Small Business Administration: Loan Accounting and Other	 
Financial Management Issues Impair Accountability (29-APR-03,	 
GAO-03-676T).							 
                                                                 
Recently, the Small Business Administration's (SBA) auditors	 
withdrew their unqualified audit opinions on SBA's fiscal year	 
2000 and 2001 financial statements and issued disclaimers of	 
opinion. The auditors also issued a disclaimer of opinion on	 
SBA's fiscal year 2002 financial statements. This turn of events 
was primarily due to flaws in the way SBA accounted for its loan 
sales and for the remaining portfolio. There were also several	 
other issues affecting SBA's fiscal year 2002 audit, including	 
key internal control weaknesses and systems that did not	 
substantially comply with the Federal Financial Management	 
Improvement Act. The information GAO presents in this testimony, 
which is discussed in greater detail in our January 2003 report, 
Small Business Administration: Accounting Anomalies and Limited  
Operational Data Make Results of Loan Sales Uncertain		 
(GAO-03-87), is intended to assist Congress in assessing the	 
current status of financial accountability at SBA.		 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-03-676T					        
    ACCNO:   A06753						        
  TITLE:     Small Business Administration: Loan Accounting and Other 
Financial Management Issues Impair Accountability		 
     DATE:   04/29/2003 
  SUBJECT:   Accounting 					 
	     Auditors						 
	     Budget activities					 
	     Budgeting						 
	     Financial management				 
	     Financial statement audits 			 

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GAO-03-676T

                                       A

Test i mony Before the Subcommittee on Government Efficiency and Financial
Management, Government Reform Committee, House of Representatives

For Release on Delivery Expected at 2 p. m. EDT SMALL BUSINESS April 29,
2003 ADMINISTRATION

Loan Accounting and Other Financial Management Issues Impair
Accountability

Statement of Linda M. Calbom, Director Financial Management and Assurance

GAO- 03- 676T

Mr. Chairman and Members of the Subcommittee: I am pleased to be here
today to discuss the status of financial management at the Small Business
Administration (SBA). Recently SBA's auditor withdrew its unqualified
audit opinions on SBA's fiscal year 2000 and 2001 financial statements and
issued disclaimers of opinion. The auditor also issued a disclaimer of
opinion on SBA's fiscal year 2002 financial statements. This turn of
events was primarily due to flaws we identified in the way SBA accounted
for its loan sales and for the remaining portfolio. There were also
several other issues affecting SBA's fiscal year 2002 financial statement
audit, including key internal control weaknesses and systems that did not
substantially comply with the Federal Financial

Management Improvement Act (FFMIA). I will discuss all of these issues
today which, when combined, point to an overall lack of financial
accountability at SBA.

SBA*s Accounting for This January, we reported 1 that SBA had sold almost
110, 000 loans with an unpaid principal balance of about $4.4 billion in
five loan sales from August

Loan Sales and the 1999 through January 2002. 2 Our review of the
budgeting and accounting

Remaining Portfolio for these loan sales found errors that could
significantly affect the reported

was Flawed results in SBA*s budget and financial statements.

1 U. S. General Accounting Office, Small Business Administration:
Accounting Anomalies and Limited Operational Data Make Results of Loan
Sales Uncertain, GAO- 03- 87 (Washington, D. C.: Jan. 3, 2003).

2 SBA has held two additional loan sales that were not included in our
review. In August 2002, SBA held its sixth sale, which included about
30,000 loans with an outstanding balance of $657 million. The seventh sale
took place in December 2002 and consisted of about 29,000 loans with an
outstanding balance of $682 million. In all seven sales SBA has sold about
169,000 loans with an outstanding balance of $5.8 billion.

We found that SBA (1) incorrectly calculated losses on loan sales reported
in the footnotes to its financial statements, (2) did not appropriately
consider the effect of loan sales on its estimates of the cost of the
remaining portfolio, which could significantly affect its budget and
financial statement reporting, and (3) had significant unexplained
declines in its subsidy allowance 3 for the disaster loan program. Until
SBA makes the necessary corrections to its procedures to estimate the cost
of its credit programs, including the effect of its loan sales, the
reliability of the current and future subsidy rates will remain unknown.
We understand that SBA is taking steps to address the issues we
identified, including working with a consulting firm to perform a detailed
analysis of its loan sale accounting and cost estimation procedures.

SBA Improperly Calculated Accounting records related to SBA*s first five
loan sales indicated that

Losses on Loan Sales losses exceeded $1.5 billion. However, this amount is
overstated because

of errors in the way SBA calculated the losses. Because of the lack of
reliable financial data, we were unable to determine the financial effect
of loan sales on SBA*s budget and financial statements. These errors raise
serious concerns about the information related to the results of loan
sales included in the footnotes to the annual financial statements that
SBA provided to the Office of Management and Budget (OMB) and the Congress
for decision- making purposes.

3 For a subsidized loan program, the subsidy allowance account generally
represents the subsidized portion * the amount of expected losses related
to estimated defaults and financing costs from making below- market rate
loans * assumed by the federal government. The subsidy allowance account
is subtracted from the loans receivable balance on the

balance sheet to arrive at the net loan amount expected to be repaid.

For accounting purposes, the gain or loss on a loan sale represents the
difference between the net book value (the outstanding loans receivable
balance minus the subsidy allowance) of the loans sold and the net sale
proceeds. 4 The footnotes to SBA*s fiscal year 1999 and 2000 financial
statements reported accounting losses of $75 million and $600 million,
respectively, on its loan sales. SBA did not separately disclose the
losses calculated on the two loan sales that took place during fiscal year
2001. 5 According to SBA*s accounting records, the first five sales
resulted in total

losses of more than $1.5 billion. Prior to a loan sale, an estimate of the
loans* current value to the government or *hold value* is calculated to
determine what the loans are worth to the government in the event that the
loans are held to maturity or

some other resolution, such as prepayment or default. 6 This hold value is
compared to an estimate of the expected net sale proceeds to determine if
it is advantageous for the loans to be sold. 7 After a sale, the hold
value is compared to the actual net sale proceeds to determine whether or
not and

by how much the government benefited from the sale. SBA determined that
the first five loan sales resulted in a $606 million benefit to the
government. 8 This benefit calculation differs from the accounting gain or
loss because the benefit calculation is not designed to take into
consideration changes in interest rates from the time the loans were
disbursed to the date of the sale, while the accounting gain or loss, if
properly computed, does take these changes into account.

4 OMB Circular A- 11 defines net sale proceeds in the context of loan
sales as the amounts paid by purchasers less all seller transaction costs
(such as underwriting, rating agency, legal, financial advisory, and due
diligence fees) that are paid out of the gross sales proceeds rather than
paid as direct obligations by the agency.

5 SBA also did not disclose any gain or loss on the two loan sales, number
5 and 6, which took place during fiscal year 2002 in its financial
statements for that year. 6 The hold value is calculated on a present
value basis, meaning the worth of a future stream of returns or costs in
terms of money paid immediately. In calculating the hold value, interest
rates from the most recent President*s budget at the time the estimate is
prepared provide the basis for converting future amounts into their *money
now,* or present value, equivalents.

7 OMB reviews these calculations as part of its approval process for SBA
to conduct a loan sale. 8 We did not audit the data used to calculate the
hold values for each sale, and therefore did not conclude on the
reasonableness of the hold values for any of the sales.

We reviewed the methodology SBA used to calculate the results of its loan
sales for accounting purposes and found significant errors. When
calculating whether loans are sold at a gain or a loss, agencies must
estimate the portion of the subsidy allowance to allocate to each loan
sold in order to calculate the net book value for those loans. Since SBA*s
calculation of the net book value of the loans sold exceeded the net
proceeds from the sales, losses were calculated. Our review of these
calculations found that SBA*s estimates did not consider all the
appropriate cash flows when allocating the subsidy allowance to the sold
loans. For example, when calculating the gains or losses for the disaster
loan program, SBA failed to allocate a portion of the subsidy allowance
for financing costs associated with lending to borrowers at below market
interest rates. Doing so would have reduced the amount of loss that SBA
reported on the loan sales.

In addition, SBA incorrectly allocated the subsidy allowance for the
previously defaulted 7( a) and 504 guaranteed loans, which could
materially distort the gain or loss. SBA used its estimated net default
cost, which considers first the probability of default and then the
estimated recovery rate after default. For example, if a $10,000
guaranteed loan has an estimated default rate of 10 percent and an
estimated recovery rate of 50 percent, the subsidy allowance allocated by
SBA would be $500 ([$ 10,000 x .10] x .50). Therefore, the net book value
calculated for the loan would be $9, 500. However, since guaranteed loans
sold have already defaulted, it is

not appropriate to apply the estimated default rate of 10 percent. SBA
should have applied only the estimated recovery rate of 50 percent for
these loans, and the subsidy allowance allocated would be $5,000 ($ 10,000
x .50) and the net book value calculated for the loan would be $5,000.
Figure 1 illustrates the difference in the calculated gain or loss
resulting

from this error if the previously defaulted loan were sold for $6,500. The
left column, based on SBA*s incorrect methodology, shows that the loan was
sold for a $3,000 loss, while the right column appropriately allocates the
allowance based on expected recoveries and results in a $1,500 gain, a
difference of $4, 500 for this example of a $10, 000 guaranteed loan sold.

Figure 1: Gain / Loss Calculation on Previously Defaulted Guaranteed Loans
Sold

SBA*s errors in calculating the losses on disaster loans and previously
defaulted guaranteed loans sold both resulted in overestimates of the net
book value of the loans sold and the losses that SBA reported in the
footnotes to its fiscal year 1999 and 2000 financial statements. Because
of the way the results of loan sales are incorporated in the budget and
the financial statements, the reestimates, if done properly, should have

corrected the impact of these errors. However, as I discuss next, the
reestimates were not reliable.

Subsidy Cost Reestimates SBA did not conduct key analyses of the loans
sold and those remaining in

are Unreliable its portfolio so it could determine how the sales affected
its reestimates of

program costs for its remaining loans. OMB*s budget guidance directs
agencies to make reestimates for all changes in cash flow assumptions in
order to adjust the subsidy estimate for differences between the original

estimated cash flows and the actual cash flows. SBA officials acknowledged
that analyses of the impact of loan sales on its historical averages
should be done. However, they told us they lacked the appropriate
historical data and resources to perform these analyses. Because SBA did
not assess the effect loan sales would have on its historical averages of
loan performance, such as when loans default or prepay, the agency did not
know whether these averages, which can significantly affect the estimated
cost of a loan program, reasonably predict future loan performance. As a
result, information in both the budget and financial statements related to
the reestimated cost of SBA*s loan programs cannot be relied upon.

SBA is generally required to update or *reestimate* loan program costs
annually. OMB Circular A- 11 directs agencies to do reestimates for all
changes in cash flow assumptions. Thus, reestimates should include all

aspects of the original cost estimate, including prepayments, defaults,
delinquencies, and recoveries. These reestimates are done to adjust the
subsidy cost estimate for differences between the original cash flow
projections and the amount and timing of cash flows that are expected

based on actual experience, new forecasts about future economic
conditions, and other events that affect the cash flows.

Even after selling about $4.4 billion of loans, nearly half of its loan
portfolio, SBA had not analyzed the effect of loan sales on the estimated
cost of the remaining loans in its portfolio. SBA officials told us loans
are selected for sale based on certain criteria, such as where the loan is
located or serviced, the type of collateral, or whether the loan is
performing. Since the loan selection process is not random* that is, all
loans do not have an equal chance of being selected* it is likely that the
loans sold had different characteristics than the portfolio*s historical
averages prior to sales.

Consequently, the characteristics of the remaining loans may also differ
substantially from the portfolio historical averages prior to the sales.
For example, during our analysis of the loans that were sold, we
determined that 84 percent of the $3.8 billion of disaster loans sold were
performing* meaning that payments were not more than 30 days delinquent.
Selling mostly performing loans could leave a disproportionate level of
nonperforming loans in SBA*s portfolio. Because SBA had not analyzed the
effect of loan sales on the characteristics of its remaining portfolio, it
does not know if the percentages of remaining performing and nonperforming
loans are different from the historical averages prior to the sales. A
change in these percentages could indicate that expected defaults in the
remaining

portfolio could be higher or lower than current assumptions, based on
historical data, suggest.

Another important loan characteristic is the stated loan term. This term
is the contractual amount of time borrowers have to repay their loans.
SBA*s estimated costs of the disaster loan program are based on historical
average loan term assumptions of 16 years for business disaster loans and
17 years for home disaster loans. Based on our review of the disaster
loans sold in the first five sales, the average loan term was about 25
years. However, SBA continued to use average loan term assumptions of 16
and

17 years in its reestimates without doing the appropriate analysis to
determine whether these assumptions were still valid. Based on our recent
discussion with SBA officials, their detailed analysis of the cost
estimation procedures for the disaster loan program found that, among
other things, the average loan term assumption should have been greater.
Relatively

minor changes in some cash flow assumptions, such as higher or lower

default and recovery rates and changes in loan terms, can significantly
affect the estimated cost of the loan program and therefore the program*s
budget.

The Subsidy Allowance During our review of the accounting for loan sales,
we noted that the

Account Was Misstated subsidy allowance account for the disaster loan
program had an unusually

low balance. For a subsidized loan program, the subsidy allowance account
is generally the amount of expected losses on a group of loans related to
estimated defaults and financing costs from making belowmarket rate loans.
In effect, the subsidy allowance is the cost associated with the loans
that SBA does not expect to recover from borrowers. For

financial reporting purposes, the subsidy allowance reduces the
outstanding loans receivable balance to the amount that SBA expects to
collect from borrowers, known as the net loans receivable balance (or net
book value), which is shown on the balance sheet. Table 1 summarizes the
disaster loan program*s reported outstanding loans

receivable balance, the subsidy allowance balance, the net book value, and
the subsidy allowance as a percentage of the loans receivable balance for
fiscal years 1998 through 2002. The reported subsidy allowance compared to
the loans receivable balance decreased significantly in fiscal years 2000
and 2001, to the point of showing that the remaining portfolio of the

disaster program was expected to generate a profit. This declining trend
continued into fiscal year 2002. SBA could not provide support for the
balance or explain the reason for this anomaly. Tabl e 1: Reported Loans
Receivable Balances of SBA*s Disaster Loan Program

Dollars in millions

Fiscal Fiscal

Fiscal Fiscal

Fiscal Disaster loan program year 1998 year 1999 year 2000 year 2001 year
2002

Loans receivable Outstanding $5, 614 $5, 659 $5,305 $3, 293 $3, 110

Less / (plus): subsidy allowance balance $1, 502 $929 $505 ($ 77) ($ 522)

Net book value $4, 112 $4, 730 $4,800 $3, 370 $3, 632 Subsidy allowance as
a percentage of loans

receivable balance 26.8% 16. 4% 9.5% (2.3%) (16.8%) Source: SBA.

Table 1 shows a rapid decrease in the reported subsidy allowance between
fiscal year 2000 and 2001. Most of this decrease actually occurred in
fiscal year 2000, but was masked by an adjustment made during the fiscal
year 2000 financial statement audit. Before SBA made the audit adjustment,
the subsidy allowance for the disaster program was about $91 million for
fiscal year 2000. This balance was $838 million, or about 90 percent, less
than the $929 million balance for fiscal year 1999, while loans receivable
outstanding decreased by only $354 million, or about 6 percent.

In order to restore the subsidy allowance to a more reasonable balance at
the end of fiscal year 2000, in agreement with its auditor, SBA increased
the subsidy allowance balance by recording an audit adjustment that was
essentially meant to reflect the expected impact of loan sales on the
reestimates prepared in fiscal year 2000, which did not factor in the
effects of loan sales. 9 This increased the reported cost of the disaster
loan program by $414 million in fiscal year 2000. Since the amount of the

adjustment was based on SBA*s erroneous calculations of loan sale losses,
as previously discussed, the amount of the adjustment was incorrect.
During fiscal year 2001, SBA reversed the audit adjustment and revised its
reestimates to include cash flows related to loan sales. Our review of the
fiscal year 2001 disaster loan program reestimates indicated that loan
sales increased the reported cost of the program by about $292 million.
However, this amount is also likely misstated because, as I previously

mentioned, the reestimates did not consider the specific characteristics
of the loans sold or the loans remaining in the portfolio.

9 Theoretically, had the reestimates factored in the loan sales, the
subsidy allowance account would have been appropriately adjusted,
regardless of any errors made in recording the calculated accounting
losses.

The unexplained decline in the subsidy allowance continued in the fiscal
year 2001 financial statements where SBA reported a negative balance in
the subsidy allowance for the disaster loan program. As shown in table 1,
this allowance account no longer reduced the amount SBA expected borrowers
to repay * it actually increased the expected repayments from

borrowers and indicated that the loan program was profitable. However,
because the program is subsidized, with estimated default and financing
costs exceeding the amount of interest borrowers are expected to pay, it
should not show an expected profit, and thus the balance for the subsidy
allowance account appears to be significantly misstated. 10 As in the
prior year, SBA could not explain the unusual balance. Based on our review
of SBA*s fiscal year 2002 financial statements, the unexplained trend
continued and the negative balance of the subsidy allowance (expected
profit) increased to $522 million.

While the objective of our work was not to determine the specific cause of
the unusual balance, several possibilities exist. As previously mentioned,
not considering the characteristics of the loans sold or of those
remaining in SBA*s portfolio could contribute to the unusual balance.
Another possibility is that SBA may have underestimated the cost of its
disaster loan program because the cash flow assumptions used to estimate
the subsidy cost did not reflect the true characteristics or performance
of its loan portfolio. For example, as I previously discussed, SBA used
average loan term assumptions of 16 and 17 years to estimate the cost of
the disaster loan program. However, based on recent discussions with SBA
officials, they have found that the average loan term should have been
greater. Underestimating the loan term would mean that SBA did not put
enough

into the subsidy allowance account to cover interest costs associated with
these loans and the subsidy allowance would be depleted as these costs
were written off against it until there was a negative balance. From a
budgetary perspective, this could mean that SBA did not request an
appropriation large enough to cover the cost of the loan program. Despite
the significant, unexplained decline in the subsidy allowance and

the errors in calculating the losses on loan sales, SBA received
unqualified or *clean* audit opinions on its fiscal year 2000 and 2001
financial statements. An unqualified audit opinion indicates that the
balances in the

10 Based on SBA*s reestimates for its fiscal year 2001 financial
statements, the subsidy cost of this program ranged from $17 to $33 for
every $100 the federal government lends, depending on the interest rates
in effect when the loans were made.

financial statements are free of significant errors, known as material
misstatements. As previously mentioned, SBA*s auditor attempted to adjust
the anomalies in the subsidy allowance during the fiscal year 2000
financial statement audit. However, the adjustment was based on the
previously described erroneous loss calculation. For the fiscal year 2001
audit, SBA*s auditor performed a number of audit procedures related to the
disaster loan program subsidy allowance account. For example, the auditor
evaluated the methodology and formulas used to calculate reestimates,
assessed data used to calculate key cash flow assumptions, and reviewed
various internal controls over the subsidy estimation process. However,
this work did not appear to focus on determining the cause of the unusual

negative balance of the account, which, contrary to the fact that this is
a subsidized loan program, would indicate that these loans were expected
to generate a profit. The auditor*s workpapers indicated that the auditor
had agreed, in discussions with SBA management, that if the *methodology
and data were materially correct, we [the auditor] would conclude that the
resulting subsidy reserve [allowance] would be materially correct for
financial statement reporting purposes.* The workpapers also indicated
that, *whatever the results of the reestimates are, as long as the

methodology is sound and supportable, we [the auditor] would not consider
the balance [of the subsidy allowance] anything other than *natural. **

Although SBA*s auditor may have recognized some of the errors we
identified, they did not determine the cause of the unusual balance and
propose the necessary audit adjustments or modify their audit report as
appropriate. In such situations, when auditors cannot determine whether a
balance is fairly stated because sufficient reliable supporting
documentation is not available, audit standards 11 call for auditors to
either

qualify their opinion with the noted exception or issue a disclaimer of
opinion, meaning that the auditor was unable to obtain satisfaction that
the financial statements are fairly stated and therefore does not express
an opinion. We discussed these issues with SBA*s auditor and they have
since reevaluated and withdrawn their unqualified audit opinions on SBA*s
fiscal year 2000 and 2001 financial statements and issued disclaimers of
opinion.

In response to our findings, SBA contracted with an independent consulting
firm to complete a more detailed analysis of its loan sale accounting and
cost estimation procedures to determine the cause of the 11 Statements on
Auditing Standards, AU S:508 paragraphs 22 and 23.

unusual balance in the subsidy allowance account. We recently met with SBA
officials to discuss the steps taken to date to address the issues we
identified. We understand that SBA, working with the consultants, has
identified a number of issues related to the methods and assumptions used
to estimate the cost for the disaster loan program. While we have not had
an opportunity to analyze their findings in detail, based on our previous
work, several of the issues they identified, including the understated

average loan term, appear to be plausible causes of the decline in the
subsidy allowance for the disaster loan program. Results of Fiscal Year

SBA*s inability to account for its loan sales or adequately reestimate the
2002 Financial

cost of loans not sold, combined with other financial management issues,
led to the auditors issuing a disclaimer of opinion on SBA*s fiscal year
2002 Statement Audit

financial statements. I will now briefly discuss the disclaimer of
opinion, the internal control weaknesses they reflect, and the
consequences of these weaknesses regarding compliance with FFMIA.

Disclaimer of Opinion The disclaimer of opinion for fiscal year 2002 was
primarily due to three issues: (1) SBA's disaster loan modeling contained
deficiencies and was no longer adequate for determining the costs of
disaster loans sold or reestimating the cost of loans not sold, (2) SBA
did not present future

expected default costs on pre- 1992 loan guarantees 12 or determine the
correct valuation of related balances, and (3) SBA could not ensure that
the balance in the Master Reserve Fund 13 residual asset or liability was
reliable.

As I*ve previously discussed, SBA*s inability to determine the cost of
loans sold or adequately reestimate the cost of loans not sold could
materially affect amounts reported in the budget and the financial
statements. SBA and its consultants had not completed their analysis of
SBA*s loan sale accounting and cost estimation procedures prior to the
completion of the fiscal year 2002 audit. Therefore, SBA was not able to
provide sufficient

12 Pre- 1992 loan guarantees are loan guarantees committed prior to
October 1, 1991. The accounting standard requires that the liabilities of
pre- 1992 loan guarantees be recognized when it is more likely than not
that the loan guarantees will require a future cash outlaw to pay default
claims.

13 The 7( a) secondary market program, one of SBA*s business loan
programs, is administered by an agent of SBA. Payments for this program
flow through the Master Reserve Fund.

evidence to its auditors to support certain amounts reported and
disclosures made in its fiscal year 2001 and 2002 financial statements,
thereby limiting the scope of the audit and leading to the disclaimer of
opinion.

Additionally, SBA did not present future expected default costs on pre-
1992 loan guarantees. SBA made several adjusting entries to both the
fiscal year 2002 and fiscal year 2001 financial statements in an effort to
correct this. However, SBA did not have a calculation methodology to
determine its

expected future default costs and related liability or to support the
adjustments made. Therefore, SBA could not provide sufficient
documentation that the liability balance of $116 million as of September
30, 2002, was fairly stated. The final issue contributing to SBA*s
disclaimer related to the Master

Reserve Fund. SBA's fiscal and transfer agent maintains the Master Reserve
Fund to facilitate operation of the secondary market program 14 for 7( a)
Business Loans, a loan guarantee program for small businesses that would
otherwise be unable to obtain financing at reasonable rates. The

Master Reserve Fund receives payments from lenders who have SBAguaranteed
loans and makes payments to the investors in the secondary market program.
In fiscal year 2002, SBA estimated that there was a

potential future deficit (shortfall resulting from payments to investors
exceeding payments from lenders) in the range of zero to $18.3 million
required to liquidate the obligations in the 7( a) secondary market. This
potential deficit contrasted with fiscal year 2001 where an estimated
excess

of $68 million was reported. According to SBA*s auditor, SBA used samples
of Master Reserve Fund activity for fiscal years 2002 and fiscal year 2001
to estimate the year- end balances. The samples were small and differed in
important respects from the total population of loans. Thus, the sampling
was not entirely representative of the loan population and did not provide
sufficient evidence that the estimate of the Master Reserve Fund balance
was fairly stated.

14 The secondary market program was created to increase the attractiveness
of small business lending to the lending community. Through this market,
lenders are able to sell the guaranteed portion of SBA guaranteed loans to
investors, thereby improving the lenders* liquidity and increasing the
yield on the nonguaranteed portion of the SBA loan.

Internal Control The study and evaluation of the system of internal
control over financial

Weaknesses reporting are included as part of the financial statement audit
under

generally accepted auditing standards. Internal control is an integral
component of an agency*s management that provides reasonable assurance
that the following objectives are being achieved: (1) effectiveness and

efficiency of operations, (2) reliability of financial reporting, and (3)
compliance with applicable laws and regulations. 15 Internal control
serves as the first line of defense in safeguarding assets and in
preventing and detecting errors and fraud. As federal policymakers and
program managers continually seek to better achieve agencies* missions and
program results, they seek ways to improve accountability. A key factor in
achieving these outcomes and minimizing operational problems is the

implementation of appropriate internal control. Internal control over
financial information is evaluated during the audit, and the auditor is
required to communicate to the agency any condition that represents a
significant deficiency in internal controls* referred to as a reportable
condition. 16 A material internal control weakness is a

reportable condition that does not reduce to a relatively low level the
risk that errors, fraud, or noncompliance involving significant amounts
may occur and not be detected in a timely manner by employees in the
normal course of performing their assigned functions. SBA*s auditor
identified five material weaknesses and one reportable condition.

As I previously stated, SBA received a disclaimer of opinion from its
auditor in fiscal year 2002 primarily due to three issues, and each of
these issues resulted from a material weakness in their internal controls.
SBA*s auditor reported material weaknesses relating to (1) disaster loan
modeling, (2) the liability for loan guarantees and related accounts for
pre1992 loan commitments, and (3) the Master Reserve Fund, all of which I
have discussed. The fourth material weakness related to SBA*s financial
reporting process. According to SBA*s auditor, SBA continued to experience
widespread difficulties in producing complete, accurate, timely, and
adequately supported draft and final financial statements, including

15 Standards for Internal Control in the Federal Government, (GAO/ AIMD-
00- 21. 3.1) Washington, D. C.: November 1999) 16 A reportable condition
is a significant deficiency in the design or operation of internal
controls that could adversely affect the organization*s ability to provide
reasonable assurance on the reliability of its financial reporting,
performance reporting, and compliance with laws and regulations.

footnotes. The auditor stated that additional attention is needed to
ensure that a fully effective quality assurance process is documented and
in place. The auditor further stated that SBA's difficulties with
financial reporting may be attributable to devoting insufficient resources
to the process,

particularly the quality control process. The fifth material weakness was
due to funds control weaknesses. For example, the auditor reported that
SBA established invalid undelivered orders in its liquidating funds and
did not return all unobligated balances in its liquidating funds to the
general fund at the end of the fiscal year. Also, SBA did not have
sufficient funds controls in place to ensure that payments for defaulted
7( a) loan guarantees did not exceed authorized amounts or to ensure that
obligations were not incurred against anticipated budgetary resources.
These shortcomings increase the risk that SBA may violate the
Antideficiency Act. 17

Finally, while SBA has continued to improve internal controls over its
information system environment in certain areas, the auditor reported that
further improvement is needed to ensure a sound information system

control environment. This internal control deficiency was included as a
reportable condition in the auditor*s 2002 report on internal controls.
Weaknesses were reported in all six categories of general computer
controls. 18 General computer controls create the environment in which
application systems and controls operate. During a financial statement
audit, the auditor focuses on general controls for the agency*s major
computer facilities and systems supporting a number of different computer
applications, such as major data processing installations or local area
networks. If general computer controls are weak, as is the case at SBA,
they severely diminish the reliability of controls associated with
individual applications.

17 The Antideficiency Act, among other things, prohibits the making of
expenditures or the incurring of obligations prior to or in excess of
appropriations. 18 The six general control categories are: (1) entity-
wide security program control, (2) access

control, (3) application software development and program change control,
(4) system software control, (5) segregation- of- duty control, and (6)
service continuity control.

Federal Financial SBA*s auditor also concluded that SBA*s systems did not
substantially

Management Improvement comply with the Federal Financial Management
Improvement Act of 1996 Act of 1996

(FFMIA). FFMIA is a measure of an agency*s ability to incorporate into its
financial management system accounting standards and reporting objectives
established for the federal government, so that all assets,

liabilities, revenues, expenses, and the full costs of programs and
activities can be consistently and accurately recorded, monitored, and
uniformly reported. Substantial noncompliance with FFMIA indicates that
SBA*s financial management systems do not routinely provide reliable,
useful, timely, and consistent information to fulfill its responsibility
of being accountable to the public and of providing timely financial
information to manage on a day- to- day basis.

SBA*s financial management systems in fiscal year 2002 did not
substantially comply with all three aspects of FFMIA: (1) federal
financial management systems requirements, (2) federal accounting
standards, or (3) the U. S. government standard general ledger (SGL) at
the transaction level.

SBA*s auditor noted that SBA was not in substantial compliance with
federal financial management systems requirements because its core
financial system is not able to provide complete, reliable, timely and
consistent financial information on programs to enable management to
fulfill its responsibility to the public and to provide timely information
for managing current operations. Also, access control, segregation- of-
duties, and other general control weaknesses exist in SBA*s information
systems controls. Additionally, funds control deficiencies exist as is
evidenced in SBA*s material weakness in that area.

The auditor concluded that SBA did not substantially comply with federal
accounting standards because it cannot support the reported cost of loans
sold, the reestimates of the subsidy for loans not sold, or the liability
for pre- 1992 loan guarantees. SBA also cannot support the balance in the
Master Reserve Fund.

Finally SBA*s auditor concluded that SBA*s financial systems did not
substantially comply with the SGL at the transaction level. During fiscal
year 2002, SBA modified its Financial Reporting Information System but

did not detect in a timely manner an error created by the modification.
SBA also experienced problems that resulted in the posting of invalid
information to the system when it converted to its current Oracle- based
administrative accounting system.

In closing, Mr. Chairman, SBA*s financial management deficiencies are
quite severe and point to an inability to provide full accountability for
taxpayer funds provided to the agency for carrying out its programs. Until
these deficiencies are corrected, SBA*s financial accounting and budgetary
reporting will be unreliable. In our January 2003 report, we made a number
of recommendations to SBA covering these matters related to accounting for
loan sales. SBA agreed with our recommendations, and we understand that
they are making progress identifying potential causes of these

deficiencies and actions to address them. We look forward to assessing the
results of these activities.

Mr. Chairman, this concludes my statement. I would be happy to answer any
questions you or other members of the subcommittee may have.

Contact and For information about this statement, please contact Linda
Calbom,

Acknowledgments Director, Financial Management and Assurance, at (202)
512- 9508, or Julia

Duquette, Assistant Director, at (202) 512- 5131. You may also reach them
by e- mail at calboml@ gao. gov or duquettej@ gao. gov. Other individuals
who made key contributions to this testimony include Marcia Carlsen and
Lisa Crye. Numerous other individuals made contributions to the work
supporting this testimony.

(190092)

GAO United States General Accounting Office

A

Since August 1999, SBA held seven loan asset sales, disposing of a total
of $5.8 billion in disaster assistance and business loans. Our review of
the budgeting and accounting for the first five loan sales found errors
that could significantly affect the reported results in SBA*s budget and
financial statements. We found that SBA (1) incorrectly calculated losses
on loan sales reported in the footnotes to its financial statements, (2)
did not appropriately consider the effect of loan sales on its estimates
of the cost of the remaining portfolio, which could significantly affect
its budget and financial statement reporting, and (3) had significant
unexplained declines in its subsidy allowance for the disaster loan
program. As shown in the figure, the subsidy allowance eventually declined
to a negative balance, which indicated that SBA expected profits on its
subsidized disaster loans.

Despite these errors and uncertainties, SBA*s auditor gave unqualified
audit opinions on SBA*s fiscal year 2000 and 2001 financial statements. We
discussed these issues with SBA*s auditors, who have since reassessed the

unusual balance in the subsidy allowance account and withdrawn their
unqualified audit opinions on the fiscal year 2000 and 2001 financial
statements. The agency*s inability to properly account for its loans sold
and not sold, combined with several other financial management issues, led
the auditors to issue a disclaimer of opinion on SBA*s fiscal year 2002
financial statements. Until SBA corrects its financial management
deficiencies, the agency*s financial accounting and budgetary reporting
will be unreliable. Based on recent discussions with SBA officials, we
understand that they are

making progress in identifying the sources of the loan accounting problems
and in determining corrective actions. SBA Disaster Loans Subsidy
Allowance

Note: Analysis based on SBA data.

Recently, the Small Business Administration*s (SBA) auditors withdrew
their unqualified audit opinions on SBA's fiscal year 2000 and 2001
financial statements and issued disclaimers of opinion. The auditors also
issued a disclaimer of opinion on SBA's fiscal year 2002

financial statements. This turn of events was primarily due to flaws in
the way SBA accounted for its loan sales and for the remaining portfolio.
There were also several other issues affecting SBA's fiscal year 2002
audit, including key

internal control weaknesses and systems that did not substantially comply
with the Federal Financial Management Improvement Act. The information GAO
presents in

this testimony, which is discussed in greater detail in our January 2003
report, Small Business Administration: Accounting Anomalies and Limited
Operational Data Make Results of Loan Sales Uncertain (GAO- 03- 87), is
intended to assist Congress in

assessing the current status of financial accountability at SBA. GAO is
not making new recommendations in this testimony, but in a past report has
made specific recommendations aimed at addressing the deficiencies in the
accounting for loan asset sales and the remaining portfolio. www. gao.
gov/ cgi- bin/ getrpt? GAO- 03- 676T. To view the full testimony, click on
the link

above. For more information, contact Linda Calbom at (202) 512- 9508 or
calboml@ gao. gov. Highlights of GAO- 03- 676T, a testimony

before the Subcommittee on Government Efficiency and Financial Management,
Government Reform Committee, House of Representatives

April 29, 2003

SMALL BUSINESS ADMINISTRATION

Loan Accounting and Other Financial Management Issues Impair
Accountability

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