Material Internal Control Issues Reported in SEC's Fiscal Year	 
2004 Financial Statement Audit Report (27-JUL-05, GAO-05-691R).  
                                                                 
In May 2005, we issued our report expressing an opinion on the	 
Securities and Exchange Commission's (SEC) fiscal year 2004	 
financial statements and an opinion on SEC's internal controls as
of September 30, 2004. We also reported on the results of our	 
tests of SEC's compliance with selected provisions of laws and	 
regulations during fiscal year 2004. Our report on SEC's fiscal  
year 2004 financial statements identified reportable conditions  
in the internal controls over financial reporting that we	 
considered to be material weaknesses. These weaknesses related to
SEC's controls over (1) recording and reporting disgorgements and
penalties pertaining to those who violate securities laws, (2)	 
preparing financial statements and related disclosures, and (3)  
information security. In March 2005, we reported on the 	 
information security weaknesses, making six recommendations to	 
address those weaknesses. The purpose of this report is to	 
provide SEC with 18 recommendations to addresses the remaining	 
weaknesses concerning disgorgements and penalties, and financial 
statement preparation and reporting.				 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-05-691R					        
    ACCNO:   A31338						        
  TITLE:     Material Internal Control Issues Reported in SEC's Fiscal
Year 2004 Financial Statement Audit Report			 
     DATE:   07/27/2005 
  SUBJECT:   Agency missions					 
	     Audit reports					 
	     Federal law					 
	     Financial statement audits 			 
	     Financial statements				 
	     Fines (penalties)					 
	     Internal controls					 
	     Regulatory agencies				 
	     Securities 					 
	     Securities regulation				 

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GAO-05-691R

United States Government Accountability Office Washington, DC 20548

July 27, 2005

The Honorable Cynthia A. Glassman
Acting Chairman
U.S. Securities and Exchange Commission

Subject: Material Internal Control Issues Reported in SEC's Fiscal Year
2004 Financial Statement Audit Report

Dear Ms. Glassman:

In May 2005, we issued our report expressing an opinion on the Securities
and Exchange Commission's (SEC) fiscal year 2004 financial statements and
an opinion on SEC's internal control as of September 30, 2004.1 We also
reported on the results of our tests of SEC's compliance with selected
provisions of laws and regulations during fiscal year 2004.

Our report on SEC's fiscal year 2004 financial statements identified
reportable conditions in the internal controls over financial reporting
that we considered to be material weaknesses.2 These weaknesses related to
SEC's controls over (1) recording and reporting disgorgements3 and
penalties4 pertaining to those who violate securities laws, (2) preparing
financial statements and related disclosures, and (3) information
security. In March 2005, we reported on the information security
weaknesses, making six recommendations to address those weaknesses.5 The
purpose of this report is to provide SEC with 18 recommendations to
addresses the remaining weaknesses concerning disgorgements and penalties,
and financial statement preparation and reporting.6

1 GAO, Financial Audit: SEC's Fiscal Year 2004 Financial Statements,
GAO-05-244 (Washington,
D.C.: May 26, 2005).
2 A material weakness is a condition in which the design or operation of
one or more of the internal
control components does not reduce to a relatively low level the risk that
errors, fraud, or
noncompliance in amounts that would be material to the financial
statements may occur and not be
detected promptly by employees in the normal course of their duties.
3 A disgorgement is the repayment of illegally earned profits.
4A penalty is a monetary sum that is to be paid by the registrant to SEC
as a result of a security law
violation. The monetary sum is usually based on amounts prescribed by
statute or the amount of
disgorgement.
5GAO, Information Security: Securities and Exchange Commission Needs to
Address Weak Controls
over Financial and Sensitive Data, GAO-05-262 (Washington, D.C.: Mar. 23,
2005).
6 A separate report to management on other issues identified during our
audit that, although not
material in relation to the financial statements, warrant management's
consideration, will be issued
shortly.

GAO-05-691R SEC's FY 2004 Material Internal Control Issues

As part of our audit of SEC's fiscal year 2004 financial statements, we
evaluated SEC's internal controls and its compliance with selected
provisions of laws and regulations. We designed our audit procedures to
test relevant controls, including those for the proper authorization,
execution, accounting, and reporting of transactions. We conducted our
audit in accordance with U.S. generally accepted government auditing
standards. SEC's written comments on a draft of this report are included
in enclosure I. Further details on our scope and methodology are included
in our May 2005 report on the results of our audit of the 2004 financial
statements and are reproduced in enclosure II.

Disgorgements and Civil Penalties

As part of its enforcement responsibilities, SEC issues and administers
judgments that order, among other things, disgorgements and civil
penalties against violators of federal securities laws. The resulting
transactions involve material amounts of collections, which amounted to
about $945 million in fiscal year 2004, and the recording and reporting of
fiduciary and custodial balances on the financial statements.7

Presently, SEC records and tracks information on disgorgements and
penalties through a case-tracking system. In August 2004, the Office of
Financial Management assumed responsibility from the Division of
Enforcement for entering and maintaining financial data on disgorgements
and penalties in the case-tracking system, and making the necessary
calculations and adjustments for preparing SEC's financial statements.8
However, the case-tracking system is not designed for financial reporting
purposes and is not integrated with the general ledger.

To compensate for limitations in the system, SEC staff performed extensive
and timeconsuming manual procedures to compile quarterly subsidiary
ledgers to update the accounting system for disgorgement and penalty
balances and activity. Notwithstanding the inherent inefficiencies of such
manual processes, they also increase the risk of reporting inaccurate
amounts and inhibit timely reporting. Despite this risk, SEC did not
perform the requisite control procedures to reasonably assure the
completeness and reliability of the disgorgement and penalty financial
information in the case-tracking system. The risk of incomplete or
inaccurate disgorgement and penalty data is further increased because of
ineffective coordination and communication between various SEC divisions
and offices that share responsibility for recording and maintaining
disgorgement and penalty information. Our audit noted instances where,
while disgorgement activity was entered into the case-tracking system by
the Division of Enforcement and supporting

7 Fiduciary activities represent the moneys collected from federal
securities law violators and maintained by SEC to be distributed to harmed
investors. Custodial activities represent the moneys collected by SEC from
violators of federal securities laws that are returned to the General Fund
of the Treasury, as nonfederal individuals or entities do not have an
ownership interest in these revenues. 8 Prior to August 2004, SEC's
Division of Enforcement was responsible for entering disgorgement and
penalty information, including financial information, into the
case-tracking database.

documentation was in the files maintained by the case managers, the
finance staff responsible for the accounting entries did not have the
documentation necessary to make the entries into the general ledger, and
therefore, had not made the related entries.

GAO's Standards for Internal Control in the Federal Government9 requires
that agencies establish controls to ensure that transactions be recorded
in a complete, accurate, and timely manner. SEC has a draft policy, dated
October 1, 2002, that covers certain aspects of accounting for
disgorgements and penalties, but the policy is not comprehensive. For
example, the draft policy does not define who is responsible for the
various aspects of recording disgorgement and penalty data or the
documentation that should be maintained to support the amounts recorded.
Of even more importance, the draft policy does not identify the processes
and controls that are critical for determining the amounts to be recorded
and for reviewing the disgorgement and penalty financial information and
related accounting entries for completeness and accuracy. Nor does the
policy address the supervisory review procedures necessary to ensure
consistent application of the procedures. We found instances where
documentation in the case files contained hand-written annotations,
without sufficient evidence, instructing certain activity with regard to a
disgorgement or penalty amount. While SEC did not make entries into the
case-tracking system on the basis of these handwritten instructions, their
existence raises concern about the reliability and accuracy of the amounts
recorded in the case-tracking system.

A lack of comprehensive policies and controls increases the risk that
disgorgement and penalty transactions will not be completely, accurately,
and consistently recorded and reported. For example, in our audit of the
estimated net amounts receivable from disgorgements and penalties, we
found errors in the recorded balances for the related gross accounts
receivable and allowance for loss. Specifically, we noted errors where SEC
had made entries to the accounting system that conflicted with information
in the files, and we noted inconsistent treatment in recording judgment
and interest amounts, terminated debts, and collection fees imposed by the
Department of the Treasury. We believe that these errors and
inconsistencies occurred because of the weaknesses discussed above. While,
in most cases, these errors and inconsistencies were offsetting, such
errors raise concern about the controls over the reliability of the gross
accounts receivable and related allowance amounts reported in footnote 3
to SEC's financial statements.

Recommendations for Executive Action

We recommend that the Chairman, SEC, take the following five actions to
improve internal controls over disgorgements and penalties:

1. 	Implement a system that is integrated with the accounting system or
that provides the necessary input to the accounting system to facilitate
timely,

9 GAO, Standards for Internal Control in the Federal Government,
GAO/AIMD-00-21.3.1 (Washington, D.C.: November 1999).

accurate, and efficient recording and reporting of disgorgement and
penalty activity.

2. 	Review the disgorgement and penalty judgments and subsequent
activities documented in each case file by defendant to determine whether
the individual amounts recorded in the case-tracking system are accurate
and reliable.

3. 	Implement controls so that the ongoing activities involving
disgorgements and penalties are properly, accurately, and timely recorded
in the accounting system.

4. 	Strengthen coordination, communication, and data flow among staff of
SEC's Division of Enforcement and Office of Financial Management who share
responsibility for recording and maintaining disgorgement and penalty
data.

5. 	Develop and implement written policies covering the procedures,
documentation, systems, and responsible personnel involved in recording
and reporting disgorgement and penalty financial information. The written
procedures should also address quality control and managerial review
responsibilities and documentation of such a review.

Financial Statement Preparation and Reporting

GAO's Standards for Internal Control in the Federal Government requires
that controls over the financial statement preparation process be designed
to provide reasonable assurance regarding the reliability of the balances
and disclosures reported in the financial statements and related notes in
conformity with generally accepted accounting principles, including the
maintenance of detailed support that accurately and fairly reflects the
transactions making up the balances in the financial statements and
disclosures. Established tools, including checklists and implementation
guides, are available to assist in developing controls over financial
statement compilation and review.

We found that SEC had neither the formalized processes or documentation
showing the procedures, systems, analysis of accounts, and personnel
involved in developing key balances and preparing the financial statements
and related disclosures, nor the related quality control and review
procedures. As a result, SEC's opening balances for its fiscal year 2004
financial statements contained material misstatements, some of which also
materially affected the unadjusted fiscal year 2004 reported operating
results. Although SEC ultimately posted the necessary audit adjustments
and produced financial statements for fiscal year 2004 that were fairly
presented in all material respects, the lack of processes and documented
procedures significantly delayed the reporting of SEC's fiscal year 2004
financial results, consumed significant SEC staff resources, caused audit
inefficiencies, and resulted in higher financial statement preparation and
audit costs. For example, SEC did not have

documentation providing an explanation or a cross-walk between the
financial statements and the source systems, general ledger accounts,
account queries, and account analyses. SEC did not maintain a subsidiary
ledger for certain activity, such as customer deposit amounts pertaining
to filing fees. Accounting staff also had difficulty in retrieving support
for certain account balances, such as undelivered orders amounts, and for
certain property and equipment leases. In addition, reconciliations of
subsidiary and summary account balances were not prepared for certain
financial statement line items, such as for the customer deposit liability
relating to filing fees and the associated earned filing fee revenue, the
accounts receivable related to exchange fees and the related amount of
earned exchange fee revenue, and the budgetary accounts related to
undelivered and delivered orders, thus requiring SEC staff to create an
audit trail after the fact in order to reconcile support to general ledger
balances. There also was no consistent evidence of supervisory review of
journal entries, including closing and adjusting journal entries made in
connection with preparing quarterly and year-end financial statements.
Another factor contributing to identified accounting issues was that
comprehensive accounting policies and procedures for several major areas,
including disgorgements and penalties, filing fees, exchange fees, and
fixed asset capitalization, were still in draft or had not yet been
developed.

If properly designed and implemented, a financial statement preparation
process with documented policies and procedures, support, and quality
assurance reviews should reasonably assure SEC management that the
balances presented in the financial statements and related disclosures are
supported by SEC's underlying accounting records. The process should
include certain components and provide a discipline that should greatly
help SEC in preparing financial statements without having to go through
heroic efforts as was done in fiscal year 2004.

A fundamental problem leading to SEC's staff-intensive and time-consuming
efforts to prepare financial statements is that SEC's general ledger and
core financial management system are not set up to generate most data
analysis user reports on a real-time basis. Users have to request reports
that are generated on an ad hoc basis by a software application whose
operations are known only to some SEC staff. Also, other management
systems used at SEC, such as the case-tracking system used for
disgorgements and penalties and the system used to track property, along
with various spreadsheet applications, are not integrated with the core
financial management system. Again, this means that such information is
not readily available, and as we determined during the audit, necessitated
significant manual processes to determine account balances.

OMB Circular No. A-127, Financial Management Systems, requires that each
agency establish and maintain a single integrated financial management
system. A single integrated financial management system is a unified set
of financial systems linked together electronically in an efficient and
effective manner to provide agencywide financial system support.
Integration means that the user is able to have one view into systems such
that, at whatever level the individual is using the system, he or she can
obtain needed information efficiently and effectively through electronic
means.

A single integrated financial management system does not necessarily mean
having only one software application within each agency covering all
financial management system needs or storing all information in the same
database. Interfaces between systems are acceptable as long as the
supporting detail to enable reconciliation between the systems is
maintained and accessible to managers. Interface linkages should be
electronic unless the number of transactions is so small that it is not
cost beneficial to automate the interface. Reconciliations between
systems, where interface linkages are appropriate, should be maintained to
ensure data accuracy.

To support its financial management functions, SEC relies on several
different systems to process and track financial transactions that include
filing fees paid by corporations and disgorgements and penalties assessed
and collected from enforcement activities. In SEC's case, without an
integrated financial management system to help ensure timely and reliable
financial data, decision makers run the risk of delays in attaining
relevant data or using inaccurate information inadvertently while at the
same time dedicating scarce resources toward the basic collection of
information.

Recommendations for Executive Action

We recommend that the Chairman, SEC, take the following 13 actions to
improve controls over financial statement preparation and reporting. The
first 11 recommendations concern the minimum elements that should be
included in policies and procedures covering the financial reporting
process. The other 2 recommendations concern the leveraging of in-house
resources for accounting advice and upgrading SEC's capacity to improve
its financial reporting system.

1. 	Develop written policies and procedures that provide sufficient
guidance for the year-end closing of the general ledger as well as the
preparation and analysis of quarterly and annual financial statements.

2. 	Establish clearly defined roles and responsibilities for the staff
involved in financial reporting and the preparation of interim and
year-end financial statements.

3. 	Prepare a cross-walk between the financial statements and the source
systems, general ledger accounts, and the various account queries and
analyses that make up key balances in the financial statements.

4. 	Maintain subsidiary records or ledgers for all significant accounts
and disclosures so that the amounts presented in the financial statements
and footnotes can be supported by the collective transactions making up
the balances.

5. 	Perform monthly reconciliations of subsidiary records and summary
account balances.

6. 	Consider a "formal closing" of all accounts at an interim date(s),
which will reduce the level of accounting activity and analysis required
at year-end. The formal closing entails ensuring that all transactions are
recorded in the proper period through month's end.

7. 	Collect common closing and adjusting entries in a formal listing,
which is used in the general ledger closing process and in preparing
financial statements.

8. 	Require supervisory review for all entries posted to the general
ledger and financial statements, including closing entries. A supervisor
should review revisions to previously approved entries and revised
financial statements and footnotes. All entries and reviews should be
documented.

9. 	Establish milestones for preparing and reviewing the financial
statements by setting dates for critical phases such as closing the
general ledger; preparing financial statements, footnotes, and the
performance and accountability report; and performing specific quality
control review procedures.

10. Utilize established tools (i.e., checklists and implementation guides)
available for assistance in compiling and reviewing financial statements.

11. Maintain documentation supporting all information included in the
financial statements and footnotes. This documentation should be more
selfexplanatory than what has been retained in the past. The documentation
should be at a level of detail to enable a third party, such as an
auditor, to use the documentation for substantiating reported data without
extensive explanation or re-creation by the original preparer.

12. Take advantage of in-house resources and expertise in establishing
financial reporting policies, internal controls, and business practices,
as well as in the review of financial statement and footnote presentation.

13. Develop or acquire an integrated financial management system to
provide timely and accurate recording of financial data for financial
reporting and management decision making.

Agency Comments

In commenting on a draft of this report, SEC acknowledged the material
weaknesses in internal control. SEC stated that our recommendations for
resolving the material weakness related to disgorgements and penalties
were consistent with the actions that it has planned, including completing
a comprehensive review of files and data and strengthening and documenting
policies and procedures for disgorgements and penalties. SEC anticipates
that this weakness will be resolved in fiscal year 2006. Ultimately, SEC
said it plans to undertake a multiyear project to replace the current
case-tracking system with a system that is integrated with the accounting
system in

order to improve the timeliness and better ensure the accuracy of SEC's
financial reporting for disgorgements and penalties.

With regard to the material weakness related to controls over the
preparation of financial statements, SEC stated that it intends to
continue active and serious efforts to complete documentation of the
procedures and management systems that were used to prepare its financial
statements. To address this issue, SEC has increased its financial
reporting staff; SEC financial management staff will continue to solicit
advice from in-house experts; and management has confirmed, modified, or
recommended for further review certain policies applied in preparing the
fiscal year 2004 financial statements. SEC also plans to establish a
formal senior management committee to provide for continued regular review
and advice by key officials.

The complete text of SEC's comments is included in enclosure I.

This report contains recommendations to you. The head of a federal agency
is required by 31 U.S.C. S: 720 to submit a written statement to the
Senate Committee on Homeland Security and Governmental Affairs and the
House Committee on Government Reform of the actions taken on our
recommendations no later than 60 days after the date of this report. A
written statement also must be sent to the House and Senate Committees on
Appropriations with agency's first request for appropriations made more
than 60 days after the date of this report.

This report is intended for use by management of SEC. We are sending
copies of this report to the Chairmen and Ranking Members of the Senate
Committee on Banking, Housing, and Urban Affairs; the Senate Committee on
Homeland Security and Governmental Affairs; the House Committee on
Financial Services; and the House Committee on Government Reform. We are
also sending copies to the Secretary of the Treasury, the Director of the
Office of Management and Budget, and other interested parties. In
addition, this report will be available at no charge on GAO's Web site at
http://www.gao.gov.

We acknowledge and appreciate the cooperation and assistance provided by
SEC management and staff during our audit of SEC's fiscal year 2004
financial statements. If you have any questions about this report or need
assistance in addressing these

issues, please contact me at (202) 512-9471 or at [email protected].
Contact points for
our Offices of Congressional Relations and Public Affairs may be found on
the last
page of this report.

Sincerely yours,

Jeanette M. Franzel
Director
Financial Management and Assurance

Enclosures - 2

Enclosure I

              Comments from the Securities and Exchange Commission

                                  Enclosure I

Enclosure II

                     Details on Audit Scope and Methodology

To fulfill our responsibilities as auditor of the financial statements of
the Securities and Exchange Commission (SEC), we did the following:

o  	examined, on a test basis, evidence supporting the amounts and
disclosure in the financial statements;

o  	assessed the accounting principles used and significant estimates made
by management;

o  evaluated the overall presentation of the financial statements;

o  	obtained an understanding of internal controls related to financial
reporting and compliance with laws and regulations;

o  	obtained an understanding of the recording, processing, and
summarizing of performance measures as reported in Management's Discussion
and Analysis;

o  	tested relevant internal controls over financial reporting and
compliance, and evaluated the design and operating effectiveness of
internal control;

o  	considered SEC's process for evaluating and reporting on internal
control and financial management systems under the Federal Managers'
Financial Integrity Act of 1982; and

o  	tested compliance with selected provisions of the following laws and
regulations: the Securities Exchange Act of 1934, as amended; the
Securities Act of 1933, as amended; the Anti-Deficiency Act; laws
governing the pay and allowance system for SEC employees; and the Prompt
Payment Act.

We performed our review from February 2004 through February 2005 in
accordance with generally accepted government auditing standards. For a
further explanation of our audit scope and methodology, see our financial
audit report (GAO-05-244).

(194497)

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