Financial Audit: Restatements to the Department of State's Fiscal
Year 2003 Financial Statements (20-SEP-05, GAO-05-814R).	 
                                                                 
The Secretary of the Treasury, in coordination with the Director 
of the Office of Management and Budget (OMB), is required to	 
annually prepare and submit audited financial statements of the  
U.S. government to the President and Congress. We are required to
audit these consolidated financial statements (CFS) and report on
the results of our work. An issue meriting concern and close	 
scrutiny that emerged during our fiscal year 2004 CFS audit was  
the growing number of Chief Financial Officers (CFO) Act agencies
that restated certain of their financial statements for fiscal	 
year 2003 to correct errors. Errors in financial statements can  
result from mathematical mistakes, mistakes in the application of
accounting principles, or oversight or misuse of facts that	 
existed at the time the financial statements were prepared.	 
Frequent restatements to correct errors can undermine public	 
trust and confidence in both the entity and all responsible	 
parties. Further, when restatements do occur, it is important	 
that financial statements clearly communicate and readers of the 
restated financial statements understand that the financial	 
statements originally issued by management in the previous year  
and the opinion thereon should no longer be relied on and instead
the restated financial statements and related auditor's opinion  
should be used. Nine of the 11 agencies that had restatements for
fiscal year 2003 received unqualified opinions on their 	 
originally issued fiscal year 2003 financial statements. The	 
auditors for 6 of these 9 agencies issued unqualified opinions on
the restated financial statements, replacing the previous	 
unqualified opinions on the respective agencies' original fiscal 
year 2003 financial statements. The auditors for 2 of these 9	 
withdrew their unqualified opinions on the fiscal year 2003	 
financial statements and issued other than unqualified opinions  
on the respective agencies' restated fiscal year 2003 financial  
statements because they could not determine whether there were	 
any additional misstatements and the effect of any such 	 
misstatements on the restated fiscal year 2003 financial	 
statements. For the remaining agency, the principal auditor of	 
the agency's fiscal year 2004 financial statements was not the	 
principal auditor of the agency's fiscal year 2003 financial	 
statements, and an audit opinion on the agency's restated fiscal 
year 2003 financial statements was not issued. Because of the	 
varying nature and circumstances surrounding the restatements, we
are issuing a number of separate reports on the matter. This	 
report communicates our observations regarding State's fiscal	 
year 2003 restatements. We reviewed four key areas with respect  
to the restatements of State's fiscal year 2003 financial	 
statements: (1) the nature and cause of the errors that 	 
necessitated the restatements, including planned corrective	 
actions by the agency and its auditors; (2) the timing of	 
communicating the material misstatement to users of the financial
statements; (3) the extent of transparency exhibited in 	 
disclosing the nature and impact of the material misstatement in 
the financial statements and the reissued auditor's report; and  
(4) audit issues that contributed to the failure to detect the	 
errors that necessitated the restatements during the audit of the
agency's fiscal year 2003 financial statements. 		 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-05-814R					        
    ACCNO:   A37438						        
  TITLE:     Financial Audit: Restatements to the Department of       
State's Fiscal Year 2003 Financial Statements			 
     DATE:   09/20/2005 
  SUBJECT:   Accounting procedures				 
	     Accounting standards				 
	     Errors						 
	     Financial statement audits 			 
	     Financial statements				 
	     Reporting requirements				 
	     Corrective action					 
	     Transparency					 

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GAO-05-814R

United States Government Accountability Office Washington, DC 20548

September 20, 2005

Mr. Sid L. Kaplan
Acting Assistant Secretary and Chief Financial Officer
Department of State

The Honorable Howard J. Krongard
Inspector General
Department of State

Subject: 	Financial Audit: Restatements to the Department of State's
Fiscal Year 2003 Financial Statements

As you know, the Secretary of the Treasury, in coordination with the
Director of the Office of Management and Budget (OMB), is required to
annually prepare and submit audited financial statements of the U.S.
government to the President and Congress. We are required to audit these
consolidated financial statements (CFS) and report on the results of our
work.1 An issue meriting concern and close scrutiny that emerged during
our fiscal year 2004 CFS audit was the growing number of Chief Financial
Officers (CFO) Act agencies that restated2 certain of their financial
statements for fiscal year 2003 to correct errors.3 Errors in financial
statements can result from mathematical mistakes, mistakes in the
application of accounting principles, or oversight or misuse of facts that
existed at the time the financial statements were prepared. Frequent
restatements to correct errors can undermine public trust and confidence
in both the entity and all responsible parties. Further, when restatements
do occur, it is important that financial statements clearly communicate
and readers of the restated financial statements understand that the
financial statements originally issued by management in the previous year
and the opinion thereon should no longer

1The Government Management Reform Act of 1994 has required such reporting,
covering the executive branch of government, beginning with financial
statements prepared for fiscal year 1997. 31 U.S.C. S: 331 (e). The
federal government has elected to include certain financial information on
the legislative and judicial branches in the CFS as well.

2A financial statement restatement occurs when an entity either
voluntarily or prompted by its auditors or regulators revises public
financial information that has previously been reported.

3According to Federal Accounting Standards Advisory Board, Statement of
Federal Financial Accounting Standards (SFFAS) No. 21, Reporting
Corrections of Errors and Changes in Accounting Principles, prior period
financial statements presented should be restated only to correct errors
that caused such statements to be materially misstated.

be relied on and instead the restated financial statements and related
auditor's opinion should be used.

Eleven of the 23 CFO Act agencies4 restated certain of their financial
statements for fiscal year 2003. Five CFO Act agencies had restatements in
fiscal year 2003 covering their fiscal year 2002 financial statements.
Three CFO Act agencies had restatements covering both years. We noted that
the extent of the restatements to CFO Act agencies' fiscal year 2003
financial statements varied from agency to agency, ranging from correcting
two line items on an agency's balance sheet to correcting numerous line
items on several of another agency's financial statements. In some cases,
the net operating results of the agency were affected by the restatement.
The amounts of the agencies' restatements ranged from several million
dollars to more than $91 billion.

Nine of the 11 agencies that had restatements for fiscal year 2003
received unqualified opinions on their originally issued fiscal year 2003
financial statements. The auditors for 6 of these 9 agencies issued
unqualified opinions on the restated financial statements, replacing the
previous unqualified opinions on the respective agencies' original fiscal
year 2003 financial statements. The auditors for 2 of these 9 withdrew
their unqualified opinions on the fiscal year 2003 financial statements
and issued other than unqualified opinions on the respective agencies'
restated fiscal year 2003 financial statements because they could not
determine whether there were any additional misstatements and the effect
of any such misstatements on the restated fiscal year 2003 financial
statements. For the remaining agency, the principal auditor of the
agency's fiscal year 2004 financial statements was not the principal
auditor of the agency's fiscal year 2003 financial statements, and an
audit opinion on the agency's restated fiscal year 2003 financial
statements was not issued.

Our review focused on the 9 agencies with restatements for fiscal year
2003 that received unqualified opinions on their originally issued fiscal
year 2003 financial statements.5 These were the Department of Agriculture,
Department of State (State), Department of Justice, Department of
Transportation, Department of Health and Human Services, General Services
Administration, National Science Foundation, Nuclear Regulatory
Commission, and Office of Personnel Management.

Because of the varying nature and circumstances surrounding the
restatements, we are issuing a number of separate reports on the matter.
This report communicates our observations regarding State's fiscal year
2003 restatements. Going forward, we

4The Federal Emergency Management Agency (FEMA) was transferred to the
Department of Homeland Security (DHS) effective March 1, 2003. With this
transfer, FEMA was no longer required to prepare and have audited
stand-alone financial statements under the CFO Act, leaving 23 CFO Act
agencies for the remainder of fiscal year 2003 and for fiscal year 2004.
The DHS Financial Accountability Act, Pub. L. No. 108-330, 118 Stat. 1275
(October 16, 2004), added DHS to the list of CFO Act agencies, increasing
the number of CFO Act agencies again to 24 beginning in fiscal year 2005.

5The 2 agencies that had restatements for fiscal year 2003 but did not
receive unqualified opinions on their originally issued fiscal year 2003
financial statements were the Department of Defense and the Small Business
Administration.

hope that the lessons learned from the fiscal year 2003 restatements,
together with our recommendations, (1) help State avoid the need for
restatements to its future financial statements and (2) help ensure that
State's auditor applies appropriate auditing procedures for journal
voucher entries in the Bureau of International Organizations unfunded and
funded liabilities accounts, which is where the original fiscal year 2003
financial statements were subsequently found to have been misstated.

We reviewed four key areas with respect to the restatements of State's
fiscal year 2003 financial statements: (1) the nature and cause of the
errors that necessitated the restatements, including planned corrective
actions by the agency and its auditors; (2) the timing of communicating
the material misstatement to users of the financial statements; (3) the
extent of transparency6 exhibited in disclosing the nature and impact of
the material misstatement in the financial statements and the reissued
auditor's report; and (4) audit issues that contributed to the failure to
detect the errors that necessitated the restatements during the audit of
the agency's fiscal year 2003 financial statements.

Results in Brief

Failure to properly record journal voucher entries for two large
transactions that together accounted for most of a $927 million error and
inadequate management review of these journal vouchers to detect the
improper entries led to the material error that necessitated State's
restatements of certain of its fiscal year 2003 financial statements. We
determined that State's auditor did not detect the errors because the
fiscal year 2003 audit tests performed by the auditor were not designed to
detect journal voucher entry errors for the affected accounts. In
addition, the title of State's note disclosure of the restatements could
be misinterpreted.

We are making a recommendation to State's Acting CFO to address the issues
we identified with respect to the journal voucher errors that necessitated
the fiscal year 2003 restatements. We are also making a recommendation to
State's Inspector General to work with the contracted independent public
accountant (IPA) to ensure that audit tests to detect any similar journal
voucher errors in the future are implemented.

In commenting on a draft of this report, State's Acting CFO stated that
his office agrees with our recommendation for management to evaluate
whether State's new journal voucher review procedures are effective and
that State is currently reviewing the effectiveness of these procedures.
State's Inspector General concurred with our recommendation and stated
that his office will work with the IPA to implement audit

6Transparency is the full, accurate, and timely disclosure of information.

steps in conformance with the Financial Audit Manual (FAM)7 to test
journal vouchers in the Bureau of International Organizations unfunded and
funded liabilities accounts. We also received technical comments from
State's Acting CFO and Inspector General, which we have incorporated as
appropriate.

Background

In conducting the fiscal year 2004 audit of the CFS, we reviewed the 23
CFO Act agencies' performance and accountability reports for possible
restatements and identified 11 agencies that had restated certain of their
audited fiscal year 2003 financial statements.

The primary intended users of federal agencies' financial reports are
citizens, Congress, federal executives, and federal program managers.8
Each of these groups may use federal agencies' financial statements to
satisfy their specific needs. Citizens are interested in many aspects of
the federal government, particularly federal programs that affect their
financial well-being. Congress is interested in monitoring and assessing
the efficiency and effectiveness of federal programs. Federal executives,
such as central agency officials at OMB and the Department of the Treasury
(Treasury), are interested in federal financial statements to assist the
President of the United States. OMB assists the President in overseeing
the preparation of the federal budget by formulating the President's
spending plans, evaluating the effectiveness of agency programs, assessing
competing funding demands among agencies, and setting funding priorities.
Treasury assists the President in managing the finances of the federal
government and prepares the CFS, which is based on audited financial
statements prepared by federal agencies. GAO audits the CFS and reports on
the results of its audit. Finally, federal program managers use agency
financial statements as tools for managing their operations within the
limits of the spending authority granted by Congress.

The primary accounting and auditing standards that apply to restatement
disclosures by federal entities are the Federal Accounting Standards
Advisory Board's Statement of Federal Financial Accounting Standards
(SFFAS) No. 21, Reporting Corrections of Errors and Changes in Accounting
Principles, and the American Institute of Certified Public Accountants
(AICPA) Codification of Auditing Standards, AU section

9

561, Subsequent Discovery of Facts Existing at the Date of the Auditor's
Report.

7GAO/President's Council on Integrity and Efficiency, Financial Audit
Manual, GAO-01-765G (Washington, D.C.: July 2001), updated by GAO-04-1015G
and GAO-04-942G (July 2004).

8Federal Accounting Standards Advisory Board, Statement of Federal
Financial Accounting Concepts No. 1, Objectives of Federal Financial
Reporting.

9Generally accepted government auditing standards incorporate AICPA
reporting and auditing standards unless the Comptroller General of the
United States excludes them by formal announcement.

Objective, Scope, and Methodology

The objective of our review of restatements of State's fiscal year 2003
financial statements was to determine the nature and cause of the errors,
the transparency and timing of communicating the material misstatements,
any audit issues relating to such misstatements, and any actions being
taken to help preclude similar errors from occurring in the future.

We reviewed the nature and causes of the restatements, and we also
examined corrective actions taken by State to help preclude similar errors
from occurring in the future. We interviewed the preparers and auditors of
State's fiscal year 2003 financial statements, including staff from the
agency's Office of Inspector General (OIG), and we obtained and reviewed
relevant audit documentation.

In our review, we considered certain accounting and auditing standards,
including SFFAS No. 21; the Financial Accounting Standards Board's
Statement of Financial Accounting Standards No. 16, Prior Period
Adjustments; and the AICPA Codification of Auditing Standards, AU section
420, Consistency of Application of Generally Accepted Accounting
Principles, AU section 508, Reports on Audited Financial Statements, and
AU section 561.

We performed our review of the restatements of State's fiscal year 2003
financial statements from December 2004 to July 2005 in accordance with
U.S. generally accepted government auditing standards.

We requested comments on a draft of this report from State's Acting CFO
and Inspector General or their designees. Written comments from State's
Acting CFO and Inspector General are reprinted in enclosures I and II,
respectively, and are also discussed in the Agency Comments section.

Issues Related to Restatement of Certain of State's Fiscal Year 2003
Financial Statements

With respect to the restatement of certain of State's fiscal year 2003
financial statements, we identified the following three areas that need
improvement: (1) review of journal voucher transactions for the Bureau of
International Organizations accounts, (2) design of journal voucher audit
steps for the Bureau of International Organizations accounts, and (3) the
title of the note disclosure of the restatements. These issues are
discussed in detail below.

Bureau of International Organizations Journal Voucher Transactions Were
Not Sufficiently Reviewed

Certain of State's financial statements for fiscal year 2003 were restated
to reflect activity related to approximately $927 million in liabilities
incurred by the department's Bureau of International Organizations.
Specifically, in connection with recording two large transactions in
fiscal year 2003 that involved the reclassification

of certain liabilities as funded liabilities from unfunded liabilities, a
State official informed us that State failed to record the companion
proprietary10 journal entries that are necessary once a liability has been
funded. As a result, Unexpended Appropriations-Used was overstated by
approximately $927 million, and Expended Appropriations was understated by
approximately $927 million. The overall effect of the errors was that the
amounts for Unexpended Appropriations and Cumulative Results of Operations
on the originally issued fiscal year 2003 Balance Sheet and fiscal year
2003 Statement of Changes in Net Position were materially overstated and
understated, respectively, by $927 million.

State officials discovered the fiscal year 2003 errors in late October
2004, during State's year-end analysis of the fiscal year 2004 financial
statements. Through analytical procedures and research, State observed
inconsistencies between the unfunded and funded liabilities accounts.
Following the discovery, State informed its IPA of the errors, which was
appropriate. State completed its analysis of the errors on November 10,
2004. According to State, two incorrectly entered journal vouchers
primarily caused the errors.

Although State had a process for reviewing journal vouchers, it was not
followed in the case of these two journal vouchers. The process called for
a supervisor to approve journal vouchers before they were entered into the
general ledger. According to a State official, however, the erroneous
journal vouchers were not reviewed by a supervisor before they were
entered into the accounting system. According to another State official,
prior to the discovery of these errors, State took steps to improve its
journal voucher postings by strengthening its journal voucher review
process. Specifically, accounting personnel who create journal vouchers
are now required to have a coworker review and sign the journal voucher
before forwarding it for supervisory approval. The Director or Deputy
Director of Financial Reporting and Analysis is then required to enforce
compliance with the approval process by reviewing the approved journal
vouchers-including determining that they have been signed by a
supervisor-before the journal vouchers are entered into the accounting
system.

Journal Voucher Audit Steps Did Not Detect Errors in the Bureau of
International Organizations Accounts

The above-noted accounting breakdown was not discovered during the audit
of the department's fiscal year 2003 financial statements because the
fiscal year 2003 audit tests performed by State's IPA were not designed to
detect journal voucher errors in the Bureau of International Organizations
unfunded and funded liabilities accounts.

The FAM states that during the audit planning process, the auditor should
identify conditions that significantly increase inherent, fraud, and
control risk. Among other

10Proprietary accounts provide the information for the financial
statements based on Federal Accounting Standards Advisory Board standards
and are intended to provide an economic, rather than a budgetary, measure
of operations and resources.

things, the auditor should perform procedures to identify account balances
and transactions that might signal inherent risk. According to FAM 260.40,
to detect evidence of possible material misstatement due to fraud, the
auditor should examine journal entries and other adjustments, including
reclassifications, consolidating entries, and other routine and nonroutine
journal entries and adjustments. This section of the FAM also states that
the auditor should obtain an understanding of the financial reporting
process and the controls over journal entries and other adjustments;
identify and select journal entries and other adjustments for testing;
determine the nature, timing, and extent of the testing; and inquire of
individuals involved in the financial reporting process about
inappropriate or unusual activity related to the processing of journal
entries and adjustments. If the IPA had identified the journal vouchers
involving the Bureau of International Organizations accounts as presenting
increased inherent, fraud, or control risk and had then followed the
abovenoted FAM procedures, the errors that necessitated the restatements
might have been detected.

According to State's OIG, future audit tests will be designed to detect
any material journal voucher errors in the Bureau of International
Organizations unfunded and funded liabilities accounts.

The Title of State's Note Disclosure of the Restatements Could Be
Misinterpreted

The notes to State's comparative fiscal years 2004 and 2003 financial
statements included a note disclosure titled "Prior Period Adjustment."
This title could be misinterpreted, since the note disclosure discussed
the adjustment to correct the $927 million material misstatement and the
adjustment represented a restatement rather than a prior period adjustment
as defined by SFFAS No. 21.

Conclusions

The restatements were caused by an error that State identified. State
corrected the error and issued restated financial statements. Going
forward, the key will be for State to ensure that the planned corrective
actions to address the cause of the error are fully and effectively
implemented. In addition, it will be important that State's OIG work with
State's IPA to ensure that audit tests to detect any similar errors in the
future are fully and effectively implemented.

Recommendations for Executive Action

We recommend that State's Acting CFO determine whether the new journal
voucher review procedures established to ensure adequate review of Bureau
of International Organizations journal voucher transactions are being
fully and effectively implemented.

We recommend that State's Inspector General work with State's IPA to
ensure that audit tests in conformance with the FAM to test journal
vouchers in the Bureau of

International Organizations unfunded and funded liabilities accounts are
fully and effectively implemented.

Agency Comments

In commenting on a draft of this report, State's Acting CFO stated that
his office agrees with our recommendation for management to evaluate
whether State's new journal voucher review procedures are effective and
that State is currently reviewing the effectiveness of these procedures.
State's Inspector General concurred with our recommendation and stated
that his office will work with the IPA to implement audit steps in
conformance with the FAM to test journal vouchers in the Bureau of
International Organizations' unfunded and funded liabilities accounts. We
also received technical comments from State's Acting CFO and Inspector
General, which we have incorporated as appropriate.

Within 60 days of the date of this report, we would appreciate receiving a
written
statement on actions taken to address these recommendations.

We are sending copies of this report to the Chairmen and Ranking Minority
Members
of the Senate Committee on Homeland Security and Governmental Affairs; the
Subcommittee on Federal Financial Management, Government Information, and
International Security, Senate Committee on Homeland Security and
Governmental
Affairs; the House Committee on Government Reform; and the Subcommittee on
Government Management, Finance and Accountability, House Committee on
Government Reform. In addition, we are sending copies to the Fiscal
Assistant
Secretary of the Treasury and the Controller of OMB. This report is also
available at
no charge on GAO's Web site at www.gao.gov.

We appreciate the courtesy and cooperation extended to us by your staff
throughout
our work. We look forward to continuing to work with your offices to help
improve
financial management in the federal government. If you have any questions
about the
contents of this report, please contact me at (202) 512-3406 or
[email protected].

Gary T. Engel
Director
Financial Management and Assurance

Enclosure II: Comments from the Inspector General, Department of State

(198364)

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