Compact of Free Association: Single Audits Demonstrate		 
Accountability Problems over Compact Funds (07-OCT-03, GAO-04-7).
                                                                 
In 1986, the United States entered into a Compact of Free	 
Association (Compact) that provided about $2.1 billion in U.S.	 
assistance from 1987 through 2003 to the Pacific Island nations  
of the Federated States of Micronesia (FSM) and the Republic of  
the Marshall Islands (RMI). GAO has issued a number of reports	 
raising concerns about the effectiveness of this assistance. GAO 
was asked to review possible FSM and RMI misuse of Compact funds.
We reviewed single audits for 1996 through 2000 and this report  
summarizes the audit results.					 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-04-7						        
    ACCNO:   A08679						        
  TITLE:     Compact of Free Association: Single Audits Demonstrate   
Accountability Problems over Compact Funds			 
     DATE:   10/07/2003 
  SUBJECT:   Audit reports					 
	     Funds management					 
	     Noncompliance					 
	     Foreign financial assistance			 
	     Federal funds					 
	     Accountability					 
	     International agreements				 
	     International relations				 
	     Financial statement audits 			 
	     Federated States of Micronesia			 
	     Republic of the Marshall Islands			 
	     Compact of Free Association			 

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GAO-04-7

United States General Accounting Office

GAO

                       Report to Congressional Requesters

October 2003

COMPACT OF FREE ASSOCIATION

      Single Audits Demonstrate Accountability Problems over Compact Funds

                                       a

GAO-04-7

Highlights of GAO-04-7, a report to congressional requesters

In 1986, the United States entered into a Compact of Free Association
(Compact) that provided about

$2.1 billion in U.S. assistance from 1987 through 2003 to the Pacific
Island nations of the Federated States of Micronesia (FSM) and the
Republic of the Marshall Islands (RMI). GAO has issued a number of reports
raising concerns about the effectiveness of this assistance. GAO was asked
to review possible FSM and RMI misuse of Compact funds. We reviewed single
audits for 1996 through 2000 and this report summarizes the audit results.

GAO recommends that the Secretary of the Interior delegate responsibility
to and hold the Office of Insular Affairs accountable for monitoring and
reporting on FSM and RMI actions to address Compact-related single audit
findings and initiating appropriate actions when the FSM or the RMI do not
implement appropriate and adequate actions to correct Compact-related
single audit findings in a timely manner.

In commenting on this report, the Office of Insular Affairs of the
Department of the Interior, FSM, and RMI agreed with our findings or
conclusions and recommendations. They also cited the amended Compacts as
mechanisms that should result in improved financial management over
Compact assistance.

www.gao.gov/cgi-bin/getrpt?GAO-04-7.

To view the full product, including the scope and methodology, click on
the link above. For more information, contact McCoy

October 2003

COMPACT OF FREE ASSOCIATION

Single Audits Demonstrate Accountability Problems over Compact Funds

GAO's review of 30 single audit reports for the FSM, 4 FSM states, and the
RMI for the years 1996 through 2000 identified pervasive and persistent
noncompliance with Compact requirements and financial statement-related
audit findings. These single audit reports identified 458 audit findings
relevant to the Compact. Significant numbers of these audit findings
occurred during each year of the 5-year period and at each of the
auditees. In addition, successive single audits identified recurring audit
findings over the 5-year period despite corrective action plans prepared
by the auditees. While none of the audit findings specifically discussed
misuse of Compact funds, they did describe noncompliance with Compact
requirements and financial management problems in areas that GAO considers
highly susceptible to misuse, such as poor control over cash and
equipment. When considered in conjunction with the qualified opinions or
disclaimers of opinion on the financial statements in all 30 reports and
for 60 percent of the Schedules of Expenditure of Federal Awards required
by the Single Audit Act, the audit findings reveal one thing: overall poor
accountability of Compact funds.

In responding to GAO's previous reviews of the original Compact, Interior
officials expressed concerns about the U.S. government's limited ability
to enforce accountability over Compact funds due to certain provisions of
the Compact and the related fiscal procedures agreement (FPA). Recently,
an Interior official noted that departmental officials have been
frustrated with the lack of tools to administer or track federal
assistance in a manner that could reasonably ensure that such assistance
is having its intended effect. GAO found that the amended Compacts and
related FPAs, which are scheduled to become effective upon legislative
approval in the three countries, include many strengthened reporting and
monitoring measures that could improve accountability, if diligently
implemented. For example, funds could be withheld for noncompliance with
Compact terms and conditions. In addition, joint economic committees and
an Interior oversight team will focus on monitoring and overseeing Compact
funds.

Percentage of 1996 through 2000 Single Audit Findings That Recurred 3 or
More Years

FSM

Pohnpei

Yap

Chuuk

Kosrae

RMI

                 Williams at (202) 512-6906 or 0 10203040506070

Percentage of findings

[email protected] or Susan Westin at Source: GAO analysis of single audit
reports.

(202) 512-4128 or [email protected].

Contents

  Letter

Results in Brief
Background
Objectives, Scope, and Methodology
Pervasive Audit Findings Demonstrate Poor Accountability over

Compact Funds Amended Compact Agreements Contain Improved Accountability

Measures Conclusions Recommendations for Executive Action Government and
Agency Comments and Our Evaluation

1 3 5 7

8

16 19 19 20

Appendixes

                          Appendix I: Appendix II: Appendix III: Appendix IV:

Comments from the Federated States of Micronesia Comments from the
Republic of the Marshall Islands Comments from the Department of the
Interior GAO Contacts and Staff Acknowledgments

GAO Contacts Acknowledgments 22

24

27

28 28 28 Figures Figure 1: Number of Audit Findings Reported Annually from
1996

through 2000 9

Figure 2: Auditee Findings as a Percentage of Total Findings 10

Figure 3: Percentage of Corrective Action Plans Developed for

Audit Findings 11 Figure 4: Percentage of 1996 through 2000 Single Audit
Findings That Recurred 3 or More Years 12

Contents

Abbreviations

CAP corrective action plan
FPA fiscal procedures agreement
FSM Federated States of Micronesia
OMB Office of Management and Budget
RMI Republic of the Marshall Islands
U.N. United Nations

This is a work of the U.S. government and is not subject to copyright
protection in the United States. It may be reproduced and distributed in
its entirety without further permission from GAO. However, because this
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copyright holder may be necessary if you wish to reproduce this material
separately.

A

United States General Accounting Office Washington, D.C. 20548

October 7, 2003

The Honorable Tom Lantos
Ranking Minority Member
Committee on International Relations
House of Representatives

The Honorable James A. Leach
Chairman
The Honorable Eni Faleomaveaga
Ranking Minority Member
Subcommittee on Asia and the Pacific
Committee on International Relations
House of Representatives

The Honorable Doug Bereuter
House of Representatives

In 1986, the United States entered into a Compact of Free Association
(Compact) with the Pacific Island nations of the Federated States of
Micronesia (FSM) and the Republic of the Marshall Islands (RMI). Through
the Compact, the United States has provided about $2.1 billion in
assistance to these nations in the form of direct funding and federal
services and programs. Further, the Compact established U.S. defense
rights and obligations in the region and allowed for migration from both
nations to the United States. The Compact provisions that address
economic assistance were scheduled to expire in 2001; however, they
remained in effect while the United States negotiated amended Compacts
with each nation.

Over the last several years, we issued reports that raised concerns about
the effectiveness of the FSM and the RMI use of and accountability over
U.S. assistance provided under the Compact.1 In commenting on the
accountability issues raised in our 2000 report, officials at the
Department of the Interior, the agency responsible for overseeing the
assistance program, pointed out the limited ability of the United States
to enforce accountability over Compact funds because basic elements of
federal grant management were lacking. They also noted that additional
personnel and funding could have been committed to Compact oversight, but
the United States would still have had almost no ability to influence
fiscal decisions made by the FSM and the RMI. In recent testimony, an
official from the Office of Insular Affairs, Department of the Interior,
noted that the department was hampered by the fact that the Compact
provided for large, loosely defined grants with no express enforcement
mechanisms to ensure the efficient and effective expenditure of funds.
This official also stated that departmental officials "have been greatly
frustrated with the lack of tools to properly administer or track Federal
assistance in a manner that could reasonably ensurethat such assistanceis
having its intended effect."2

In conjunction with our monitoring and reporting on Compact renegotiation
efforts, you asked us to review possible FSM or RMI misuse of Compact
funds. The annual single audits of the FSM and the RMI, which are required
by the fiscal procedures agreement (FPA) for implementing the Compact, are
a potential source of this information.3 While the single audit reports do
not specifically use the phrase "misuse of Compact funds," many of the
problems they identify are in areas that are susceptible to the misuse of
funds.

1 U.S. General Accounting Office, Foreign Assistance: Effectiveness and
Accountability Problems Common in U.S. Programs to Assist Two Micronesian
Nations, GAO-02-70 (Washington, D.C.: Jan. 22, 2002); Foreign Assistance:
U.S. Funds to Two Micronesian Nations Had Little Impact on Economic
Development, GAO/NSIAD-00-216 (Washington, D.C.: Sept. 22, 2000); and
Foreign Relations: Better Accountability Needed Over U.S. Assistance to
Micronesia and the Marshall Islands, GAO/RCED-00-67 (Washington, D.C.: May
31, 2000).

2 Statement of David B. Cohen, Deputy Assistant Secretary of the Interior
for Insular Affairs, before the Subcommittee on Asia and the Pacific,
House Committee on International Relations, June 18, 2003.

3 The FPA provides for a financial and compliance audit within the meaning
of the Single Audit Act. See 31 U.S.C. Chapter 75.

We obtained the 30 single audit reports for the years 1996 through 2000
for the national government of the FSM; the FSM state governments of
Chuuk, Kosrae, Pohnpei, and Yap; and the national government of the RMI.
We reviewed and summarized the audit findings contained in these reports,
the most recently completed reports available at the start of our review,
to identify instances of possible misuse of Compact funds. On February 12,
March 12, and March 13, 2003, we briefed your staffs on our results. This
report summarizes our briefing results regarding the single audit reports.
In addition, it provides information on the enhanced accountability
measures that are built into the amended or renegotiated Compacts. The
amended Compacts4 and related FPAs, which are scheduled to become
effective upon legislative approval in the United States, the FSM, and the
RMI, include many strengthened reporting and monitoring measures that
could improve accountability, if diligently implemented.5 (Further details
on our scope and methodology are provided later in this report.)

Results in Brief	Single audits are intended to promote sound financial
management, including effective internal control over federal awards. Our
review of 30 single audit reports for the FSM, the four FSM states, and
the RMI for the years 1996 through 2000 identified pervasive and
persistent compliance-and financial statement-related audit findings. More
specifically, the audit reports contained about 90 audit findings for each
year of the 5-year period that we reviewed and a significant number of
audit findings for each of the auditees. In total, they contained 458
audit findings. Further, these reports showed recurring audit findings
over the 5-year period despite the fact that the corrective action plans
prepared by the FSM, the four FSM states, and the RMI indicated more
timely completion of actions to address these findings.

4 According to a Department of State official, while the original Compact
was one document that applied to both the FSM and the RMI, an amended
Compact has been prepared for each nation.

5 Although the three governments have signed the amended Compacts, the
Compacts have not been approved by the legislature of any country.
Therefore, in this report, we describe the amended Compacts' requirements
and potential impact conditionally, recognizing that the Compacts have not
yet been enacted. The total possible cost to renew expiring assistance in
fiscal year 2004 U.S. dollars would be $3.8 billion on the basis of the
Congressional Budget Office's forecasted inflation rate.

None of the audit report discussions of the 458 audit findings
specifically cited misuse of Compact funds. However, they did discuss
noncompliance with Compact requirements and financial management problems
in areas that we consider highly susceptible to such misuse. For example,
one finding noted that differences between the cash balance shown in the
entity's financial records and the bank records amounted to over $150,000.
Further, the independent auditors issued qualified opinions or disclaimers
of opinion on the entitywide financial statements in all 30 reports and
for about 60 percent of the Schedules of Expenditures of Federal Awards
required by the Single Audit Act.6 These opinions were frequently issued
because the audited entity did not provide the auditor with all required
financial reports and/or other financial records. Taken together, the
audit findings of and the financial statement opinions rendered by the
auditors demonstrate that the FSM, the 4 FSM states, and the RMI did not
provide reasonable accountability over Compact funds and assurance that
these funds were used as intended.

The amended Compacts and related FPAs, which are scheduled to become
effective upon legislative approval in all three countries, include many
accountability provisions that would strengthen reporting and monitoring,
if diligently implemented. If so implemented, they would address most of
the recommendations that we made in past reports regarding assistance
accountability, fiscal control and accounting procedures, and standards
for financial management systems. For example, under the amended Compacts,
the annual reporting and consultation requirements would be expanded;
funds could be withheld for noncompliance with Compact terms and
conditions; and the FPAs call for the establishment of a joint economic
management committee for each nation. These committees will consist of
three members appointed by the United States, including the chairman, and
two members appointed by FSM or RMI and will have significant oversight
and monitoring responsibilities. In addition, Interior officials have
stated that they are in the process of assembling a Compact oversight team
of full-time employees that will focus exclusively on monitoring and
oversight of Compact financial assistance. The successful implementation
of these strengthened reporting and monitoring measures will require a
sustained commitment and appropriate resources from the United States, the
FSM and the RMI.

6 An audit of these schedules as part of the single audit is required by
the Single Audit Act, as amended, 31 U.S.C. 7502(e)(2).

To help promote compliance with Compact requirements and sound financial
management, we are recommending that the Secretary of the Interior
delegate this responsibility to the Office of Insular Affairs and hold
appropriate officials in that office accountable for (1) ensuring the
adequacy of staff dedicated to Compact oversight and monitoring
activities, (2) monitoring FSM and RMI progress in correcting
Compact-related single audit report findings, (3) reporting on the FSM and
the RMI actions to address Compact-related compliance and financial
statement findings identified in single audit reports to the Secretary of
the Interior or other appropriate high-level Interior official, (4)
initiating appropriate actions if the FSM or the RMI do not implement
timely and adequate actions to correct Compact-related single audit
findings, and (5) investigating single audit findings that indicate
possible violations of grant conditions or misuse of funds and taking
appropriate actions when such problems are verified.

The Department of the Interior and the RMI concurred with the findings
cited. The FSM noted that the report was constructive and useful as it
continues to prepare for the implementation of the amended Compact and its
related agreements. The FSM and RMI also provided technical comments and
other information on current actions to address the financial management
issues that the report raised.

Background	In 1947, the United Nations (U.N.) created the Trust Territory
of the Pacific Islands. The United States entered into a trusteeship with
the U.N. Security Council and became the administering authority of the
current islands of the FSM and the RMI. The United States administered the
islands under this trusteeship until 1986, when it entered into a Compact
of Free Association with the FSM and the RMI, both of which are located in
the Pacific Ocean.

The original Compact represented both a continuation of U.S. rights and
obligations first embodied in the U.N. trusteeship agreement and a new
phase in the unique and special relationship that had existed between the
United States and these island nations. It also provided a framework for
the United States to work toward achieving its three main goals of (1)
securing self-government for the FSM and the RMI,7 (2) assisting the

7 The FSM and RMI are now independent nations and are members of
international organizations such as the U.N.

FSM and the RMI in their efforts to advance economic development and
self-sufficiency, and (3) ensuring certain national security rights for
all of the parties.

The Department of the Interior's Office of Insular Affairs was responsible
for disbursing and monitoring Compact funds. For the 15-year period from
1987 through 2001, it provided funding at levels that decreased every 5
years. For 2002 and 2003, while negotiations to renew the expiring Compact
provisions were ongoing, funding levels increased to equal an average of
the funding provided during the previous 15 years. For 1987 through 2003,
total U.S. assistance to the FSM and the RMI to support economic
development is estimated, based on Interior data, to be about $2.1
billion.

In addition, the Compact identified several services that U.S. agencies
would supply to the FSM and the RMI and further stated that these agencies
could provide direct program assistance as authorized by the Congress.
This assistance included grants, loans, and technical assistance that, for
fiscal years 1987 through 2001, totaled about $700 million from 19 U.S.
agencies. The Department of the Interior was responsible for supervising,
coordinating, and monitoring program assistance, while the Department of
State was responsible for directing and coordinating all U.S. government
employees in foreign countries, except those under the command of U.S.
area military commanders.

In 2000, we reported that one tool that should be used for ensuring
accountability over Compact assistance was the annual audits required by
the Compact. FPAs for implementing the Compact required that financial and
compliance audits be conducted in accordance with the provisions of the
Single Audit Act.8 This act is intended to, among other things, promote
sound financial management, including effective internal controls, with
respect to the use of federal awards. Entities that expend $300,000 or
more in federal awards in a year are required to comply with act's
requirements. Further, the act requires entities to (1) maintain internal
control over federal programs, (2) comply with laws, regulations, and the
provisions of contracts or grant agreements, (3) prepare appropriate
financial statements, including a Schedule of Expenditures of Federal
Awards, (4) ensure that the required audits are properly performed and
submitted

8 The Single Audit Act of 1984 was substantially amended by the Single
Audit Act Amendments of 1996, which is codified in Chapter 75 of Title 31,
United States Code.

when due, and (5) follow up and take corrective actions on audit findings.
Deloitte Touche Tohmatsu, an independent public accounting firm, conducted
the 30 single audits that we reviewed for the FSM; the 4 FSM states of
Chuuk, Kosrae, Pohnpei, and Yap; and the RMI.

Objectives, Scope, and Methodology

Our objective was to review possible FSM and RMI misuse of Compact funds.
One source of this type of information is the annual single audits that
the fiscal procedures agreement for the implementation of the Compact
requires the FSM and the RMI to obtain.

We obtained the single audit reports for the years 1996 through 2000, the
most recent single audit reports available at the time of our review, for
the national government of the FSM; the FSM state governments of Chuuk,
Kosrae, Pohnpei and Yap; and the national government of the RMI. In total,
this amounted to 30 single audit reports representing 5 years, a period
that we considered sufficient for identifying misuse of funds and common
or persistent compliance and financial management problems involving
Compact funds. While these reports did not specifically identify any
findings as instances of misuse of Compact funds, they did identify
problems that could leave Compact funds susceptible to misuse, including
poor control over cash and equipment.

We reviewed each report to identify and categorize the audit findings
relevant to the Compact, paying particular attention to those involving
assets or other financial accounts (i.e., cash and equipment) that we
considered particularly susceptible to misuse. (We did not independently
assess the quality of these audits or the reliability of the audit finding
information. However, based on the fact that the audited entities
developed corrective action plans for about 93 percent of the findings
contained in the audit reports, we concluded that the audit findings
provide an accurate representation of the problems reported.) We also
reviewed the reports to identify auditee responses to the audit findings
and their corrective action plans. These plans indicate auditee agreement
or disagreement with the audit findings and the actions they planned to
take or had taken to fix the findings. In addition, we reviewed the audit
findings to determine if they recurred in successive single audits over
the 5-year period. We completed our review of each single audit report by
identifying and categorizing the auditor's opinions on the financial
statements and the Schedules of Expenditures of Federal Awards.

In responding to our previous review of the Compact program, Interior
officials expressed concerns about the U.S. government's limited ability
to enforce accountability over Compact funds due to certain provisions of
the original Compact and the related FPA. In light of these concerns, we
reviewed the amended Compacts and related FPAs to determine if they
included measures that could increase accountability over Compact funds.
In addition, we supplemented our review of these documents with a
discussion about the amended Compacts with Interior officials to determine
if the new provisions addressed their prior concerns about limited actions
available to them for holding the FSM and the RMI accountable.

Interior's Compact-related expenditures represented about 80 percent of
the total expenditures of U.S. assistance made by the FSM, the 4 FSM
states, and the RMI during the 5-year period. Because of the relatively
small amount of funding from other federal agencies at these recipients,
we did not discuss finding resolution with representatives of those
agencies.

We conducted our audit from August 2002 through May 2003 in accordance
with generally accepted government auditing standards. We requested
written comments on a draft of this report from the governments of the FSM
and the RMI and the Secretary of the Interior. Their comments are
discussed in the section entitled Government and Agency Comments and Our
Evaluation and are reprinted in appendixes I, II, and III. Further, we
considered all comments and made changes to the report, as appropriate.

Pervasive Audit Findings Demonstrate Poor Accountability over Compact
Funds

Single audits of the FSM, the four FSM states, and the RMI identified
pervasive audit findings involving noncompliance with Compact requirements
and financial statement problems in areas that we consider highly
susceptible to misuse. In addition, the independent auditor performing the
single audits issued qualified opinions or disclaimers of opinion on the
financial statements in all 30 single audit reports reviewed and for 60
percent of the Schedules of Expenditures of Federal Awards. Taken
together, these findings and opinions demonstrate that the FSM, the four
FSM states, and the RMI did not provide reasonable accountability over
Compact funds and assurance that these funds were used for their intended
purposes.

Single Audit Reports Identify Pervasive Audit Findings Involving Compact
Funds

The 30 single audit reports that we examined contained about 90 audit
findings for each year of the 5-year period covered by our review. In
total, they contained 458 audit findings relevant to Compact funds and
significant numbers of findings for each of the auditees for which we
reviewed single audit reports. Further, successive single audits during
the 5-year period contained recurring audit findings despite corrective
action time frames established by the auditees and our conclusion that few
of the findings involved significant issues, such as implementing an
accounting system, that could be expected to require more than 2 years to
correct.

Figure 1 shows the number of audit findings reported annually from 1996
through 2000. It demonstrates that the auditors performing the 30 single
audits in our review identified a significant number of audit findings
both in total and in each year of the 5-year period of our review.

Figure 1: Number of Audit Findings Reported Annually from 1996 through
2000

120 Number of findings

100

80

60

40

20

0 1996 1997 1998 1999 2000

Source: GAO analysis of single audit reports.

In addition, the 30 audit reports identified a significant number of audit
findings for each of the auditees. Figure 2 shows the percentages of the
458 audit findings related to Compact funds for each auditee.

Figure 2: Auditee Findings as a Percentage of Total Findings

                                      RMI

                                      FSM

                                     Kosrae

                                    Pohnpei

                                      Yap

                                     Chuuk

Office of Management and Budget (OMB) Circular No. A-133, Audits of
States, Local Governments, and Non-Profit Organizations, establishes
policies for federal agency use in implementing the Single Audit Act, as
amended, and provides an administrative foundation for consistent and
uniform audit requirements for nonfederal entities that administer federal
awards. In part, the circular requires the auditee to follow up and take
corrective actions on audit findings identified by the single audits. It
clarifies this requirement by stating that, at the completion of the
single audit, the auditee shall prepare a corrective action plan (CAP) to
address each audit finding included in the current year auditor's report.
If the auditee does not agree with the audit findings or believes
corrective action is not required, the CAP is to include an explanation of
and justification for this position. Based on our review of the audit
reports, the FSM, the four FSM states, and the RMI generally fulfilled
their responsibility to either prepare a CAP or indicate their
disagreement with the audit finding and provide reasons for their
disagreement. As figure 3 shows, they prepared CAPs for 93 percent of the
audit findings identified by the single audits in our review and indicated
their disagreement and reasons for this disagreement for 5 percent of the
findings.

Figure 3: Percentage of Corrective Action Plans Developed for Audit
Findings

1%

Corrected finding

No CAP prepared

Disagree with finding

CAP prepared

Source: GAO analysis of single audit reports.

Our review of these CAPs showed that about 33 percent (138) included
anticipated completion dates, and, of these plans, only 4 percent (16)
indicated that the planned corrective actions would require more than 2
years to complete. Based on a review of the CAPs that did not include
anticipated completion dates (287), we concluded that, with a few
exceptions,9 the problems addressed by these plans could be corrected
within a year. For example, Financial Status Reports submitted to the
grantor agencies for fiscal year 2000 were not available during the single
audit of the RMI. The auditors recommended that an adequate filing system,
including the maintenance of Financial Status Reports, be maintained for
all federal awards. The CAP called for the Ministry of Finance to ensure
that an adequate filing system was in place and to review status reports
periodically.

Further analysis of the findings revealed that successive single audits
identified recurring audit findings over the 5-year period despite the
time frames identified in the auditee-prepared CAPs or our estimate of the

9 We identified 11 CAPs that we believe could require significant amounts
of time to correct. For example, 3 CAPs called for accounting system
upgrades and another 2 called for accounting systems. In another 2
instances, FSM states prepared plans that required legal opinions from the
FSM national government in order to resolve the problems.

amount of time corrective action should take. As figure 4 shows, many
audit findings that were identified in more than one single audit report
recurred in 3 or more years over the 5-year period. The percentage of each
auditee's single audit findings that recurred 3 or more years over the
5-year period of our review ranged from RMI's high of 69 percent to a low
of 17 percent for the FSM.

Figure 4: Percentage of 1996 through 2000 Single Audit Findings That
Recurred 3 or More Years

                             FSM Pohnpei Yap Chuuk

                                   Kosrae RMI

Compliance and Financial Statement Problems Persisted over Compact Funds

The auditors categorized the audit findings related to the Compact into
three areas-federal award findings, local findings, and financial
statement findings. Upon further review, we determined that 117 audit
findings that the auditors categorized as federal award findings or local
findings discussed problems related to compliance with Compact
requirements, and the remaining 341 discussed financial statement
problems. The auditors who performed these single audits qualified or
disclaimed their opinion on all of the financial statements and about 60
percent of the Schedules of Expenditures of Federal Awards generally
because the auditees did not provide them with all needed financial
statements or documentation to

0 102030 4050 60 Percentage of findings

Source: GAO analysis of single audit reports.

support transactions recorded in their books. Taken together, the
compliance and financial statement findings and audit opinions demonstrate
poor accountability over Compact funds and an inability on the part of the
entities involved to provide assurances that all program funds are used as
intended. They highlight the need for a stronger control environment and
greater efforts to implement control activities that strengthen
accountability and help ensure that Compact funds are used for program
purposes.

Compliance requirements for federal assistance set forth what is to be
done, who is to do it, the purpose to be achieved, the population to be
served, and how much can be spent in certain areas. OMB's Single Audit Act
guidance includes 15 compliance categories10 used by auditors to report on
compliance-related findings. Our analysis of the compliance categories the
auditors cited for the Compact-related audit findings showed that over
half of the audit findings related to two categories-allowable costs/cost
principles and equipment and real property management. The first category,
allowable costs/cost principles, specifies the allowability of costs under
federal awards. For example, expenditures for 17 types of projects or
activities were allowable under the original Compact capital account,
including construction or major repair of capital infrastructure, public
and private sector projects, training activities, and debt service. The
second category, equipment and real property management, specifies how
federal award recipients should use, manage, and dispose of equipment and
real property.

The following examples illustrate the types of audit findings that the
auditors categorized into the 15 areas.

o 	Kosrae advanced $93,000 in Compact Health and Medical Program funds to
off-island health providers for medical referrals. The advances were
immediately expensed without reference to the specific medical expenses
actually incurred. This is an example of a compliance finding related to
allowable costs/cost principles.

10 The 15 areas are (1) activities allowed or unallowed, (2) allowable
costs/cost principles, (3) cash management, (4) Davis-Bacon Act, (5)
eligibility, (6) equipment and real property management, (7) matching,
level of effort, and earmarking, (8) period of availability of federal
funds, (9) procurement, (10) program income, (11) real property
acquisition and relocation assistance, (12) reporting, (13) subrecipient
monitoring, (14) special tests and provisions, and (15) none.

o 	Kosrae incurred over $274,000 in expenditures of Compact Capital funds
that lacked proper supporting vendor's invoices. This is an example of a
compliance finding related to allowable costs/cost principles.

o 	Chuuk transferred about $169,000 in Compact Capital funds to entities
(subrecipients) that have not been audited or reviewed for compliance with
Compact requirements. This is an example of a compliance finding related
to subrecipient monitoring.

As mentioned earlier, the auditors performing the single audits also
categorized findings as financial statement findings. The audit findings
for this category related to the reliability of financial reporting and
involved recording, processing, summarizing, and reporting financial data.
Unlike the findings that related to compliance with Compact requirements,
the auditors did not tie the financial statement findings to the
categories contained in the Single Audit Act guidance. Our review of these
findings identified 101 financial statement findings involving problems
with assets or accounts that we consider susceptible to misuse. The
following examples illustrate financial statement findings related to
assets or accounts that we consider susceptible to misuse.

o 	Yap's three major bank accounts (general checking, savings, and
payroll) were not reconciled to bank records at the end of fiscal year
1999. Differences between the amounts shown for these cash accounts in
Yap's books and the bank records amounted to over $150,000. The auditors
identified this lack of bank reconciliations as an internal control
weakness in Yap's single audit reports for the years 1995 through 1999. A
record being out of balance is a risk factor auditors use to identify the
possibility of fraud. This is an example of a cash problem.

o 	The RMI had not conducted a physical inventory or updated property
records for equipment and real property. As of September 30, 2000, RMI
reported that its equipment was worth about $11 million, but the auditor
could not substantiate this amount due to inadequate records. The auditor
identified a lack of updated property records for the General Fixed Asset
Group in single audit reports for the years 1988 through 2000. Missing
documents, such as the property records for equipment in this example, are
a risk factor used by auditors to identify the possibility of fraud. This
is an example of an equipment problem.

The 30 single audit reports included auditor opinions or disclaimers of
opinion on the financial statements and Schedules of Expenditures of

Federal Awards for the FSM, the four FSM states, and the RMI. The
financial statements reflect a federal award recipient's financial
position, results of operations or changes in net assets, and, where
appropriate, cash flows for the year. The Schedules of Expenditures of
Federal Awards show the amount of expenditures for each federal award
program during the year. If the auditors are not able to perform all of
the procedures necessary to complete an audit, they consider the audit
scope to be limited or restricted. Scope limitations may result from the
timing of the audit work, the inability to obtain sufficient evidence, or
inadequate accounting records. If the audit scope is limited, the auditors
must make a professional judgment about whether to qualify or disclaim an
opinion. A qualified opinion states that, except for the matter to which
the qualification relates, the financial statements are fairly presented
in accordance with generally accepted accounting principles. In a
disclaimer of opinion, the scope limitation is serious enough that the
auditor does not express an opinion.

The auditor's opinions on the financial statements and Schedules of
Expenditures of Federal Awards for the 30 single audits in our review
reveal overall poor financial management. The auditors performing these
single audits qualified or disclaimed their opinions on all of the
financial statements and about 60 percent of the Schedules of Expenditures
of Federal Awards generally because they were unable to obtain sufficient
evidence or adequate accounting records. For example, the auditor
qualified its opinion on the FSM's financial statements for the year 2000
because of the auditor's inability to ensure the propriety of receivables
from other governments and missing financial statements for a component
unit. In another example, the auditor did not express an opinion on
Chuuk's financial statements for the year 1999 because of inadequacies in
the accounting records and internal controls, incomplete financial
statements for component units, and its inability to obtain audited
financial statements supporting investments.

The significant number of audit findings involving FSM and RMI
noncompliance with Compact requirements and weaknesses in their financial
management systems, along with auditor qualified opinions or disclaimers
of opinion on financial statements, echo the control and accountability
issues that we identified in our earlier reports on Compact assistance.
Further, the pervasive and recurring nature of the compliance and
financial statement problems highlights (1) the need for stronger control
environments that will help ensure that Compact funds are used for program
purposes and (2) the limited progress made during the 5-year

period of our review in establishing accountability in the FSM, the four
FSM states, and the RMI that would provide reasonable assurance that
Compact funds are used for their intended purposes.

Amended Compact Agreements Contain Improved Accountability Measures

In responding to our previous reviews of the original Compact program,
Interior officials expressed concerns about the U.S. government's limited
ability to enforce accountability over Compact funds due to certain
provisions of the original Compact and the related FPA. According to these
officials, administrators have been reluctant to commit oversight
resources to the Compact when no enforcement mechanisms exist due to these
provisions. The United States and the FSM signed an amended Compact in May
2003. The United States and the RMI signed an amended Compact in April
2003. These amended Compacts are awaiting legislative approval in the
United States, the FSM, and the RMI. They contain strengthened reporting
and monitoring measures over the original Compact that could improve
accountability over Compact assistance, if diligently implemented.

According to Interior officials, the FPA in effect during the period of
our review created a financial management regimen unique in federal
practice. They explained that it was negotiated to give the FSM and the
RMI governments clear control over Compact funding and to limit the U.S.
government's authority to intervene in spending decisions and, most
important, to withhold payments if the terms and conditions of funding
were violated. More specifically, these officials explained that the
expiring FPAs lacked basic elements of federal grant management practice
similar to those in OMB Circular A-102, Grants and Cooperative Agreements
with State and Local Governments, which requires standard procurement
practices and cost principles. They elaborated that, when coupled with the
full faith and credit provisions of the Compact,11 this lack of standards
limited the U.S. government's response to mismanagement. In summing up,
they stated that while additional personnel and funding could have been
committed to Compact oversight, the United States would still have had
almost no ability to influence fiscal decisions made by the FSM or the
RMI.

11 "Except as otherwise provided, approval of the Compact by the
Government of the United States shall constitute a pledge of the full
faith and credit of the United States for the full payment of the sums and
amounts specified in Articles I and III of this Title. The obligations of
the United States under Article I and III of this Title shall be
enforceable in the United States Claims Court." Compact of Free
Association, section 236 (Jan. 14, 1986).

The amended Compacts could potentially cost the U.S. government about $6.6
billion in new assistance. Of this amount, $3.5 billion would cover
payments over a 20-year period (2004-23), while $3.1 billion represents
payments for U.S. military access to the Kwajalein Atoll in the RMI for
the years 2024 through 2086. The amended Compacts contain strengthened
reporting and monitoring measures that could improve accountability over
Compact assistance, if diligently implemented. In addition, the Department
of the Interior has taken actions to increase resources dedicated to
monitoring and oversight of Compact funds.

The following are amended Compact and related FPA measures that represent
changes from the prior Compact and FPAs.

o 	In 2000, we reported that Compact funds were placed in a general
government fund and commingled with other revenues and, therefore, could
not be further tracked. In addition, some Compact assistance was only
traced at a high level with few details readily available regarding final
use. The amended Compacts and FPAs include requirements that should
address these accountability concerns. Specifically, they require fiscal
control and accounting procedures sufficient to permit (1) preparation of
required reports and (2) tracing of funds to a level of expenditures
adequate to establish that such funds have been used in compliance with
applicable requirements. Further, the amended Compacts specify standards
for the financial management systems used by the FSM and the RMI. For
example, these systems should maintain effective controls to safeguard
assets and ensure that they are used solely for authorized purposes.

o 	The new FPAs would establish a joint economic management committee for
the FSM and the RMI that would meet at least once a year. The committee
would be composed of three U.S. appointed members, including the chairman,
and two members appointed, as appropriate, by either the FSM or the RMI.
The committee's duties would include (1) reviewing planning documents and
evaluating island government progress to foster economic advancement and
budgetary self-reliance, (2) consulting with program and service providers
and other bilateral and multilateral partners to coordinate or monitor the
use of development assistance, (3) reviewing audits, (4) reviewing
performance outcomes in relation to the previous year's grant funding
level, terms, and conditions, and (5) reviewing and approving grant
allocations (which would be binding) and performance objectives for the
upcoming year.

o 	Grant conditions normally applicable to U.S. state and local
governments would apply to each grant. General terms and conditions for
the grants would include conformance to plans, strategies, budgets,
project specifications, architectural and engineering specifications, and
performance standards. Specific postaward requirements address financial
administration by establishing, for example, (1) improved financial
reporting, accounting records, internal controls, and budget controls, (2)
appropriate use of real property and equipment, and (3) competitive and
well-documented procurement.

o 	The United States could withhold payments if either the FSM or the RMI
fails to comply with grant terms and conditions. The amount withheld would
be proportional to the breach of the term or condition. In addition, funds
could be withheld if the FSM or RMI governments do not cooperate in U.S.
investigations of whether Compact funds have been used for purposes other
than those set forth in the amended Compacts.

o 	The new FPAs include numerous reporting requirements for the two
countries. For example, each country must prepare strategic planning
documents that are updated regularly, annual budgets that propose sector
expenditures and performance measures, annual reports to the U.S.
President regarding the use of assistance, quarterly and annual financial
reports, and quarterly grant performance reports.

The successful implementation of the new accountability provisions will
require a sustained commitment by the three governments to fulfilling
their new roles and responsibilities. Appropriate resources from the
United States, the FSM, and the RMI represent one form of this commitment.
While the amended Compacts do not address staffing issues, officials from
Interior's Office of Insular Affairs have informed us that they intend to
post six staff in a new Honolulu office: a health grant specialist, an
education grant specialist, an accountant, an economist, an auditor, and
an office assistant. Interior can also contract with the Army Corps of
Engineers for engineering assistance, when necessary. These Honolulu-based
staff may spend about half of their time in the FSM and the RMI. Further,
an Interior official noted that his office has brought one new staff
member on board in Washington, D.C. and intends to post one person to work
in the RMI (one staff member already works in the FSM). We have not
conducted an assessment of Interior's staffing plan and rationale and
cannot comment on the adequacy of the plan or whether it represents
sufficient resources in the right locations.

Conclusions	The 30 single audit reports demonstrate a lack of or poor
accountability over U.S. Compact assistance that has totaled an estimated
$2.1 billion since 1987. The large number and recurring nature of the
findings involving noncompliance with Compact requirements or financial
management weaknesses, along with the preponderance of auditor's qualified
opinions or disclaimers of opinion on FSM and RMI financial statements,
clearly indicate the need for improved FSM and RMI management of U.S.
assistance and greater U.S. oversight and monitoring of the use of this
assistance. Changes are needed especially considering the fact that the
amended Compacts with these nations could potentially cost the U.S.
government about $3.5 billion in new assistance over the next 20 years.

Under the original Compact, the Department of the Interior was responsible
for supervising, coordinating, and monitoring the program assistance
provided. Interior officials expressed frustration with the lack of tools
available to them to administer or track this assistance in a manner that
could reasonably ensure that such assistance was having its intended
effect. The amended Compacts strengthen reporting and monitoring measures
that could improve accountability over assistance, if diligently
implemented. These measures include strengthened fiscal control and
accounting procedures requirements, expanded annual reporting and
consultation requirements, and the ability to withhold funds for
noncompliance with grant terms and conditions. The successful
implementation of the new accountability provisions will require
appropriate resources and sustained commitment from the United States, the
FSM, and the RMI. The joint economic committees called for in the Compact
with each nation and Interior's planned increase in staff associated with
Compact oversight and monitoring functions should play key roles in
improving accountability over Compact funds.

Recommendations for Executive Action

To help promote compliance with Compact requirements and sound financial
management, the Secretary of the Interior should delegate responsibility
to the Office of Insular Affairs and hold appropriate officials in that
office accountable for

o 	ensuring the adequacy of staff dedicated to Compact oversight and
monitoring,

o 	monitoring FSM and RMI progress in addressing Compact-related single
audit report findings,

o 	reporting on the FSM and RMI actions to correct Compact-related
compliance and financial management findings identified in single audit
reports to the Secretary of the Interior or other appropriate high-level
Interior official,

o 	initiating appropriate actions when the FSM or the RMI do not undertake
adequate actions to address Compact-related single audit findings in a
timely manner, and

o 	investigating single audit findings that indicate possible violations
of grant conditions or misuse of funds and taking appropriate actions when
such problems are verified.

Government and Agency Comments and Our Evaluation

In commenting on this report, the Office of Insular Affairs of the
Department of the Interior, FSM, and RMI agreed with our findings or
conclusions and recommendations. They also cited the amended Compacts as
mechanisms that should result in improved financial management over
Compact assistance. The FSM and RMI also provided technical comments and
information on current actions to address financial management issues. We
considered all comments and made changes to the report, as appropriate.

The FSM comments noted that it found the report constructive and useful as
it continues to prepare for the implementation of the amended Compact and
its related agreements. The comments (reprinted in app. I) recognized
that, although FSM has worked hard to develop a consistent approach to
satisfy the Compact and FPA requirements, significant work remains to be
done to improve and strengthen accountability in all aspects throughout
the nation. Further, FSM agreed that it must continue to improve internal
financial control through upgrading the current financial management
system, providing for capacity building, and retaining its most productive
and experienced employees. Finally, it noted that the amended Compact and
related fiscal procedures agreement include requirements that will address
all of the accountability concerns expressed in the report.

RMI's comments (reprinted in app. II) stated that it concurred with the
report's findings and noted that the report will be useful since it gives
a summary of the financial and management situation of the RMI between
1996 and 2000. RMI noted that its problems stem partly from the fact that
it has not had a global system for following up on audits that would apply
throughout all ministries of the government as well as other entities that

receive Compact grant assistance. RMI stated that it has made progress
recently by upgrading its information system and strengthening its
internal control procedures and noted that it will add personnel to the
budget, procurement, and supply areas.

In its comments (reprinted in app. III), the Office of Insular Affairs of
the Department of the Interior agreed with the conclusions and
recommendations in the report. The Office also noted that it looks forward
to discharging its responsibilities under the amended Compacts and that it
is confident that it will now have the tools needed to properly protect
the American taxpayer's investment in the freely associated states.

As agreed with your offices, unless you publicly announce its contents
earlier, we will not distribute this report until 30 days after its date.
At that
time, we will send copies to the Secretary of the Interior, the President
of
the Federated States of Micronesia, the President of the Republic of the
Marshall Islands, and appropriate congressional committees. Copies will
also be made available to others on request. This report will also be
available at no charge on GAO's Web site at http://www.gao.gov.

For future contacts regarding this report, please call McCoy Williams at
(202) 512-6906 or Susan S. Westin at (202) 512-4128. Staff contacts and
other key contributors to this report are listed in appendix IV.

McCoy Williams
Director
Financial Management and Assurance

Susan S. Westin
Managing Director
International Affairs and Trade

Appendix I

Comments from the Federated States of Micronesia

Appendix I
Comments from the Federated States of
Micronesia

Appendix II

Comments from the Republic of the Marshall Islands

Appendix II
Comments from the Republic of the Marshall
Islands

Appendix II
Comments from the Republic of the Marshall
Islands

Appendix III

Comments from the Department of the Interior

Appendix IV

                     GAO Contacts and Staff Acknowledgments

GAO Contacts	Tom Broderick, (202) 512-8705 or [email protected] Emil
Friberg, Jr., (202) 512-8990 or [email protected]

Acknowledgments	In addition to the contacts named above, Perry Datwyler
and Leslie Holen made key contributions to this report.

(195008) Page 28

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