Fiscal Year 2003 U.S. Government Financial Statements: Sustained 
Improvement in Federal Financial Management Is Crucial to	 
Addressing Our Nation's Future Fiscal Challenges (08-JUL-04,	 
GAO-04-886T).							 
                                                                 
GAO is required to annually audit the consolidated financial	 
statements of the U.S. government. Proper accounting and	 
reporting practices are essential in the public sector. The U.S. 
government is the largest, most diverse, most complex, and	 
arguably the most important entity on earth today. Its		 
services--homeland security, national defense, Social Security,  
mail delivery, and food inspection, to name a few--directly	 
affect the well-being of almost every American. But sound	 
decisions on the future direction of vital federal government	 
programs and policies are made more difficult without timely,	 
accurate, and useful financial and performance information. Until
the problems discussed in GAO's audit report on the U.S.	 
government's consolidated financial statements are adequately	 
addressed, they will continue to (1) hamper the federal 	 
government's ability to accurately report a significant portion  
of its assets, liabilities, and costs; (2) affect the federal	 
government's ability to accurately measure the full cost as well 
as the financial and nonfinancial performance of certain programs
while effectively managing related operations; and (3)		 
significantly impair the federal government's ability to	 
adequately safeguard certain significant assets and properly	 
record various transactions.					 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-04-886T					        
    ACCNO:   A10875						        
  TITLE:     Fiscal Year 2003 U.S. Government Financial Statements:   
Sustained Improvement in Federal Financial Management Is Crucial 
to Addressing Our Nation's Future Fiscal Challenges		 
     DATE:   07/08/2004 
  SUBJECT:   Accounting procedures				 
	     Accounting standards				 
	     Audit reports					 
	     Financial management				 
	     Financial management systems			 
	     Financial records					 
	     Financial statement audits 			 
	     Financial statements				 
	     Internal controls					 
	     Performance measures				 
	     Reporting requirements				 
	     Accountability					 
	     Federal agency accounting systems			 
	     Cost control					 
	     President's Management Agenda			 
	     U.S. Government Standard General Ledger		 

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GAO-04-886T

United States General Accounting Office

GAO Testimony

Before the Subcommittee on Financial Management, the Budget, and
International Security, Committee on Governmental Affairs, U.S. Senate

For Release on Delivery Expected at 10:30 a.m. EDT Thursday, July 8, 2004

FISCAL YEAR 2003 U.S. GOVERNMENT FINANCIAL STATEMENTS

 Sustained Improvement in Federal Financial Management Is Crucial to Addressing
                     Our Nation's Future Fiscal Challenges

Statement of David M. Walker Comptroller General of the United States

                                       a

GAO-04-886T

Highlights of GAO-04-886T, testimony before the Subcommittee on Financial
Management, the Budget, and International Security, Committee on
Governmental Affairs, U.S. Senate

GAO is required to annually audit the consolidated financial statements of
the U.S. government.

Proper accounting and reporting practices are essential in the public
sector. The U.S. government is the largest, most diverse, most complex,
and arguably the most important entity on earth today. Its
services-homeland security, national defense, Social Security, mail
delivery, and food inspection, to name a few-directly affect the
well-being of almost every American. But sound decisions on the future
direction of vital federal government programs and policies are made more
difficult without timely, accurate, and useful financial and performance
information.

Until the problems discussed in GAO's audit report on the U.S.
government's consolidated financial statements are adequately addressed,
they will continue to (1) hamper the federal government's ability to
accurately report a significant portion of its assets, liabilities, and
costs; (2) affect the federal government's ability to accurately measure
the full cost as well as the financial and nonfinancial performance of
certain programs while effectively managing related operations; and (3)
significantly impair the federal government's ability to adequately
safeguard certain significant assets and properly record various
transactions.

www.gao.gov/cgi-bin/getrpt?GAO-04-886T.

To view the full product, including the scope and methodology, click on
the link above. For more information, contact Jeffrey C. Steinhoff or Gary
T. Engel at (202) 512-2600.

July 8, 2004

FISCAL YEAR 2003 U.S. GOVERNMENT FINANCIAL STATEMENTS

Sustained Improvement in Federal Financial Management Is Crucial to Addressing
Our Nation's Future Fiscal Challenges

As in the 6 previous fiscal years, certain material weaknesses in internal
control and in selected accounting and reporting practices resulted in
conditions that continued to prevent GAO from being able to provide the
Congress and American citizens an opinion as to whether the consolidated
financial statements of the U.S. government are fairly stated in
conformity with U.S. generally accepted accounting principles. Three major
impediments to an opinion on the consolidated financial statements
continue to be (1) serious financial management problems at DOD, (2) the
federal government's inability to fully account for and reconcile
transactions between federal government entities, and (3) the federal
government's ineffective process for preparing the consolidated financial
statements.

For fiscal year 2003, 20 of 23 Chief Financial Officers (CFO) Act agencies
received unqualified opinions, the same number received by these agencies
in fiscal year 2002, up from 6 for fiscal year 1996. However, only 3 of
the CFO Act agencies had neither a material weakness in internal control,
an issue involving compliance with applicable laws and regulations, nor an
instance of lack of substantial compliance with Federal Financial
Management Improvement Act requirements.

The requirement for timely, accurate, and useful financial and performance
management information is greater than ever as our nation faces major
longterm fiscal challenges that will require tough choices in setting
priorities and linking resources to results. Given the nation's large and
growing long-term fiscal imbalance, which is driven largely by known
demographic trends and health care costs, coupled with new homeland
security and defense commitments, the status quo is unsustainable. Current
financial reporting does not clearly and transparently show the wide range
of responsibilities, programs, and activities that may either obligate the
federal government to future spending or create an expectation for such
spending and provides an unrealistic and even misleading picture of the
federal government's overall performance and financial condition. In
addition, too many significant federal government commitments and
obligations, such as Social Security and Medicare, are not adequately
addressed in the federal government's financial statements and budget
process, and current federal financial reporting standards do not require
such disclosure.

A top-to-bottom review of government activities to ensure their relevance
and fit for the 21st century and their relative priority is long overdue.
The federal government needs a three-pronged approach to (1) restructure
existing entitlement programs, (2) reexamine the base of discretionary and
other spending, and (3) review and revise the federal government's tax
policy and enforcement programs. New accounting and reporting approaches,
budget control mechanisms, and metrics are needed for considering and
measuring the impact of spending and tax policies and decisions over the
long term.

Mr. Chairman and Members of the Subcommittee:

I am pleased to be here today to discuss our report on the U.S.
government's consolidated financial statements for fiscal years 2003 and
2002.1 Both the consolidated financial statements and our report are
included in the fiscal year 2003 Financial Report of the United States
Government, which was issued by the Department of the Treasury (Treasury)
on February 27, 2004, and is available through GAO's Internet site, at
www.gao.gov, and Treasury's Internet site, at
www.fms.treas.gov/fr/index.html.

As in the 6 previous fiscal years, certain material weaknesses2 in
internal control and in selected accounting and reporting practices
resulted in conditions that continued to prevent us from being able to
provide the Congress and American citizens an opinion as to whether the
consolidated financial statements of the U.S. government are fairly stated
in conformity with U.S. generally accepted accounting principles (GAAP).
Until the problems discussed in our report are adequately addressed, they
will continue to (1) hamper the federal government's ability to accurately
report a significant portion of its assets, liabilities, and costs; (2)
affect the federal government's ability to accurately measure the full
cost as well as the financial and nonfinancial performance of certain
programs while effectively managing related operations; and (3)
significantly impair the federal government's ability to adequately
safeguard certain significant assets and properly record various
transactions.

While the federal government has not yet been able to prepare auditable
financial statements, the requirement to do so at the consolidated level
as well as at the agency level has already yielded important results. We
see continuous movement toward the ultimate goals of annual accountability

1In addition, GAO is providing separate statements today on problems
related to financial and business management systems and processes at the
Department of Defense and the Department of Homeland Security. See U.S.
General Accounting Office, Department of Defense: Financial and Business
Management Transformation Hindered by Longstanding Problems, GAO-04-941T
(Washington, D.C.: July 8, 2004), and Department of Homeland Security:
Financial Management Challenges, GAO-04-945T (Washington, D.C.: July 8,
2004).

2A material weakness is a condition that precludes the entity's internal
control from providing reasonable assurance that misstatements, losses, or
noncompliance material in relation to the financial statements or to
stewardship information would be prevented or detected on a timely basis.

and, more importantly, of development of the day-to-day financial
information that the federal government will need to best address today's
budgetary challenges and the looming longer-term fiscal imbalance driven
by demographic trends, rising health care costs, and new homeland security
and defense commitments. Across government, financial management
improvement initiatives are under way that, if effectively implemented,
have the potential to appreciably improve the quality of the federal
government's financial management and reporting. Federal agencies continue
to make progress in their efforts to modernize their financial management
systems and improve financial management performance as called for in the
President's Management Agenda.3

The Principals of the Joint Financial Management Improvement Program
(JFMIP)4 agreed with the Office of Management and Budget's (OMB)
initiative to accelerate the agency financial statements reporting date to
November 15 for fiscal year 2004. For fiscal year 2003, OMB required the
Chief Financial Officers (CFO) Act agencies5 to deliver their Performance
and Accountability Reports, including their audited financial statements,
to OMB by January 30, 2004. However, to prepare for meeting the required
November 15 accelerated reporting date for fiscal year 2004, OMB
encouraged the CFO Act agencies to accelerate the issuance of their fiscal
year 2003 audited financial statements to November 15, 2003, or as close
to that date as possible. OMB reported that 8 CFO Act agencies-the
Department of Education, the Environmental Protection Agency, the
Department of Health and Human Services, the National Science Foundation,
the Social Security Administration, the Department of the

3The President's Management Agenda is the Bush administration's strategy
for improving the management and performance of the federal government.
Its purpose is to identify and address the most significant problems
facing the federal government. It contains five governmentwide and nine
agency-specific goals to improve federal management and deliver results to
the American people.

4JFMIP is a joint and cooperative undertaking of the Department of the
Treasury, GAO, the Officeof Management and Budget (OMB), andthe Officeof
Personnel Management working in cooperation with each other and other
federal agencies to improve financial management practices in the federal
government. Leadership and program guidance are provided by the four
Principals of the JFMIP-the Comptroller General of the United States, the
Secretary of the Treasury, and the Directors of OMB and the Office of
Personnel Management.

531 U.S.C. S: 901(b). One of the 24 CFO Act agencies, the Federal
Emergency Management Agency, was transferred to the new Department of
Homeland Security effective March 1, 2003. With this transfer, the Federal
Emergency Management Agency will no longer be required to prepare and have
audited stand-alone financial statements under the CFO Act, leaving 23 CFO
Act agencies.

Treasury, the Agency for International Development, and the Department of
Veterans Affairs-were able to issue their fiscal year 2003 financial
statements with unqualified audit opinions by mid-November 2003. Another
10 CFO Act agencies issued their financial statements by December 31,
2003, and the remaining 5 CFO Act agencies issued by the end of January
2004. A 24th major agency, the Department of Homeland Security (DHS),6
issued its financial statements on February 13, 2004. DHS faced a
herculean challenge with respect to issuing audited financial statements,
since the department had been in operation only for the last 7 months of
the fiscal year and involved a transfer of operations from a number of
diverse entities, some with known financial management problems.

While these results represent a significant improvement over previous
years in the timeliness of CFO Act agencies' issuance of audited financial
statements, they also demonstrate the significant challenges that the
federal government will face in meeting the November 15 accelerated
reporting date for fiscal year 2004. Auditors at several of the CFO Act
agencies reported that the agencies may not be able to produce auditable
financial statements within the accelerated time frame for fiscal year
2004 without making fundamental changes to improve a number of their
financial management practices. For example, certain federal agency
auditors reported that major improvements are needed in (1) management
controls to monitor established policies and procedures for conducting
financial analyses and reconciliations throughout the year, (2) fully
integrating financial management systems, and (3) providing adequate and
skilled staff to support efficient, effective preparation of federal
agency consolidated financial statements. Our experience as the auditor of
the financial statements of the Internal Revenue Service, which
successfully accelerated its reporting to November 15 beginning with its
fiscal year 2002 financial statements, showed that significant changes had
to be made to improve routine financial management procedures in order to
be able to accelerate reporting.

6DHS is not a CFO Act agency and is therefore not subject to CFO Act
requirements. However, along with most other executive branch agencies not
covered by the CFO Act, DHS is required to prepare and have audited
financial statements under the Accountability of Tax Dollars Act of 2002,
Pub. L. No. 107-289, 116 Stat. 2049 (Nov. 7, 2002). For fiscal year 2003,
the act provided that OMB could grant executive branch agencies' requests
for waivers from having audited financial statements for fiscal year 2003.
However, DHS and certain other agencies chose to prepare and have their
fiscal year 2003 financial statements audited.

For fiscal year 2003, as in fiscal year 2002, 20 of 23 CFO Act agencies
were able to attain unqualified audit opinions on their financial
statements (see table 1 and app. I),7 up from 6 agencies for fiscal year
1996. This is the same number of unqualified opinions received by these
CFO Act agencies for fiscal year 2002. However, 2 agencies' fiscal year
2003 opinions were different from those they received for fiscal year
2002. The Agency for International Development received an unqualified
opinion on all of its fiscal year 2003 financial statements for the first
time, while the National Aeronautics and Space Administration (NASA),
which for fiscal year 2002 received an unqualified opinion on its
financial statements, received a disclaimer of opinion for fiscal year
2003. DHS, which as I mentioned before prepared consolidated financial
statements for fiscal year 2003 covering its first 7 months of operations,
received a qualified opinion on two of the six required financial
statements.8

In identifying improved financial performance as one of its five
governmentwide initiatives, the President's Management Agenda recognized
that a clean (unqualified) financial audit opinion is a basic prescription
for any well-managed organization. At the same time, it recognized that
"most federal agencies that obtain clean audits only do so after making
extraordinary, labor-intensive assaults on financial records" at or after
year-end. The President's Management Agenda further recognized that
without sound internal control and accurate and timely financial
information, it is not possible to accomplish the agenda and secure the
best performance and highest measure of accountability for the American
people. The JFMIP Principals have defined certain measures, in addition to
receiving an unqualified financial statement opinion, for achieving
financial

7At least 4 CFO Act agencies restated certain of their audited fiscal year
2002 financial statements to correct misstatements in such financial
statements. All 4 of the agencies had received unqualified opinions on
their fiscal year 2002 financial statements. These restatements were not
material to the consolidated financial statements.

8DHS began operations as an agency 5 months after the start of the fiscal
year, on March 1, 2003. Transfers of funds, assets, liabilities, and
obligations from 22 existing federal agencies to DHS began on March 1,
2003. DHS's auditors issued a qualified opinion on the consolidated
balance sheet and statement of custodial activity as of September 30,
2003, and disclaimed on the consolidated statement of net cost,
consolidated statement of changes in net position, combined statement of
budgetary resources, and consolidated statement of financing for the 7
months ended September 30, 2003. In accordance with Federal Accounting
Standards Advisory Board Technical Bulletin 2003-1, Certain Questions and
Answers Related to the Homeland Security Act of 2002, the fiscal year 2003
activities that occurred prior to the transfer of operations to DHS were
to be reflected in the transferring agencies' financial statements.

management success. These additional measures include being able to
routinely provide timely, accurate, and useful financial and performance
information and having no material internal control weaknesses or material
noncompliance with laws and regulations and the requirements of the
Federal Financial Management Improvement Act of 1996 (FFMIA).9 As shown in
table 1, while the severity and magnitude of the problems identified vary
greatly, reports of inspectors general and their contract auditors
indicated that for fiscal year 2003 only 3 of the 23 CFO Act agencies had
neither a material weakness in internal control, an issue involving
compliance with applicable laws and regulations, nor an instance of lack
of substantial compliance with the requirements of FFMIA.

Table 1: Fiscal Year 2003 CFO Act Agency Results Reported by Auditors

                                       Agencies with unqualified opinions and
                                                    no material weaknesses or
                            Agencies with unqualified opinions noncompliances

                                     20a 3b

Source: GAO.

aAgriculture, Commerce, Education, Energy, Health and Human Services,
Housing and Urban Development, Interior, Justice, Labor, State,
Transportation, Treasury, Veterans Affairs, Agency for International
Development, Environmental Protection Agency, General Services
Administration, National Science Foundation, Nuclear Regulatory
Commission, Office of Personnel Management, and Social Security
Administration.

bEnergy, National Science Foundation, and Social Security Administration.

In this testimony, I will highlight the major issues relating to the
consolidated financial statements for fiscal years 2003 and 2002, discuss
systems problems that continue to hinder federal agency accountability,
and describe progress that has been made toward addressing major
impediments to an opinion on the consolidated financial statements. I will
also discuss why sound financial management today and in the future is
critical to meeting tomorrow's fiscal needs and the need for "truth and
transparency" in connection with our nation's financial condition and
fiscal outlook.

9FFMIA, Pub. L. No. 104-208, div. A, S: 101(f), title VIII, 110 Stat.
3009, 3009-389 (Sept. 30, 1996).

  Highlights of Major Issues Related to the U.S. Government's Consolidated
  Financial Statements for Fiscal Years 2003 and 2002

As I mentioned earlier, as has been the case for the previous 6 fiscal
years, the federal government continues to have a significant number of
material weaknesses related to financial systems, fundamental
recordkeeping and financial reporting, and incomplete documentation.
Several of these material weaknesses (referred to hereafter as material
deficiencies) resulted in conditions that continued to prevent us from
forming and expressing an opinion on the U.S. government's consolidated
financial statements for the fiscal years ended September 30, 2003 and
2002.10 There may also be additional issues that could affect the
consolidated financial statements that have not been identified.

Major challenges include the federal government's inability to

o properly account for and report property, plant, and equipment and
inventories and related property, primarily at the Department of Defense
(DOD);

o reasonably estimate or adequately support amounts reported for certain
liabilities, such as environmental and disposal liabilities and related
costs at DOD, and ensure complete and proper reporting for commitments and
contingencies;

o support major portions of the total net cost of government operations,
most notably related to DOD, and ensure that all disbursements are
properly recorded;

o  fully account for and reconcile intragovernmental activity and
balances;

o demonstrate how net outlay amounts reported in the consolidated
financial statements were related to net outlay amounts reported in the
underlying federal agencies' financial statements; and

o effectively prepare the federal government's financial statements,
including ensuring that the consolidated financial statements are
consistent with the underlying audited agency financial statements,
balanced, and in conformity with GAAP.

10We previously reported that material deficiencies prevented us from
expressing an opinion on the fiscal years 1997, 1998, 1999, 2000, 2001,
and 2002 consolidated financial statements of the U.S. government.

In addition to these material deficiencies, we identified four other
material weaknesses in internal control related to loans receivable and
loan guarantee liabilities, improper payments, information security, and
tax collection activities.

The material weaknesses identified by our work are discussed in more
detail in appendix II, and their primary effects are described in appendix

III.

  Recurring Systems Problems Hinder Accountability

The ability to produce the data needed to efficiently and effectively
manage the day-to-day operations of the federal government and provide
accountability to taxpayers and the Congress has been a long-standing
challenge at most federal agencies. The results of the fiscal year 2003
assessments performed by agency inspectors general or their contract
auditors under FFMIA show that these problems continue to plague the
financial management systems used by most of the CFO Act agencies. While
the problems are much more severe at some agencies than at others, their
nature and severity indicate that overall, management at most CFO Act
agencies lacks the full range of information needed for accountability,
performance reporting, and decision making. These problems include
nonintegrated financial systems, lack of accurate and timely recording of
data, inadequate reconciliation procedures, and noncompliance with
accounting standards and the U.S. Government Standard General Ledger
(SGL).

Agencies' inability to meet the federal financial management systems
requirements continues to be the major barrier to achieving compliance
with FFMIA. Under FFMIA, CFO Act agency auditors are required to report,
as part of the agencies' financial statement audits, whether agencies'
financial management systems substantially comply with (1) federal
financial management systems requirements, (2) applicable federal
accounting standards, and (3) the SGL at the transaction level. As shown
in figure 1, auditors most frequently reported instances of noncompliance
with federal financial management systems requirements. These instances of
noncompliance involved not only core financial systems, but also
administrative and programmatic systems.

Figure 1: Auditors' FFMIA Assessments for Fiscal Years 2000, 2001, 2002,
and 2003

For fiscal year 2003, auditors for 17 of the 23 CFO Act agencies reported
that the agencies' financial management systems did not comply
substantially with one or more of FFMIA's three requirements. For the
remaining 6 CFO Act agencies, auditors provided negative assurance,
meaning that nothing came to their attention indicating that the agencies'
financial management systems did not substantially meet FFMIA
requirements. The auditors for these 6 agencies did not definitively state
whether the agencies' systems substantially complied with FFMIA
requirements, as is required under the statute. DHS is not subject to the
requirements of the CFO Act and, consequently, is not required to comply
with FFMIA. Accordingly, DHS's auditors did not report on DHS's compliance
with FFMIA. However, the auditors identified and reported deficiencies
that related to the aforementioned three requirements of FFMIA.

Federal agencies have recognized the seriousness of their financial
systems weaknesses and have efforts under way to implement or upgrade
their financial systems to alleviate long-standing problems, but some of
these

efforts face significant challenges. For example, as we testified in May
2004,11 we have identified several issues related to NASA's financial
management systems modernization effort: (1) NASA did not involve key
stakeholders in the design and implementation of the agency's new
financial management system's core financial module; (2) NASA did not
follow key best practices for acquiring and implementing this system; and
(3) the new system lacks key external reporting capabilities for property
and budgetary data. In addition, as I will discuss later in this
testimony, DOD faces major challenges in its efforts to develop a business
enterprise architecture. We recognize that it will take time, investment,
and sustained emphasis to improve agencies' underlying financial
management systems.

  Addressing Major Impediments to an Opinion on Consolidated Financial
  Statements

As I mentioned earlier, for the past 7 fiscal years, the federal
government has been required to prepare, and have audited, consolidated
financial statements. Successfully meeting this requirement is tightly
linked to the requirements for the CFO Act agencies to also have audited
financial statements. This has stimulated extensive cooperative efforts
and considerable attention by agency chief financial officers, inspectors
general, Treasury and OMB officials, and GAO. With the benefit of the past
7 years' experience by the federal government in having the required
financial statements subjected to audit, more intensified attention will
be needed on the most serious obstacles to achieving an opinion on the
U.S. government's consolidated financial statements. Three major
impediments to an opinion on the consolidated financial statements are (1)
serious financial management problems at DOD, (2) the federal government's
inability to fully account for and reconcile transactions between federal
government entities, and (3) the federal government's ineffective process
for preparing the consolidated financial statements.

 Financial Management at Essential to achieving an opinion on the consolidated
financial statements DOD is resolution of the serious financial management
                             problems at DOD, which

11U.S. General Accounting Office, National Aeronautics and Space
Administration: Significant Actions Needed to Address Long-standing
Financial Management Problems, GAO-04-754T (Washington, D.C.: May 19,
2004).

we have designated as high risk12 since 1995. In accordance with section
1008 of the National Defense Authorization Act for Fiscal Year 2002,13 DOD
reported that for fiscal year 2003, it was not able to provide adequate
evidence supporting material amounts in its financial statements. DOD
stated that it is unable to comply with applicable financial reporting
requirements for (1) property, plant, and equipment (PP&E); (2) inventory
and operating materials and supplies; (3) environmental liabilities; (4)
intragovernmental eliminations and related accounting adjustments; (5)
disbursement activity; and (6) cost accounting by responsibility segment.
Although DOD represented that the military retirement health care
liability data had improved for fiscal year 2003, the cost of direct
health care provided by DOD-managed military treatment facilities was a
significant amount of DOD's total recorded health care liability and was
based on estimates for which adequate support was not available.

DOD continues to confront pervasive decades-old financial management and
business problems related to its systems, processes (including internal
controls), and people (human capital). These problems preclude the
department from producing accurate, reliable, and timely information to
make sound decisions and to accurately report on its billions of dollars
of assets. DOD's long-standing business management systems problems
adversely affect the economy, effectiveness, and efficiency of its
operations and have resulted in a lack of adequate accountability across
all major business areas. To date, none of the military services or major
DOD components has passed the test of an independent financial audit14
because of pervasive weaknesses in financial management systems,
operations, and controls.

Additionally, the department's stovepiped, duplicative, and nonintegrated
systems contribute to its vulnerability to fraud, waste, and abuse. In
this

12GAO identifies areas at high risk due to either their greater
vulnerabilities to waste, fraud, abuse, and mismanagement or major
challenges associated with their economy, efficiency, or effectiveness.

13Pub. L. No. 107-107, S: 1008, 115 Stat. 1012, 1204 (Dec. 28, 2001).

14Although not major DOD components, the Military Retirement Fund received
an unqualified opinion on its fiscal year 2003 financial statements, and
the DOD Medicare-Eligible Retiree Health Care Fund received a qualified
opinion on its fiscal year 2003 financial statements.

regard, we have recently testified on problems related to military pay15
and unused airline tickets.16 Vulnerability to fraud, waste, and abuse
continues despite substantial systems investment. For fiscal year 2004,
DOD requested approximately $19 billion to operate, maintain, and
modernize its reported 2,274 business systems. The duplicative and
stovepiped nature of DOD's systems environment is illustrated by the
numerous systems it has in the same functional areas. For example, DOD
reported that it has 565 systems to support logistics functions. These
systems are not integrated and thus have multiple points of data entry,
which can result in significant data integrity problems.

Further, DOD continues to lack effective management oversight and control
over business systems modernization investments. The actual funding
continues to be distributed among the military services and defense
agencies, thereby enabling the numerous DOD components to continue to
develop stovepiped, parochial solutions to the department's long-standing
financial management and business operation challenges. Lacking a
departmentwide focus and effective management oversight and control of
business systems investment, DOD continuesto invest billions of dollars in
systems that fail to provide integrated corporate solutions to its
long-standing business operations problems.

Over the past 14 years, DOD has initiated several broad-based reform
efforts intended to fundamentally reform its business operations and
improve the reliability of information used in the decision-making
process. While these initiatives produced some incremental improvements,
they did not result in the fundamental reform necessary to resolve the
department's long-standing management challenges. Secretary Rumsfeld has
made business transformation a priority. For example, through its Business
Management Modernization Program, DOD is continuing its efforts to develop
and implement a business enterprise architecture and establish effective
management and control over its business system modernization investments.

15U.S. General Accounting Office, Military Pay: Army National Guard
Personnel Mobilized to Active Duty Experienced Significant Pay Problems,
GAO-04-413T (Washington, D.C.: Jan. 28, 2004).

16U.S. General Accounting Office, DOD Travel Cards: Control Weaknesses Led
to Millions in Fraud, Waste, and Improper Payments, GAO-04-825T
(Washington, D.C.: June 9, 2004).

However, we recently reported17 that after about 3 years of effort and
over $203 million in obligations, we have not seen significant change in
the content of DOD's architecture or in DOD's approach to investing
billions of dollars annually in existing and new systems. Few actions have
been taken to address the recommendations we made in our previous
reports,18 which were aimed at improving DOD's plans for developing the
next version of the architecture and implementing the institutional means
for selecting and controlling both planned and ongoing business systems
investments. To date, DOD has not addressed 22 of our 24 recommendations.

Currently, DOD has various initiatives under way to support its efforts to
obtain an unqualified audit opinion on its fiscal year 2007 financial
statements. Because there are not yet detailed plans guiding these
activities, however, it is unclear whether and how they support each other
and whether they support this goal. Therefore, the feasibility of meeting
this goal is as yet unknown.

The seriousness of DOD's business management weaknesses underscores the
importance of no longer condoning "status quo" business operations at DOD.
Cultural resistance to change, military service parochialism, and
stovepiped operations have all contributed significantly to the failure of
previous attempts to implement broad-based management reforms at DOD. The
department has acknowledged that it confronts decades-old problems deeply
grounded in the bureaucratic history and operating practices of a complex,
multifaceted organization and that many of these practices were developed
piecemeal and evolved to accommodate different organizations, each with
its own policies and procedures.

17U.S. General Accounting Office, DOD Business Systems Modernization:
Limited Progress in Development of Business Enterprise Architecture and
Oversight of Information Technology Investments, GAO-04-731R (Washington,
D.C.: May 17, 2004).

18U.S. General Accounting Office, DOD Business Systems Modernizations:
Improvements to Enterprise Architecture Development and Implementation
Efforts Needed, GAO-03-458 (Washington, D.C.: Feb. 28, 2003), and DOD
Business Systems Modernizations: Important Progress Made to Develop
Business Enterprise Architecture, but Much Work Remains,

GAO-03-1018 (Washington, D.C.: Sept. 19, 2003).

To improve the likelihood that the department's current business
transformation efforts will be successful, we have previously suggested19
that a chief management official20 position be created. Previous failed
attempts to improve DOD's business operations illustrate the need for
sustained involvement of DOD leadership in helping to assure that DOD's
financial and overall business process transformation efforts remain a
priority. While the Secretary and other key DOD leaders have demonstrated
their commitment to the current business transformation efforts, the
longterm nature of these efforts requires the development of an executive
position capable of providing strong and sustained executive leadership
over a number of years and various administrations.

This position would provide the sustained attention essential for
addressing key stewardship responsibilities such as strategic planning,
performance and financial management, and business systems modernization
in an integrated manner. This position could be filled by an individual,
appointed by the President and confirmed by the Senate, for a set term of
7 years with the potential for reappointment. Such an individual should
have a proven track record as a business process change agent in large,
complex, and diverse organizations-experience necessary to spearhead
business process transformation across the department, and potentially
administrations, and serve as an integrator for the needed business
transformation efforts.

Further, in a recent report21 we also suggest that to improve management
oversight, accountability, and control of the department's business
systems funding, Congress may wish to consider providing the funds to
operate, maintain, and modernize DOD's business systems to the functional
areas,

19U.S. General Accounting Office, Department of Defense: Further Actions
Needed to Establish and Implement a Framework for Successful Financial and
Business Management Transformation, GAO-04-551T (Washington, D.C.: Mar.
23, 2004), and Department of Defense: Further Actions Needed to Establish
and Implement a Framework for Successful Business Transformation,
GAO-04-626T (Washington, D.C.: Mar. 31, 2004).

20On September 9, 2002, GAO convened a roundtable of executive branch
leaders and management experts to discuss the Chief Operating Officer
concept. For more information, see U.S. General Accounting Office,
Highlights of a GAO Roundtable: The Chief Operating Officer Concept: A
Potential Strategy to Address Federal Governance Challenges, GAO-03192SP
(Washington, D.C.: Oct. 4, 2002).

21U.S. General Accounting Office, DOD Business Systems Modernization:
Billions Continue to Be Invested with Inadequate Management Oversight and
Accountability, GAO-04-615 (Washington, D.C.: May 27, 2004).

known as domains, rather than the military services and the defense
agencies. Currently, each military service and defense agency receives its
own funding and is largely autonomous in deciding how to spend these
funds, thereby hindering the development of broad-based, integrated
corporate system solutions to common DOD-wide problems. We believe it is
critical that funds for DOD business systems be appropriated to the domain
owners in order to provide for accountability and the ability to prevent
the continued parochial approach to systems investment that exists today.
The domains would establish a hierarchy of investment review boards with
DOD-wide representation, including the military services and defense
agencies. These boards would be responsible for reviewing and approving
investments to develop, operate, maintain, and modernize business systems
for the domain portfolio, including ensuring that investments were
consistent with DOD's business enterprise architecture.

DOD still has a long way to go, and top leadership must continue to stress
the importance of achieving lasting improvement that truly transforms the
department's business systems and operations. Only through major
transformation, which will take time and sustained leadership from top
management, will DOD be able to meet the mandate of the CFO Act and
achieve the President's Management Agenda goal of improved financial
performance.

    Intragovernmental Transactions

OMB and Treasury require the CFOs of 35 executive departments and
agencies, including the 23 CFO Act agencies, to reconcile selected
intragovernmental activity and balances with their "trading partners"22
and to report to Treasury, the agency's inspector general, and GAO on the
extent and results of intragovernmental activity and balances
reconciliation efforts. A substantial number of the agencies continue to
be unable to fully perform reconciliations of intragovernmental activity
and balances with their trading partners, citing reasons such as (1)
trading partners not providing needed data; (2) limitations and
incompatibility of agency and trading partner information systems; and (3)
lack of human resources. Amounts reported for federal agency trading
partners for certain intragovernmental accounts were significantly out of
balance in the aggregate for both fiscal years 2003 and 2002.

22Trading partners are U.S. government agencies, departments, or other
components included in the consolidated financial statements that do
business with each other.

We reported in previous years that the heart of the intragovernmental
transactions issue was that the federal government lacked clearly
articulated business rules for these transactions so that they would be
handled consistently by agencies. In this regard, at the start of fiscal
year 2003, OMB issued business rules to transform and standardize
intragovernmental ordering and billing. To address long-standing problems
with intragovernmental exchange transactions between federal agencies,
Treasury provided federal agencies with quarterly detailed trading partner
information during fiscal year 2003 to help them better perform their
trading partner reconciliations. In addition, the federal government began
a three-phase Intragovernmental Transactions e-gov project to define a
governmentwide data architecture and provide a single source of detailed
trading partner data. On April 20, 2004, however, OMB announced that it
was appropriate to pause and evaluate the results of the project to date.
OMB estimated that the evaluation will take 120 days and will be followed
by a phased deployment. Resolving the intragovernmental transactions
problem remains a difficult challenge and will require a commitment by the
CFO Act agencies and continued strong leadership by OMB.

    Preparing the Consolidated Financial Statements

The federal government did not have adequate systems, controls, and
procedures to ensure that the consolidated financial statements are
consistent with the underlying audited agency financial statements,
balanced, and in conformity with GAAP. In this regard, Treasury is
developing a new system and procedures to prepare the consolidated
financial statements beginning with the statements for fiscal year 2004.
Treasury officials have stated that these actions are intended to, among
other things, directly link information from federal agencies' audited
financial statements to amounts reported in the consolidated financial
statements and resolve many of the issues we identified in the process for
preparing the consolidated financial statements. As part of our fiscal
year 2004 audit, we will evaluate the new system and procedures as they
are fully developed and implemented and determine the extent of linkage
accomplished for the fiscal year 2004 financial statements. Resolving
issues surrounding preparing the consolidated financial statements has
been a significant challenge and will require continued strong leadership
by Treasury management.

  Truth and Transparency in the Fiscal Outlook

Our nation's large and growing long-term fiscal imbalance, which is driven
largely by known demographic trends and rising health care costs-coupled
with new homeland security and defense commitments-serves to sharpen the
need to fundamentally review and re-examine basic federal entitlements, as
well as other mandatory and discretionary spending, and tax policies. As
we look ahead, our nation faces an unprecedented demographic challenge
with significant implications, among them budgetary and economic. Between
now and 2035, the number of people who are 65 years old or over will
double, driving federal spending on the elderly to a larger and ultimately
unsustainable share of the federal budget. As a result, tough choices will
be required to address the resulting structural imbalance.

GAO prepares long-term budget simulations that seek to illustrate the
likely fiscal consequences of the coming demographics and rising health
care costs. Our latest long-term budget simulations reinforce the need for
change in the major cost drivers-Social Security and health care programs.
As shown in figure 2, by 2040, absent reform of these entitlement
programs, projected federal revenues may be adequate to pay little beyond
interest on the debt.

Figure 2: Composition of Spending as a Share of GDP Assuming Discretionary
Spending Grows with GDP after 2004 and All Expiring Tax Provisions Are
Extended Percent of GDP

50

40

30

20

10

0 2003 2015 2030 2040

                                  Fiscal year

All other spending

Medicare & Medicaid

Social Security

Net interest

Source: GAO's March 2004 analysis.

Note: Although expiring tax provisions are extended, revenue as a share of
gross domestic product (GDP) increases through 2014 due to (1) real
bracket creep, (2) more taxpayers becoming subject to the alternative
minimum tax, and (3) increased revenue from tax-deferred retirement
accounts. After 2014, revenue as a share of GDP is held constant.

Current financial reporting does not clearly and transparently show the
wide range of responsibilities, programs, and activities that may either
obligate the federal government to future spending or create an
expectation for such spending and provides an unrealistic and even
misleading picture of the federal government's overall performance and
financial condition. Few agencies adequately show the results they are
getting with the taxpayer dollars they spend. In addition, too many
significant federal government commitments and obligations, such as Social
Security and Medicare, are not fully and consistently disclosed in the

federal government's consolidated financial statements and budget, and
current federal financial reporting standards do not require such
disclosure.23 Figure 3 shows some selected fiscal exposures. The spectrum
of these exposures ranges from covering only the explicit liabilities that
are shown on the consolidated financial statements to implicit promises
embedded in current policy or public expectations. These liabilities,
commitments, and promises have created a fiscal imbalance that will put
unprecedented strains on the nation's spending and tax policies. Although
economic growth can help, the projected fiscal gap is now so large that
the federal government will not be able to simply grow its way out of the
problem. Tough choices are inevitable.

23The Federal Accounting Standards Advisory Board has a project under way
to consider recognition, measurement, and display of social insurance
obligations.

Figure 3: Selected Fiscal Exposures: Sources and Examplesa

Type

Example (dollars in billions)

Explicit liabilities	Publicly held debt ($3,913) Military and civilian
pension and post-retirement health ($2,857) Veterans benefits payable
($955) Environmental and disposal liabilities ($250) Loan guarantees ($35)

Explicit financial commitments	Undelivered orders ($596) Long-term leases
($47)

Explicit financial contingencies	Unadjudicated claims ($9) Pension Benefit
Guaranty Corporation ($86) Other national insurance programs ($7)
Government corporations, e.g., Ginnie Mae

Implicit exposures implied by current policies or the public's
expectations about the role of government

bDebt held by government accounts ($2,859)

Future Social Security benefit payments ($3,699)c

cFuture Medicare Part A benefit payments ($8,236)

cFuture Medicare Part B benefit payments ($11,416)

                Future Medicare Part D benefit payments ($8,119)

                                       c

Life-cycle cost, including deferred and future maintenance and operating
costs (amount unknown)

Government-Sponsored Enterprises, e.g., Fannie Mae and Freddie Mac

Source: GAO analysis of data from the Department of the Treasury; the
Office of the Chief Actuary, Social Security Administration; and the
Office of the Actuary, Centers for Medicare and Medicaid Services.

aAll figures are as of the end of fiscal year 2003, except Social Security
and Medicare estimates, which are as of the end of calendar year 2003.

bThis amount includes $774 billion held by military and civilian pension
funds that would offset the explicit liabilities reported by those funds.

cFigures for Social Security and Medicare are net of debt held by the
trust funds ($1,531 billion for Social Security, $256 billion for Medicare
Part A, and $24 billion for Medicare Part B) and represent net present
value estimates over a 75-year period. Over an infinite horizon, the
estimate for Social Security would be $10.4 trillion, $21.8 trillion for
Medicare Part A, $23.2 trillion for Medicare Part B, and $16.5 trillion
for Medicare Part D.

Particularly troubling are the many big-ticket items that taxpayers will
eventually have to deal with. The federal government has pledged its
support to a long list of programs and activities, including pension and
health care benefits for senior citizens, medical care for veterans, and
contingencies associated with various government-sponsored entities,

whose claims on future spending total trillions of dollars. Despite their
serious implications for future budgets, tax burdens, and spending
flexibilities, these unfunded commitments get short shrift in the federal
government's current financial statements and in budgetary deliberations.

The federal government's gross debt as of September 2003 was about $7
trillion, or about $24,000 for every man, woman, and child in this country
today. But that number excludes many big-ticket items, including the gap
between promised and funded Social Security and Medicare benefits,
veterans' health care, and a range of other commitments and contingencies.
If these items are factored in, the total burden in current dollars is at
least $42 trillion. To put that number into perspective, $42 trillion is
18 times the current federal budget, or 3.5 times our current annual gross
domestic product. One of the biggest contributors to this total bill will
be the new Medicare prescription drug benefit, whose estimated
current-dollar cost over the next 75 years is more than $8 trillion.
Stated differently, the current total burden for every American is more
than $140,000-and every day that burden is growing larger. GAO's long-term
budget simulations show that by 2040, the federal government may have to
cut federal spending by 60 percent or raise taxes to about 2.5 times
today's level to pay for the mounting cost of the federal government's
current unfunded commitments. Either would be devastating.

Proper accounting and reporting practices are essential in the public
sector. After all, the U.S. government is the largest, most diverse, most
complex, and arguably the most important entity on earth today. Its
services-homeland security, national defense, Social Security, mail
delivery, and food inspection, to name a few-directly affect the
well-being of almost every American. But sound decisions on the future
direction of vital federal government programs and policies are made more
difficult without timely, accurate, and useful financial and performance
information.

Fortunately, we are starting to see efforts to address the shortcomings in
federal financial reporting. The President's Management Agenda, which
closely reflects GAO's list of high-risk government programs, is bringing
attention to troubled areas across the federal government and is taking
steps to better assess the results that programs are getting with the
resources they are given. The Federal Accounting Standards Advisory Board
is also making progress on many key financial reporting issues.

In addition to these efforts, we have published frameworks for analyzing
various Social Security reform proposals24 and for analyzing health care
reform proposals.25 We have also helped to create a consortium of "good
government" organizations to stimulate the development of a set of key
national indicators to assess the United States' overall position and
progress over time and in comparison to those of other industrialized
nations.

Budget experts at the Congressional Budget Office (CBO) and GAO continue
to encourage reforms to the federal budget process to better reflect the
federal government's commitments and signal emerging problems. Among other
things, we have recommended that the federal government issue an annual
report on major fiscal exposures. The President's fiscal year 2005 budget
also proposes that future President's budgets report on any enacted
legislation in the past year that worsens the unfunded obligations of
programs with long-term actuarial projections, with CBO to make a similar
report. Such reporting could be a good starting point.

Although these are positive initial steps, much more must be done given
the magnitude of the federal government's fiscal challenge. A
top-to-bottom review of government activities to ensure their relevance
and fit for the 21st century and their relative priority is long overdue.
As I have spoken about in the past, the federal government needs a
three-pronged approach to (1) restructure existing entitlement programs,
(2) reexamine the base of discretionary and other spending, and (3) review
and revise the federal government's tax policy, including major tax
preferences, and enforcement programs. New accounting and reporting
approaches, budget control mechanisms, and metrics are needed for
considering and measuring the impact of spending and tax policies and
decisions over the long term.

24U.S. General Accounting Office, Social Security Reform: Analysis of
Reform Models Developed by the President's Commission to Strengthen Social
Security, GAO-03-310 (Washington, D.C.: Jan. 15, 2003).

25GAO's health care framework can be found at
www.gao.gov/cghome/hccrisis/health.pdf. See also Comptroller General's
Forum on Health Care: Unsustainable Trends Necessitate Comprehensive and
Fundamental Reforms to Control Spending and Improve Value, GAO04-793SP
(Washington, D.C.: May 1, 2004).

Closing Comments Our report on the U.S. government's consolidated
financial statements for fiscal years 2003 and 2002 highlights the need to
continue addressing the federal government's serious financial management
weaknesses. With the significantly accelerated financial reporting time
frame for fiscal year 2004 and beyond, it is essential that the federal
government move away from the extraordinary efforts many federal agencies
continue to make to prepare financial statements and toward giving
prominence to strengthening the federal government's financial systems,
reporting, and controls. This is the only way the federal government can
meet the end goal of making timely, accurate, and useful financial and
performance information routinely available to the Congress, other
policymakers, and the American public. The requirement for timely,
accurate, and useful financial and performance management information is
greater than ever as our nation faces major long-term fiscal challenges
that will require tough choices in setting priorities and linking
resources to results.

The Congress and the President face the challenge of sorting out the many
claims on the federal budget without the budget enforcement mechanisms or
fiscal benchmarks that guided the federal government through the previous
years of deficit reduction into the brief period of surplus. While a
number of steps will be necessary to address this challenge, truth and
transparency in federal government reporting are essential elements of any
attempt to address the nation's long-term fiscal challenges. The fiscal
risks I mentioned earlier can be managed only if they are properly
accounted for and publicly disclosed. A crucial first step will be to face
facts and identify the significant commitments facing the federal
government. If citizens and federal government officials come to
understand various fiscal exposures and their potential claims on future
budgets, they are more likely to insist on prudent policy choices today
and sensible levels of fiscal risk in the future. In addition, new budget
control mechanisms will be required, along with effective approaches to
successfully engage in a fundamental review, reassessment, and
reprioritization of the base of federal government programs and policies
that I have recommended previously.

Public officials will have more incentive to make difficult but necessary
choices if the public has the facts and comes to support serious and
sustained action to address the nation's fiscal challenges. Without
meaningful public debate, however, real and lasting change is unlikely.
Clearly, the sooner action is taken, the easier it will be to turn things
around.

Ibelieve that nothinglessthan a national education campaign and outreach
effort is needed to help the public understand the nature and magnitude of
the long-term financial challenge facing this nation. An informed
electorate is essential for a healthy democracy. Members of Generations X
and Y especially need to become active in this discussion because they and
their children will bear the heaviest burden if policymakers fail to act
in a timely and responsible manner.

We at GAO are committed to doing our part, but others also need to step up
to the plate. By working together, I believe we can make a meaningful
difference for our nation, fellow citizens, and future generations of
Americans.

In closing, Mr. Chairman, I want to reiterate the value of sustained
congressional interest in these issues, as demonstrated by the Congress's
annual hearings on the results of our audit of the consolidated financial
statements and of audits of certain federal agencies' financial
statements. It will also be key that the appropriations, budget,
authorizing, and oversight committees hold agency top leadership
accountable for resolving these problems and that they support improvement
efforts.

ContactsFor further information regarding this testimony, please contact
Jeffrey C. Steinhoff, Managing Director, or Gary T. Engel, Director,
Financial Management and Assurance, at (202) 512-2600.

Appendix I

Selected Major Federal Agencies: Fiscal Year 2003 Audit Results, Principal
Auditors, and Number of Other Audit Contractors

Number of other audit

23 CFO Act agencies Audit results Principal auditor contractors

    Agency for International  Unqualified        Inspector General         
          Development                                                      
          Agriculture         Unqualified        Inspector General         
            Commerce          Unqualified             KPMG LLP             
            Defense           Disclaimer         Inspector General         
           Education          Unqualified        Ernst & Young LLP         
             Energy           Unqualified             KPMG LLP             
    Environmental Protection  Unqualified        Inspector General         
             Agency                                                        
        General Services      Unqualified    PricewaterhouseCoopers LLP    
         Administration                                                    
Health and Human Services  Unqualified        Inspector General         
       Housing and Urban      Unqualified        Inspector General         
          Development                                                      
            Interior          Unqualified             KPMG LLP             
            Justice           Unqualified    PricewaterhouseCoopers LLP    
             Labor            Unqualified  R. Navarro & Associates, Inc.   
    National Aeronautics and  Disclaimer     PricewaterhouseCoopers LLP    
      Space Administration                                                 
        National Science      Unqualified             KPMG LLP             
           Foundation                                                      
       Nuclear Regulatory     Unqualified  R. Navarro & Associates, Inc.   
           Commission                                                      
      Office of Personnel     Unqualified             KPMG LLP              0 
           Management                                                      
         Small Business       Disclaimer        Cotton & Company LLP        0 
         Administration                                                    
        Social Security       Unqualified    PricewaterhouseCoopers LLP     0 
         Administration                                                    
             State            Unqualified Leonard G. Birnbaum and Company,  2 
                                                        LLP                
         Transportation       Unqualified        Inspector General          2 
            Treasury          Unqualified        Inspector General         6a 
        Veterans Affairs      Unqualified      Deloitte & Touche LLP        0 
       Other major agency                                                  
       Homeland Security      Disclaimerb             KPMG LLP              0 

Source: GAO.

aIn addition, GAO audited the Internal Revenue Service's financial
statements and the Schedules of Federal Debt Managed by the Bureau of the
Public Debt.

bDHS began operations as an agency 5 months after the start of the fiscal
year, on March 1, 2003.

Transfers of funds, assets, liabilities, and obligations from 22 existing
federal agencies to DHS began on March 1, 2003. DHS's auditors issued a
qualified opinion on the consolidated balance sheet and statement of
custodial activity as of September 30, 2003, and disclaimed on the
consolidated statement of net cost, consolidated statement of changes in
net position, combined statement of budgetary resources, and consolidated
statement of financing for the 7 months ended September 30, 2003.

Appendix II

Material Deficiencies�

The federal government did not maintain adequate systems or have
sufficient, reliable evidence to support information reported in the
consolidated financial statements of the U.S. government, as described
below. These material deficiencies contributed to our disclaimer of
opinion on the consolidated financial statements and also constitute
material weaknesses in internal control.

  Property, Plant, and Equipment and Inventories and Related Property

The federal government could not satisfactorily determine that all PP&E
and inventories and related property were included in the consolidated
financial statements, verify that certain reported assets actually exist,
or substantiate the amounts at which they were valued. Most of the PP&E
and inventories and related property are the responsibility of DOD. As in
past years, DOD did not maintain adequate systems or have sufficient
records to provide reliable information on these assets. Other agencies,
most notably the National Aeronautics and Space Administration, reported
continued weaknesses in internal control procedures and processes related
to PP&E.

  Liabilities and Commitments and Contingencies

The federal government could not reasonably estimate or adequately support
amounts reported for certain liabilities. For example, DOD was not able to
estimate with assurance key components of its environmental and disposal
liabilities. In addition, DOD could not support a significant amount of
its estimated military postretirement health benefits liabilities included
in federal employee and veteran benefits payable. These unsupported
amounts related to the cost of direct health care provided by DODmanaged
military treatment facilities. Further, the federal government could not
determine whether commitments and contingencies, including those related
to treaties and other international agreements entered into to further the
U.S. government's interests, were complete and properly reported.

Cost of Government The previously discussed material deficiencies in
reporting assets and Operations and liabilities, material deficiencies in
financial statement preparation, as Disbursement Activity discussed below,
and the lack of adequate disbursement reconciliations at

certain federal agencies affect reported net costs. As a result, the
federal government was unable to support significant portions of the total
net cost of operations, most notably related to DOD.

                                  Appendix II
                             Material Deficiencies

With respect to disbursements, DOD and certain other federal agencies did
not adequately reconcile disbursement activity. For fiscal years 2003 and
2002 there were unsupported adjustments to federal agencies' records and
unreconciled disbursement activity, including unreconciled differences
between federal agencies' and Treasury's records of disbursements,
totaling billions of dollars, which could also affect the balance sheet.

  Accounting for and Reconciliation of Intragovernmental Activity and Balances

OMB and Treasury require the CFOs of 35 executive departments and
agencies, including the 23 CFO Act agencies, to reconcile selected
intragovernmental activity and balances with their "trading partners"1 and
to report to Treasury, the agency's inspector general, and GAO on the
extent and results of intragovernmental activity and balances
reconciliation efforts. A substantial number of the agencies did not fully
perform the required reconciliations for fiscal years 2003 and 2002,
citing reasons such as (1) trading partners not providing needed data, (2)
limitations and incompatibility of agency and trading partner information
systems, and (3) lack of human resources. For both of these years, amounts
reported for federal agency trading partners for certain intragovernmental
accounts were significantly out of balance. Treasury's ability to
eliminate certain intragovernmental activity and balances is impaired by
these federal agencies' problems in handling their intragovernmental
transactions.

Net OutlaysOMB Bulletin 01-09, Form and Content of Agency Financial
Statements, 2 states that outlays in federal agencies' Statements of
Budgetary Resources (SBR) should agree with the respective agency's net
outlays reported in the budget of the U.S. government. In addition,
Statement of Federal Financial Accounting Standards (SFFAS) No. 7,
Accounting for Revenue and Other Financing Sources and Concepts for
Reconciling Budgetary and Financial Accounting, requires explanation of
any material differences between the information required to be disclosed
(including net outlays)

1Trading partners are U.S. government agencies, departments, or other
components included in the consolidated financial statements that do
business with each other.

2Office of Management and Budget Bulletin No. 01-09, Form and Content of
Agency Financial Statements (Washington, D.C.: Sept. 25, 2001). This
bulletin is OMB's official guidance for the form and content of federal
agencies' financial statements.

Appendix II
Material Deficiencies

and the amounts described as "actual" in the budget of the U.S.
government.

We found material differences between the total net outlays reported in
selected federal agencies' audited SBRs and the records used to prepare
the Statement of Changes in Cash Balance from Unified Budget and Other
Activities (Statement of Changes in Cash Balance),3 totaling about $140
billion and $186 billion for fiscal years 2003 and 2002, respectively.4
Two agencies (Treasury and the Department of Health and Human Services
(HHS)) accounted for about 83 percent and 75 percent of the differences
identified in fiscal years 2003 and 2002, respectively. We found that the
major cause of the differences for the two agencies was the treatment of
offsetting receipts.5 Some offsetting receipts for these two agencies had
not been included in the agencies' SBRs, which would have reduced the
agencies' net outlays and made the amounts more consistent with the
records used to prepare the Statement of Changes in Cash Balance.6 For
example, we found that HHS reported net outlays for fiscal year 2003 as
$596 billion on its audited SBR, while the records that Treasury uses to
prepare the Statement of Changes in Cash Balance showed $505 billion for
fiscal year 2003 for this agency. Until these differences between the
total net outlays reported in the federal agencies' SBRs and the records
used to prepare the Statement of Changes in Cash Balance are reconciled,
the effect that these differences may have on the U.S. government's
consolidated financial statements will be unknown. OMB has stated that it
plans to work with the agencies to address this issue.

3OMB and U.S. generally accepted accounting principles (GAAP) require
agencies to report net outlays in the SBR. The Statement of Changes in
Cash Balance also reports unified budget outlays-actual. Both are intended
to represent the same amount and be consistent with the information
presented in the budget of the U.S. government.

4In some agencies' fiscal year 2003 financial statements, the comparable
fiscal year 2002 amounts were restated.

5Offsetting receipts are collections that are credited to general fund,
special fund, or trust fund receipt accounts and that offset gross outlays
at the agency or governmentwide level.

6These two agencies did not adequately explain their fiscal year 2002
differences between the net outlays reported on the SBR and the budget of
the U.S. government in their notes to the fiscal year 2003 financial
statements.

                                  Appendix II
                             Material Deficiencies

  Preparation of Consolidated Financial Statements

The federal government did not have adequate systems, controls, and
procedures to ensure that the consolidated financial statements are
consistent with the underlying audited agency financial statements,
balanced, and in conformity with generally accepted accounting principles
(GAAP). During our fiscal year 2003 audit, we found the following:7

o The process for compiling the consolidated financial statements does not
directly link information from federal agencies' audited financial
statements to amounts reported in the consolidated financial statements,
and therefore does not ensure that the information in the consolidated
financial statements is consistent with the underlying information in
federal agencies' audited financial statements and other financial data.

o Internal control weaknesses exist in Treasury's process for preparing
the consolidated financial statements, such as a lack of (1) segregation
of duties and (2) appropriate documentation of certain policies and
procedures for preparing the consolidated financial statements.

o The net position reported in the consolidated financial statements is
derived by subtracting liabilities from assets, rather than through
balanced accounting entries. To make the fiscal years 2003 and 2002
consolidated financial statements balance, Treasury recorded a net $24.5
billion and a net $17.1 billion decrease, respectively, to net operating
cost on the Statements of Operations and Changes in Net Position, which it
labeled "Unreconciled Transactions Affecting the Change in Net Position."8
An additional net $11.3 billion and $12.5 billion of unreconciled
transactions were recorded in the Statements of Net Cost for fiscal years
2003 and 2002, respectively. Treasury does not

7The same issues we identified in fiscal year 2003 existed in fiscal year
2002, and some have existed for a number of years. In October 2003, we
reported in greater detail on the issues we identified, in U.S. General
Accounting Office, Financial Audit: Process for Preparing the Consolidated
Financial Statements of the U.S. Government Needs Improvement, GAO04-45
(Washington, D.C.: Oct. 30, 2003). This report included 44 recommendations
to address weaknesses we identified. It also included recommendations
related to 16 disclosure areas that are required by GAAP. We recommended
that the 16 disclosures that are not included in the consolidated
financial statements either be included or that the rationale for their
exclusion be documented.

8Although Treasury was unable to determine how much of the unreconciled
transactions, if any, relate to operations, it reported unreconciled
transactions as a component of net operating cost in the consolidated
financial statements.

Appendix II
Material Deficiencies

identify and quantify all components of these unreconciled activities, nor
does Treasury perform reconciliation procedures, which would aid in
understanding and controlling the net position balance as well as
eliminating the unreconciled transactions associated with compiling the
consolidated financial statements.

o Significant differences in other intragovernmental accounts, primarily
related to appropriations, still remain unresolved. Intragovernmental
activity and balances are "dropped" or "offset" in the preparation of the
consolidated financial statements rather than eliminated through balanced
accounting entries. This contributes to the federal government's inability
to determine the impact of these differences on amounts reported in the
consolidated financial statements.

o The federal government did not have an adequate process to identify and
report items needed to reconcile the operating results, which for fiscal
year 2003 showed a net operating cost of $665 billion, to the budget
results, which for the same period showed a unified budget deficit of
$374.8 billion.

o The consolidated financial statements include certain financial
information for the executive, legislative, and judicial branches, to the
extent that federal agencies within those branches have provided Treasury
such information. However, there are undetermined amounts of assets,
liabilities, costs, and revenues that are not included, and the federal
government did not provide evidence or disclose in the consolidated
financial statements that such excluded financial information was
immaterial.

o Treasury lacks an adequate process to ensure that the financial
statements, related notes, Stewardship Information, and Supplemental
Information are presented in conformity with GAAP. We found that certain
financial information required by GAAP was not disclosed in the
consolidated financial statements. Treasury did not provide us with
documentation of its rationale for excluding this information. As a result
of this and certain material deficiencies noted above, we were unable to
determine if the missing information was material to the consolidated
financial statements.

                                  Appendix II
                             Material Deficiencies

Other Material In addition to the material deficiencies noted above, we
found four other material weaknesses in internal control as of September
30, 2003: (1)

Weaknessesseveral federal agencies continue to have deficiencies in the
processes and procedures used to estimate the costs of their lending
programs and value their related loans receivable; (2) most federal
agencies have not reported the magnitude of improper payments in their
programs and activities; (3) federal agencies have not yet fully
institutionalized comprehensive security management programs; and (4)
material internal control weaknesses and systems deficiencies continue to
affect the federal government's ability to effectively manage its tax
collection activities.

  Loans Receivable and Loan Guarantee Liabilities

In general, federal agencies continue to make progress in reducing the
number of material weaknesses and reportable conditions9 related to their
lending activities. However, significant deficiencies in the processes and
procedures used to estimate the costs of certain lending programs and
value the related loans receivable still remain. These deficiencies
continue to adversely affect the government's ability to support annual
budget requests for these programs, make future budgetary decisions,
manage program costs, and measure the performance of lending activities.
The most notable deficiencies existed at the Small Business Administration
(SBA), which, while improved from last year, continues to have a material
weakness related to this area. For example, SBA did not adequately
document its estimation methodologies, lacked the management controls
necessary to ensure that appropriate estimates were prepared and reported
based on complete and accurate data, and could not fully support the
reasonableness of the costs of its lending programs and valuations of its
loan portfolio. We are currently assessing SBA's actions to resolve
certain of these deficiencies related to accounting for previous loan
sales and cost estimates for disaster loans.

Improper PaymentsAcross the federal government, improper payments occur in
a variety of programs and activities, including those related to health
care, contract

9Reportable conditions are matters coming to our attention that, in our
judgment, should be communicated because they represent significant
deficiencies in the design or operation of internal control that could
adversely affect the federal government's ability to meet the internal
control objectives relating to financial reporting and compliance with
laws and regulations.

Appendix II
Material Deficiencies

management, federal financial assistance, and tax refunds.10 While
complete information on the magnitude of improper payments is not yet
available, based on available data, OMB has estimated that improper
payments exceed $35 billion annually. Many improper payments occur in
federal programs that are administered by entities other than the federal
government, such as states. Improper payments often result from a lack of
or an inadequate system of internal controls. Although the President's
Management Agenda includes an initiative to reduce improper payments, most
federal agencies have not reported the magnitude of improper payments in
their programs and activities.

The Improper Payments Information Act of 200211 provides for federal
agencies to estimate and report on their improper payments. It requires
federal agencies to (1) annually review programs and activities that they
administer to identify those that may be susceptible to significant
improper payments, (2) estimate improper payments in susceptible programs
and activities, and (3) provide reports to the Congress that discuss the
causes of improper payments identified and the status of actions to reduce
them. In accordance with the legislation, OMB issued guidance for federal
agencies' use in implementing the act. Among other things, the guidance
requires federal agencies to report on their improper payment-related
activities in the Management Discussion and Analysis section of their
annual Performance and Accountability Reports (PAR). While the act does
not require such reporting by all federal agencies until fiscal year 2004,
OMB required 44 programs and 14 CFO Act agencies to report improper
payment information in their fiscal year 2003 PARs. Our preliminary review
of the PARs found that 12 of the 14 agencies reported improper payment
amounts for 27 of the 44 programs identified in the guidance. We also
found that, for the programs where improper payments were identified, the
reports often contained information on the causes of the payments but
little information that addressed the other reporting requirements cited
in the legislation.

10Improper payments include inadvertent errors, such as duplicate payments
and miscalculations, payments for unsupported or inadequately supported
claims, payments for services not rendered, payments to ineligible
beneficiaries, and payments resulting from fraud and abuse by program
participants and/or federal employees.

11Pub. L. No. 107-300, 116 Stat. 2350 (Nov. 26, 2002). The act's reporting
requirement on actions taken by agencies to reduce improper payments
applies only to an agency program or activity with estimated improper
payments exceeding $10 million.

                                  Appendix II
                             Material Deficiencies

Information SecurityAlthough progress has been made, serious and
widespread information security weaknesses continue to place federal
assets at risk of inadvertent or deliberate misuse, financial information
at risk of unauthorized modification or destruction, sensitive information
at risk of inappropriate disclosure, and critical operations at risk of
disruption. GAO has reported information security as a high-risk area
across government since February 1997. Such information security
weaknesses could result in compromising the reliability and availability
of data that are recorded in or transmitted by federal financial
management systems. A primary reason for these weaknesses is that federal
agencies have not yet fully institutionalized comprehensive security
management programs, which are critical to identifying information
security weaknesses, resolving information security problems, and managing
information security risks on an ongoing basis. The Congress has shown
continuing interest in addressing these risks, as evidenced by recent
hearings on information security and enactment of the Federal Information
Security Management Act of 200212 and the Cyber Security Research and
Development Act.13 In addition, the administration has taken important
actions to improve information security, such as integrating information
security into the Executive Branch Management Scorecard.14

Tax Collection ActivitiesMaterial internal control weaknesses and systems
deficiencies continue to affect the federal government's ability to
effectively manage its tax collection activities.15 Due to errors and
delays in recording activity in taxpayer accounts, taxpayers were not
always credited for payments made on their taxes owed, which could result
in undue taxpayer burden. In addition, the federal government did not
always follow up on potential unreported or underreported taxes and did
not always pursue collection efforts against taxpayers owing taxes to the
federal government.

12E-Government Act of 2002, Pub. L. No. 107-347, title III, 116 Stat.
2899, 2946 (Dec. 17, 2002).

13Pub. L. No. 107-305, 116 Stat. 2367 (Nov. 27, 2002).

14The Executive Branch Management Scorecard highlights agencies' progress
in achieving management and performance improvements embodied in the
President's Management Agenda.

15U.S. General Accounting Office, Financial Audit: IRS's Fiscal Years 2003
and 2002 Financial Statements, GAO-04-126 (Washington, D.C.: Nov. 13,
2003).

Appendix III

Primary Effects of the Material Weaknesses Described in This Report

Areas Involving Material Primary Effects on the Fiscal Years 2003 and 2002
                     Consolidated Financial Statements and

Weaknesses

the Management of Government Operations

Property, plant, and equipment Without accurate asset information, the
federal government does not fully know the assets it owns and inventories
and related and their location and condition and cannot effectively (1)
safeguard assets from physical property deterioration, theft, or loss, (2)
account for acquisitions and disposals of such assets, (3) ensure the

assets are available for use when needed, (4) prevent unnecessary storage
and maintenance costs

or purchase of assets already on hand, and (5) determine the full costs of
programs that use these

assets.

Liabilities and commitments and Problems in accounting for liabilities
affect the determination of the full cost of the federal

contingencies	government's current operations and the extent of its
liabilities. Also, improperly stated environmental and disposal
liabilities and weak internal control supporting the process for their
estimation affect the federal government's ability to determine priorities
for cleanup and disposal activities and to allow for appropriate
consideration of future budgetary resources needed to carry out these
activities. In addition, when disclosures of commitments and contingencies
are incomplete or incorrect, reliable information is not available about
the extent of the federal government's obligations.

Cost of government operations Inaccurate cost information affects the
federal government's ability to control and reduce costs,

and disbursement activity	assess performance, evaluate programs, and set
fees to recover costs where required. Improperly recorded disbursements
could result in misstatements in the financial statements and in certain
data provided by federal agencies for inclusion in the President's budget
concerning obligations and outlays.

Accounting for and Problems in accounting for and reconciling
intragovernmental activity and balances impair the
reconciliation of government's ability to account for billions of dollars
of transactions between governmental entities.
intragovernmental activity and
balances

Net outlays	Until the differences between the total net outlays reported
in federal agencies' Statements of Budgetary Resources and the records
used by the Department of the Treasury to prepare the Statement of Changes
in Cash Balance from Unified Budget and Other Activities are reconciled,
the effect that these differences may have on the U.S. government's
consolidated financial statements will be unknown.

Preparation of consolidated Because the federal government did not have
adequate systems, controls, and procedures to

financial statements	prepare its consolidated financial statements, the
federal government's ability to ensure that the consolidated financial
statements are consistent with the underlying audited agency financial
statements, balanced, and in conformity with U.S. generally accepted
accounting principles was impaired.

Improper payments	Without a systematic measurement of the extent of
improper payments, federal agency management cannot determine (1) if
improper payment problems exist that require corrective action, (2)
mitigation strategies and the appropriate amount of investments to reduce
them, and (3) the success of efforts implemented to reduce improper
payments.

Loans receivable and loan Weaknesses in the processes and procedures for
estimating credit program costs affect the

guarantee liabilities	government's ability to support annual budget
requests for these programs, make future budgetary decisions, manage
program costs, and measure the performance of lending activities.

Information security weaknesses	Information security weaknesses over
computerized operations are placing enormous amounts of federal assets at
risk of inadvertent or deliberate misuse, financial information at risk of
unauthorized modification or destruction, sensitive information at risk of
inappropriate disclosure, and critical operations at risk of disruption.

Appendix III
Primary Effects of the Material Weaknesses
Described in This Report

(Continued From Previous Page)

Areas Involving Material

Primary Effects on the Fiscal Years 2003 and 2002 Consolidated Financial
Statements and

Weaknesses

the Management of Government Operations

Tax collection activities	Weaknesses in controls over tax collection
activities continue to affect the federal government's ability to
efficiently and effectively account for and collect revenue. Additionally,
weaknesses in financial reporting affect the federal government's ability
to make informed decisions about collection efforts. As a result, the
federal government is vulnerable to loss of tax revenue and exposed to
potentially billions of dollars in losses due to inappropriate refund
disbursements.

Source: GAO.

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