 28 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 29 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 30 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 31 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 32 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 33 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 34 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 35 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 36 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 37 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 38 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 39 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 40 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 41 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 42 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 43 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 44 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 45 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 46 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 47 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 48 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 49 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 50 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 51 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 52 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 53 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 54 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 55 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 56 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 57 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 58 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 59 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 60 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 61 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 62 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 63 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 64 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 65 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 66 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 67 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 68 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 69 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 70 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 71 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Management Discussion and Analysis Page 72 GAO- 03- 243 IRS's Fiscal Year
2002 and 2001 Financial Statements

Page 73 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Financial Statements Page 74 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 75 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 76 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 77 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 78 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 79 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 80 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 81 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 82 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 83 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 84 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 85 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 86 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 87 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 88 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 89 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 90 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 91 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 92 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 93 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 94 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 95 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 96 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 97 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Financial Statements Page 98 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001
Financial Statements

Page 99 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Supplemental and Other Accompanying Information Page 100 GAO- 03- 243
IRS's Fiscal Year 2002 and 2001 Financial Statements

Supplemental and Other Accompanying Information Page 101 GAO- 03- 243
IRS's Fiscal Year 2002 and 2001 Financial Statements

Supplemental and Other Accompanying Information Page 102 GAO- 03- 243
IRS's Fiscal Year 2002 and 2001 Financial Statements

Supplemental and Other Accompanying Information Page 103 GAO- 03- 243
IRS's Fiscal Year 2002 and 2001 Financial Statements

Supplemental and Other Accompanying Information Page 104 GAO- 03- 243
IRS's Fiscal Year 2002 and 2001 Financial Statements

Page 105 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 106 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 107 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 108 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 109 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 110 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 111 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 112 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 113 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 114 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 115 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 116 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 117 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 118 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 119 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 120 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 121 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 122 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 123 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 124 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 125 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 126 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 127 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 128 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 129 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix I Material Weaknesses, Reportable Conditions, and Compliance
Issues

Page 130 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Page 131 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix II

Appendix II Details on Audit Methodology

Page 132 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Page 133 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix III

Appendix III Comments from the Internal Revenue Service

Page 134 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix III Comments from the Internal Revenue Service

Page 135 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix III Comments from the Internal Revenue Service

Page 136 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

Appendix III Comments from the Internal Revenue Service

Page 138 GAO- 03- 243 IRS's Fiscal Year 2002 and 2001 Financial Statements

United States General Accounting Office Washington, D. C. 20548- 0001

Official Business Penalty for Private Use $300

Address Service Requested Presorted Standard

Postage & Fees Paid GAO Permit No. GI00
*** End of document. ***