Internal Revenue Service: Remaining Challenges to Achieve Lasting
Financial Management Improvements (Testimony, 04/15/98,
GAO/T-AIMD/GGD-98-139).

GAO discussed its audit of the Internal Revenue Service's (IRS) fiscal
year (FY) 1997 custodial financial statements.

GAO noted that: (1) in issuing an unqualified opinion on the FY 1997
custodial statements within the statutory deadline of March 1, GAO
reported that the over $1.6 trillion in tax revenue, $142 billion in tax
refunds, and $28 billion in net taxes receivable reported by the IRS
were fairly stated; (2) prior to FY 1997, GAO was unable to conclude
that IRS' custodial financial statements were fairly stated, mainly
because weaknesses in IRS' internal controls prevented it from producing
reliable financial information; (3) therefore, GAO's ability to conclude
that the FY 1997 custodial financial statements were reliable was a mark
of progress; (4) however, this could only be accomplished after
extensive use of ad hoc programming by IRS to extract data from its
systems, followed by numerous adjustments totalling tens of billions of
dollars to this data to produce the final financial statements; (5)
during GAO's FY 1997 audit, it found that IRS' internal controls remain
plaqued by weaknesses that affect its ability to timely report reliable
financial information throughout the year, safeguard assets from loss,
and assure full compliance with laws and regulations; (6) GAO reported
these weaknesses related to IRS' custodial activities as a material
weakness in its report on the FY 1997 consolidated financial statements
of the United States government; (7) these weaknesses include: (a)
unpaid assessments; (b) receipts and refunds; (c) revenue accounting and
reporting; (d) compliance with the Federal Financial Management
Improvement Act; and (e) computer security; and (8) in total, these
findings frame the remaining challenges that IRS still must meet to
assure that it is able to effectively manage unpaid assessments; assure
its financial systems are able to provide accurate, relevant, and timely
management information; assure that funds are properly safeguarded; and
assure its computer systems are properly designed and protected.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  T-AIMD/GGD-98-139
     TITLE:  Internal Revenue Service: Remaining Challenges to Achieve 
             Lasting Financial Management Improvements
      DATE:  04/15/98
   SUBJECT:  Tax administration systems
             Internal controls
             Financial statement audits
             Financial records
             Federal agency accounting systems
             Accounting procedures
             Data integrity
             Financial management
             Computer security

             
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Cover
================================================================ COVER


Before the Subcommittee on Government Management, Information and
Technology, Committee on Government Reform and Oversight, House of
Representatives

For Release on Delivery
Expected at
10 a.m.
Wednesday,
April 15, 1998

INTERNAL REVENUE SERVICE -
REMAINING CHALLENGES TO ACHIEVE
LASTING FINANCIAL MANAGEMENT
IMPROVEMENTS

Statement of Gene L.  Dodaro
Assistant Comptroller General
Accounting and Information Management Division

GAO/T-AIMD/GGD-98-139

GAO/AIMD/GGD-98-139T


(919212)


Abbreviations
=============================================================== ABBREV

  FDIC -
  HI -
  IRS -
  OMB -
  RTC -
  SMI -
  SSA -

============================================================ Chapter 0

Mr.  Chairman and Members of the Subcommittee: 

We are pleased to discuss the results of our audit of the Internal
Revenue Service's (IRS) fiscal year 1997 custodial financial
statements.\1 This audit was performed in accordance with the Chief
Financial Officers Act of 1990, as expanded by the Government
Management Reform Act of 1994.  The IRS custodial financial
statements report the assets, liabilities, and results of activities
related to IRS' responsibilities for implementing federal tax
legislation, including collecting federal tax revenues, refunding
overpayments of taxes, and pursuing collections of amounts owed.\2

After several years of concerted effort by IRS and GAO, we were, for
the first time, able to conclude that IRS' custodial financial
statements were reliable.  In issuing an unqualified opinion on the
fiscal year 1997 custodial statements within the statutory deadline
of March 1, we reported that the over $1.6 trillion in tax revenue,
$142 billion in tax refunds, and $28 billion in net taxes receivable
reported by the IRS were fairly stated.  We commend the significant
effort that IRS officials made to achieve this major accomplishment. 

These positive results show that focused attention by the Congress
and this Subcommittee on IRS' financial management, which GAO has
identified as a high-risk area for many years, has begun to pay
dividends.  Such benefits include better information available to IRS
management and to the Congress to help make decisions. 

Because of the volume and sensitivity of the tax collections and
refunds, the adequacy of IRS' financial systems deserves careful
attention.  Federal tax revenues dwarf most other financial
activities undertaken by any single entity, public or private, in the
world.  The government relies upon IRS to collect the proper amount
of tax revenues at the least cost to the public, serve the public by
continually improving the quality of its products and services, and
perform in a manner warranting the highest degree of public
confidence in its integrity.  Its revenue collections represent over
90 percent of the federal government's revenues.  Therefore, it is
imperative that IRS establish strong financial management and
internal controls to effectively meet its mission. 

Prior to fiscal year 1997, we were unable to conclude that IRS'
custodial financial statements were fairly stated, mainly because
weaknesses in IRS' internal controls and financial management systems
prevented it from producing reliable financial information.\3

Therefore, our ability to conclude that the fiscal year 1997
custodial financial statements were reliable was a mark of progress. 
However, this could only be accomplished after extensive use of ad
hoc programming by IRS to extract data from its systems, followed by
numerous adjustments to these data totaling tens of billions of
dollars to produce the final financial statements. 

During our fiscal year 1997 audit, we found that IRS' internal
controls remain plagued by weaknesses that affect its ability to
promptly report reliable financial information throughout the year,
safeguard assets from loss, and assure full compliance with laws and
regulations.  We reported these weaknesses related to IRS's custodial
activities as a material weakness in our report on the fiscal year
1997 consolidated financial statements of the U.S.  government.\4
These weaknesses fall into the following areas. 

  -- Unpaid assessments.  For fiscal year 1997, we were able to
     report that most of IRS' unpaid assessments--amounts IRS had
     recorded as taxes due to the federal government but not yet
     paid--were not receivables and were largely uncollectible.  Of
     the $214 billion in unpaid tax assessments, only $90 billion
     represented receivables of the government under federal
     accounting standards, and only $28 billion of these were
     estimated to be collectible.  However, this information had to
     be developed through extracting data from IRS systems, analyzing
     these data, and making substantial adjustments to derive
     reasonable amounts.  This condition exists because IRS' general
     ledger cannot identify the portion of unpaid assessments that
     represent taxes receivable, and because IRS does not have a
     subsidiary ledger to track unpaid assessments.  These weaknesses
     impair IRS' ability to effectively manage its unpaid
     assessments. 

  -- Receipts and refunds.  Vulnerabilities in controls over cash
     received and refunds disbursed weaken IRS' ability to assure
     that all government and taxpayer funds are properly protected. 
     Cash and checks were not always properly controlled upon
     receipt, and flawed procedures allowed improper refunds to be
     issued.  IRS must establish stronger controls over these areas
     to ensure that government and taxpayer funds are properly
     safeguarded. 

  -- Revenue accounting and reporting.  IRS cannot identify the
     specific amounts of revenue collected for certain major tax
     types at time of remittance.  Additionally, IRS certifies
     amounts to be distributed to trust funds based on amounts
     assessed, which, for excise taxes, is not in accordance with
     laws governing their distribution. 

  -- Compliance with the Federal Financial Management Improvement
     Act.  IRS' financial management systems do not comply with the
     requirements of the Federal Financial Management Improvement Act
     of 1996.\5 Consequently, IRS' financial management systems
     cannot routinely produce reliable financial information for
     management decision-making and accountability. 

  -- Computer security.  Controls over IRS' automated systems exhibit
     serious weaknesses in areas such as physical security, data
     communications management, and contingency planning.  As a
     result, these weaknesses leave the IRS vulnerable to
     unauthorized access, enabling sensitive data and programs to be
     altered or deleted. 

In total, these findings frame the remaining challenges that IRS
still must meet to ensure that (1) it is able to effectively manage
unpaid assessments, (2) its financial systems are able to provide
accurate, relevant, and timely management information, (3) funds are
properly safeguarded, and (4) its computer systems are properly
designed and protected.  IRS is taking steps to address these issues
but additional efforts will be required to fully implement corrective
measures. 

The following sections outline our findings and related implications
from the fiscal year 1997 audit for each of the five areas:  unpaid
assessments, safeguarding of assets, financial accounting and
reporting, Federal Financial Management Improvement Act compliance,
and computer systems.  We also offer our observations on (1) the
importance of IRS' efforts to prepare its automated systems to be
Year 2000 compliant and (2) potential implications of the IRS
Commissioner's proposal for restructuring the agency on IRS'
financial operations. 


--------------------
\1 See Financial Audit:  Examination of IRS' Fiscal Year 1997
Custodial Financial Statements (GAO/AIMD-98-77, February 26, 1998). 

\2 IRS' fiscal year 1997 administrative financial statements, which
were audited by the Inspector General of the Department of the
Treasury (Treasury), report on the financial position and results of
operations related to the administration of IRS funded by
appropriations and reimbursements from other agencies, state and
local governments, and the public. 

\3 For fiscal year 1996, we were able to determine for the first time
that total net revenue collections as reported in IRS' financial
statements were reliable.  However, we still could not conclude that
IRS correctly classified tax receipts and refunds by tax type because
IRS could not provide sufficient evidence supporting its
classification.  We also could not determine the reliability of
reported net federal tax receivables, as in prior years. 

\4 U.S.  Government Financial Statements:  Results of GAO's Fiscal
Year 1997 Audit (GAO/T-AIMD-98-128, April 1, 1998). 

\5 The Federal Financial Management Improvement Act of 1996 mandates
(1) certain financial management systems requirements for federal
agencies, (2) auditors to report on agency compliance with the
financial systems requirements, and (3) agency heads to correct
identified deficiencies within a specified time period. 


   UNPAID ASSESSMENTS
---------------------------------------------------------- Chapter 0:1

Unpaid assessments consist of unpaid taxes that IRS has recorded as
due to the government by taxpayers.  Based on federal accounting
standards, unpaid assessments are placed in one of the following
three categories: 

(1) taxes receivable, which are taxes due from taxpayers for which
IRS can support the existence of a receivable through taxpayer
agreement (such as the filing of a tax return) or a court ruling
favorable to IRS,

(2) compliance assessments, where neither the taxpayer nor the court
has affirmed that the amounts are owed, such as an assessment
resulting from an audit of the taxpayer, and

(3) write-offs, which are any unpaid assessments for which IRS does
not expect further collections due to factors such as the taxpayer's
bankruptcy, insolvency, or death. 

Because only taxes receivable are reportable in the financial
statements, it is essential for IRS to be able to properly identify
the portion of unpaid assessments that is receivables.  To adequately
pursue collection of these receivables, IRS must be able to readily
identify the individual debtors and to support the amounts owed.  We
found that in fact most of IRS' recorded unpaid assessments are not
receivables.  In addition, several weaknesses prevent IRS from
routinely identifying and tracking its receivables and from providing
documentation supporting the amounts taxpayers purportedly owe. 


      MOST UNPAID ASSESSMENTS ARE
      NOT RECEIVABLES AND ARE
      LARGELY UNCOLLECTIBLE
-------------------------------------------------------- Chapter 0:1.1

As reflected in the supplemental information to IRS' fiscal year 1997
custodial financial statements, the unpaid assessments balance was
about $214 billion at September 30, 1997.  This balance has
historically been referred to as IRS' taxes receivable or accounts
receivable, even though taxes receivable make up only one component
of unpaid assessments. 

Figure 1 depicts the components of the unpaid assessments balance at
September 30, 1997. 

   Figure 1:  Components of IRS'
   $214 Billion of Unpaid
   Assessments (Dollars in
   Billions)

   (See figure in printed
   edition.)

Of the $214 billion balance of unpaid assessments, $48 billion
represent compliance assessments that have not been agreed to by
either taxpayers or the courts.  Due to the lack of agreement, these
compliance assessments have significantly less potential for future
collection than those unpaid assessments that are considered federal
taxes receivable.  Seventy-six billion dollars represent write-offs,
which principally consist of payroll and corporate income taxes owed
by bankrupt or defunct businesses, including many failed financial
institutions closed or otherwise resolved by the Federal Deposit
Insurance Corporation (FDIC) and the former Resolution Trust
Corporation (RTC). 

The remaining $90 billion of unpaid assessments represent federal
taxes receivable.  About 70 percent--$62 billion--of this balance is
estimated to be uncollectible due primarily to the taxpayers'
economic situations, such as individual taxpayers who are unemployed
or having other financial problems.  However, IRS may continue
collection action for 10 years after the assessment or longer under
certain conditions.  Thus, these accounts may still ultimately have
some collection potential if the taxpayers' economic conditions
improve.  Only the remaining 30 percent--about $28 billion--of
federal taxes receivable is estimated to be collectible.  Components
of the collectible balance include installment agreements with
estates and individuals, as well as relatively newer amounts due from
individuals and businesses that have a history of compliance. 

Since traditionally the full amount of unpaid assessments has been
equated with receivables, it is significant to note that after years
of audit scrutiny, IRS has finally been able to determine that only
$28 billion of its total unpaid assessments of $214 billion--about 13
percent--actually represent collectible taxes receivable.  Thus,
while the Congress and IRS may have been making decisions based on a
presumed level of taxes receivable due the federal government, in
fact, only a small portion of that balance represented receivables
for which collection could reasonably be expected.  While such
information is necessary for IRS to prepare reliable financial
statements, on a broader level, good reliable financial data are
essential to enable management to measure and report on IRS'
performance and for the Congress to rely upon for making its
budgeting decisions. 

In addition, it is also important to note that of the unpaid
assessment balance, about $136 billion (over 60 percent) represents
interest and penalties, as depicted in figure 2, which are largely
uncollectible. 

   Figure 2:  Unpaid Taxes and
   Interest and Penalty Components
   of $214 Billion in Unpaid
   Assessments (Dollars in
   Billions)

   (See figure in printed
   edition.)

Interest and penalties are a high percentage of the balance because
IRS continues to accrue them through the 10-year statutory collection
date, regardless of whether an account meets the criteria for
financial statement recognition or has any collection potential.  For
example, despite no hope of collection, interest and penalties
continue to accrue on write-offs, such as FDIC and RTC cases, as well
as on assessments made as a result of audits of taxpayers where the
taxpayers have not agreed to the validity of the assessments.  In
fact, the overall growth in unpaid assessments during fiscal year
1997 was wholly attributable to the accrual of interest and
penalties, rather than to any significant increase in taxes due the
government. 

We plan to issue a separate report discussing the composition and
collectibility of IRS' unpaid assessments in more detail. 


      GENERAL LEDGER CANNOT
      SEPARATE CATEGORIES OF
      UNPAID ASSESSMENTS
-------------------------------------------------------- Chapter 0:1.2

While only the taxes receivable portion of unpaid assessments are
reportable in the financial statements, IRS' general ledger system
cannot separate the amount of gross or net taxes receivable from
total unpaid assessments.  Instead, IRS has to use special computer
programs to extract unpaid assessment data from its master files--the
only detailed record of taxpayer information it maintains--and
classify these unpaid assessments into the three categories (taxes
receivable, compliance assessments, and write-offs).  IRS then
analyzes those unpaid assessments classified as taxes receivable to
estimate the amount deemed to be collectible (the net taxes
receivable). 

In our prior financial audits, IRS attempted to use this approach to
determine the taxes receivable balance.  However, various problems
encountered in extracting the information as well as errors made in
attempting to classify the amounts from the data extracted precluded
us from determining that the amounts reported were reliable.  For
fiscal year 1997 we were able to determine that taxes receivable as
reported in the financial statements were reliable, but this was only
after significant adjustments totaling tens of billions of dollars
were made.  Figure 3 illustrates the level of adjustments made to the
fiscal year 1997 master file extractions in order to arrive at
reliable, auditable amounts for each category. 

   Figure 3:  Comparison of Unpaid
   Assessments Before and After
   Audit Adjustments

   (See figure in printed
   edition.)

Note:  The adjusted balance of taxes receivable presented above
represents the gross taxes receivable (does not include the allowance
for doubtful accounts).  Additionally, the original unpaid assessment
balance of $236 billion was adjusted to $214 billion, due primarily
to duplicate assessments. 

Source:  IRS masterfiles and IRS fiscal year 1997 custodial financial
statements. 

The most significant adjustments related to amounts that were
originally reported as taxes receivable or compliance assessments but
were really write-offs.  For example, 149 of the 626 items we
sampled--about 24 percent--that were initially identified as taxes
receivable in the master files were actually write-offs and consisted
primarily of corporate income and payroll taxes\6 owed by
corporations that had been defunct for years.  Similarly, 23 percent
of the compliance assessments we sampled were also write-offs.  The
extensive reliance IRS must place on ad hoc procedures to identify
actual taxes receivable and the significant adjustments necessary to
make these data reliable raise serious questions about the integrity
of unaudited IRS information and the ability of IRS to effectively
manage its unpaid assessments. 


--------------------
\6 Payroll tax withholdings consist of individual income tax
withholdings and employer and employee withholdings for Federal
Insurance Contribution Act, which include Social Security and
Hospital Insurance taxes. 


      IRS LACKS A SUBSIDIARY
      LEDGER TO TRACK UNPAID
      ASSESSMENTS
-------------------------------------------------------- Chapter 0:1.3

As we have reported in our previous financial audits, IRS does not
have a detailed listing, or subsidiary ledger that tracks and
accumulates unpaid assessments on an ongoing basis.  Such a
subsidiary ledger could have compensated for the general ledger's
inability to separate unpaid assessments.  Additionally, the lack of
a detailed subsidiary ledger also impairs IRS' ability to effectively
manage the unpaid assessments. 

For example, IRS' current systems cannot ensure that all parties
liable for certain assessments get credit for payments made on those
assessments.  Specifically, payments made on unpaid payroll tax
withholdings for a troubled company, which can be collectible from
multiple individuals, are not always credited to the responsible
parties to reflect reductions in their tax liability.  In 53 of 83
cases we reviewed involving multiple individuals and companies, we
found that payments were not accurately recorded to reflect the
reduction in the tax liability of each responsible party.  For
example, in one case we reviewed, three individuals had multimillion
dollar tax liability balances, as well as liens placed against their
property, even though the tax had been fully paid by the company. 

A proper subsidiary ledger for unpaid assessments is necessary to
provide management with complete, up-to-date information about the
amounts due from each taxpayer, so that managers will be in a
position to make informed decisions about collection efforts and
collectibility estimates.  This requires a subsidiary ledger that (1)
makes readily available to management the amount, nature, and age of
all unpaid assessments outstanding by tax liability and taxpayer and
(2) can be readily and routinely reconciled to corresponding general
ledger balances for financial reporting purposes.  Such a system
should also track and make available key information necessary to
assess collectibility, such as account status, payment and default
history, and installment agreement terms. 

We will be issuing a separate report on this issue.  In that report,
we will be making recommendations to assist IRS in identifying the
key components needed for an effective subsidiary ledger for unpaid
assessments. 


      DOCUMENTATION IMPROVEMENTS
      ARE STILL NEEDED
-------------------------------------------------------- Chapter 0:1.4

We also continued to find in our fiscal year 1997 audit that IRS has
problems locating and providing supporting documentation for its
unpaid assessments, primarily due to the age of the items.  IRS has
acknowledged problems with documentation and is working to make
needed improvements in this area.  We will continue to work with IRS
in identifying ways to improve documentation. 


   VULNERABILITIES EXIST IN
   CONTROLS OVER RECEIPTS AND
   REFUNDS
---------------------------------------------------------- Chapter 0:2

Our fiscal year 1997 audit identified vulnerabilities in IRS'
controls over both its receipts and refunds processes, which raise
concerns over IRS' ability to protect the government's money.  We
found that IRS' controls over the receipt of cash and checks it
receives directly from taxpayers are not adequate to assure that
these payments will be properly credited to taxpayer accounts and
deposited to the Treasury's general revenue fund.  To ensure
appropriate security over payments received at its lock box\7
depositories, IRS requires controls such as the use of a surveillance
camera to monitor staff when they open mail containing cash and
checks.  However, we found that controls over cash payments received
at the four IRS service centers where we tested such controls were
not held to comparable standards.  At these locations, IRS allowed
individuals to open mail unobserved, relying on them to accurately
report amounts received, and did not require payments received to be
logged or otherwise recorded at the point of receipt to immediately
establish accountability and thereby deter and detect diversion. 

In fact, accountability for cash and checks received at a service
center is not established until the money has passed through several
sets of hands, as illustrated in the attachment to this statement. 

In addition, during our review we observed that at one service
center, on several occasions, payments were being received by
personnel who should not have been authorized to accept such
payments.  As a result of these weaknesses, IRS is vulnerable to
losses of cash and checks received from taxpayers.  In fact, between
1995 and 1997, IRS identified 80 instances of actual or alleged
employee embezzlement of receipts totaling about $5.3 million.  These
actual and alleged embezzlements underscore the need for effective
internal controls over the IRS' service center and district office
receipts processes. 

We also found that IRS did not have sufficient preventive controls
over refunds to assure that inappropriate refunds were not disbursed. 
Such inappropriate payments have taken the form of refunds improperly
issued or issued for incorrect amounts that IRS did not identify
because of flawed IRS procedures, or fraud by IRS employees.  For
example, we found nine instances where refunds were paid for
inappropriate amounts.  Three of these occurred because IRS did not
compare tax returns to the attached W-2s (Wage and Tax Statement) at
the time the returns were initially processed and, consequently, did
not detect discrepancies with pertinent information on the tax
returns.  As we have reported in prior audits, such inconsistencies
generally go undetected until such time as IRS completes its document
matching program,\8 which can take as long as 18 months.  In
addition, during fiscal year 1997, IRS identified alleged employee
embezzlement of refunds totaling over $269,000.  IRS is also
vulnerable to issuance of duplicate refunds made possible by gaps in
IRS' controls.  IRS reported this condition as a material weakness in
its fiscal year 1997 Financial Managers' Financial Integrity Act
report. 

We will be reporting on these issues in more detail, and our
recommendations for strengthening controls over receipts and refund
processes, in a follow-on report on internal control issues at IRS. 


--------------------
\7 A lock box is a cash management service provided by banks under
contract to IRS.  Using this service, taxpayers mail payments to a
post office box or a lock box facility where the contract banks
collect the receipts, deposit them in Treasury's general revenue
fund, and report the receipts to IRS. 

\8 This program involves matching tax return information with
information provided by third parties (e.g., 1099, W-2) to identify
any differences for further investigation. 


   REVENUE ACCOUNTING AND
   REPORTING
---------------------------------------------------------- Chapter 0:3

IRS is unable to currently determine the specific amount of revenue
it actually collected for the Social Security, Hospital Insurance,\9
Highway, and other relevant trust funds.  As we previously
reported,\10 the primary reason for this weakness is that the
accounting information needed to validate taxpayers' liability and
record the payments to the proper trust funds is not provided at the
time that taxpayers remit payments.  Information is provided on the
tax return, which can be received as late as 9 months after a payment
is submitted.  However, the information on the return only pertains
to the amount of the tax liability, not the distribution of the
amounts previously collected.  As a result, IRS cannot currently
report actual revenue collected for Social Security, Hospital
Insurance, Highway, and other trust funds nor can it accurately
report revenue collected for individuals.  Because of this weakness,
IRS had to report Social Security, Hospital Insurance, and individual
income tax collections in the same line item on its Statement of
Custodial Activity for fiscal year 1997.  However, requirements for
the form and content of governmentwide financial statements\11
require separate reporting of Social Security, Hospital Insurance,
and individual income taxes collected.  Beginning in fiscal year
1998, federal accounting standards\12 will also require this
reporting. 

Taxes collected by IRS on behalf of the federal government are
deposited in the general revenue fund of the Treasury, where they are
subsequently distributed to the appropriate trust funds.  Amounts
representing Social Security and Hospital Insurance taxes are
distributed to their respective trust funds based on information
certified by the Social Security Administration (SSA).\13 For excise
taxes, IRS certifies the amounts to be distributed based on taxes
assessed, as reflected on the relevant tax forms.  However, by law,
distributions of excise taxes are to be based on taxes actually
collected. 

We also found IRS did not have adequate controls over its process of
certifying excise tax distributions to the appropriate trust funds. 
The lack of fundamental internal controls, such as supervisory
review, resulted in a number of errors\14 that affected the amounts
ultimately distributed to the trust funds.  We found inadequacies in
the review of excise tax

  -- returns received, resulting in taxpayer errors on the returns
     going undetected;

  -- returns processed, resulting in IRS input errors going
     undetected; and

  -- certifications prepared, resulting in human error in extracting
     and analyzing data from the master file going undetected. 

As a result of these weaknesses, trust funds may not have received
the proper amount of excise tax revenue during fiscal year 1997.  In
fact, these weaknesses were a contributing factor in the Department
of Transportation Inspector General's qualified opinion on the fiscal
year 1997 financial statements of the Highway Trust Fund. 


--------------------
\9 The Hospital Insurance Trust Fund (HI) is one of two trust funds
comprising the accumulated funds of the Medicare program.  The other
Medicare trust fund is the Supplemental Medical Insurance Trust Fund
(SMI).  Of these trust funds, only HI receives distributions from the
Treasury's general revenue fund. 

\10 Financial Management:  Important IRS Revenue Information Is
Unavailable or Unreliable (GAO/AFMD-94-22, December 21, 1993). 

\11 OMB's Format and Instructions for the Form and Content of the
Financial Statements of the U.S.  Government (September 2, 1997). 

\12 The Federal Accounting Standards Advisory Board recommends
accounting standards, and OMB, Treasury, and GAO decide whether to
adopt the recommended standards; if they are adopted, the standards
are published by OMB and GAO. 

\13 Social Security and Hospital Insurance taxes are required to be
distributed based on a certification by the Commissioner of SSA. 
This certification is based on wage information maintained by SSA,
which may be augmented by IRS assessed amounts.  However, generally
this certification is based on IRS assessed amounts. 

\14 See Agreed-Upon Procedures:  Excise Taxes (GAO/AIMD-98-78R,
February 26, 1998). 


   IRS SYSTEMS DO NOT COMPLY WITH
   REQUIREMENTS
---------------------------------------------------------- Chapter 0:4

The Federal Financial Management Improvement Act of 1996 requires
auditors performing financial audits to report whether agencies'
financial management systems comply substantially with federal
accounting standards, financial systems requirements, and the
government's standard general ledger at the transaction level.  The
act's premise is that agencies that satisfy the act's systems
requirements will be better positioned to routinely produce complete
and reliable financial information for managing operations and
ensuring management accountability. 

In our fiscal year 1997 audit of IRS, we reported that IRS' systems
do not substantially comply with the requirements of the act.  For
example, IRS' general ledger does not conform to the government
standard general ledger at the transaction level.  Additionally, IRS'
lack of a subsidiary ledger for unpaid assessments does not comply
with federal financial management systems requirements.  In many
respects, the status of IRS' systems mirrors what we found across the
federal government.  As we outlined in our report on the fiscal year
1997 consolidated financial statements of the U.S.  government, the
majority of federal agencies' financial management systems are not
designed to meet current accounting standards and systems
requirements and thus cannot routinely provide reliable information
for management decision-making and accountability. 

We have reported on many of these issues in our IRS financial audits
over the years and made recommendations for corrective action. 
Although IRS has drafted a plan of action intended to incrementally
improve its financial reporting capabilities, which is scheduled to
be fully implemented during fiscal year 1999, the plan falls short of
fully meeting federal financial management system requirements.  IRS
also has a longer range plan to address the financial management
system deficiencies noted in prior audits and in IRS' own
self-assessment.\15 During future audits, we will monitor IRS'
implementation of these initiatives, and assess their effectiveness
in resolving the issues discussed above. 


--------------------
\15 Tax Systems Modernization:  Blueprint Is a Good Start But Not Yet
Sufficiently Complete to Build or Acquire Systems
(GAO/AIMD/GGD-98-54, February 24, 1998). 


   COMPUTER SYSTEMS ISSUES
---------------------------------------------------------- Chapter 0:5

IRS places extensive reliance on computer systems to process tax
returns, maintain taxpayer data, calculate interest and penalties,
and generate refunds.  The huge volume of transactions it processes
and the decentralized structure of the agency--which includes two
computing centers, 10 service centers, and numerous district offices
nationwide--make its operations highly computer-driven.  In addition,
the IRS Commissioner recently testified that electronic filing of
returns and taxpayer use of its electronic payment system has
significantly increased and is continuing to grow.\16 Consequently,
it is critical that IRS maintain effective internal controls over
these systems. 


--------------------
\16 Hearing on the 1998 Tax Return Filing Season and the IRS Budget
for Fiscal Year 1999, Statement of Charles O.  Rossotti,
Commissioner, Internal Revenue Service, before the Committee on Ways
and Means, Subcommittee on Oversight, March 31, 1998. 


      CONTROLS OVER COMPUTER
      SECURITY ARE INADEQUATE
-------------------------------------------------------- Chapter 0:5.1

We previously reported that IRS had serious weaknesses in the
controls used to safeguard its computer systems, facilities, and
taxpayer data.\17 Our review of these controls as part of our audit
of IRS' fiscal year 1997 custodial financial statements found that
overall controls continued to be ineffective.  IRS' controls over
automated systems continued to exhibit significant weaknesses in
areas such as physical security and data communications management. 
These weaknesses can allow unauthorized individuals access to
critical hardware and software where they may intentionally or
inadvertently add, alter, or delete sensitive data or programs.  We
have found that such weaknesses are widespread throughout the
government, as discussed in our report on the fiscal year 1997
consolidated financial statements of the U.S.  government. 

IRS recognized these weaknesses in its fiscal year 1997 Financial
Managers' Financial Integrity Act report and has corrected a
significant number of the computer security weaknesses identified in
our previous audits.  Additionally, IRS has centralized
responsibility for security and privacy issues and added staff in
this area.  IRS informed us it plans to substantially address the
remaining weaknesses by June 1999.  However, until corrected fully,
IRS' automated systems remain vulnerable to losses, delays or
interruptions in service, and compromise of the sensitive information
entrusted to IRS by taxpayers.  We are continuing to review IRS'
efforts in this area, and plan to issue separate reports, by IRS
location, on computer security issues we identify, along with
recommendations for corrective action.  We will also follow up on
these issues as part of our fiscal year 1998 financial audit. 


--------------------
\17 See Financial Audit:  Examination of IRS' Fiscal Year 1996
Custodial Financial Statements (GAO/AIMD-98-18, December 24, 1997),
and IRS Systems Security:  Tax Processing Operations and Data Still
at Risk Due to Serious Weaknesses (GAO/AIMD-97-49, April 8, 1997). 


      SUCCESS OF IRS' YEAR 2000
      EFFORTS IS CRITICAL
-------------------------------------------------------- Chapter 0:5.2

It is critical that IRS successfully address its Year 2000 computing
problem.  The Year 2000 problem is rooted in the way dates are
recorded and calculated in many computer systems.  For the past
several decades, systems have typically used two digits to represent
the year in order to conserve on electronic data storage and reduce
operating costs.  With this two-digit format, however, the year 2000
is indistinguishable from the year 1900.  As a result, systems
hardware and software (system and application) that are date
dependent may generate incorrect results, or fail to work at all,
when processing years after 1999.  We have reported this issue as a
governmentwide high risk area,\18 and the President has designated it
as a priority management objective.  In addition, we discussed this
as a serious governmentwide issue in both our report on the fiscal
year 1997 consolidated financial statements of the U.S.  government
and in a recent hearing before this subcommittee.\19

IRS has one of the largest conversion efforts in the civilian sector
underway.  IRS' goal is to complete all renovation efforts scheduled
for completion by January 1999 in order to allow a full year of
operational testing.  However, with less than 21 months remaining,
the task of completing renovation and testing on time is formidable. 
If IRS is unable to make its mission-critical systems Year 2000
compliant, IRS could be rendered unable to properly process tax
returns, issue refunds, correctly calculate interest and penalties,
effectively collect taxes, or prepare accurate financial statements
and other financial reports.  We are working with the Congress and
the executive branch to strengthen our nation's Year 2000 efforts,
including those of key sectors of our nation's economy as well as the
associated efforts of key federal agencies.  We plan to review the
effectiveness of IRS' Year 2000 program in conjunction with our
fiscal year 1998 financial audit. 


--------------------
\18 High-Risk Series:  Information Management and Technology
(GAO/HR-97-9, February 1997). 

\19 Year 2000 Computing Crisis:  Strong Leadership and Effective
Public/Private Cooperation Needed to Avoid Major Disruptions
(GAO/T-AIMD-98-101, March 18, 1998). 


   COMMENTS ON IRS RESTRUCTURING
---------------------------------------------------------- Chapter 0:6

Over the past decade, IRS has proposed and initiated many efforts
aimed at reengineering its business processes and modernizing its
computer systems.  Some of these efforts have resulted in
improvements in the way IRS conducts its business and deals with
taxpayers.  Nonetheless, it is widely recognized that much more needs
to be done. 

Commissioner Rossotti recently announced his plans for modernizing
IRS.  The overriding concept of the plan is to change IRS from an
internally-focused organization to one that emphasizes assistance to
taxpayers in complying with the tax laws and ensures the fair
treatment of taxpayers.  While IRS has announced many plans for
restructuring and modernization over the past decade, Mr.  Rossotti's
plan appears to go far beyond past proposals by, among other things,
changing IRS' organizational structure to reflect a new focus.  The
Commissioner has categorized his proposed changes as falling into
several key areas, including (1) an organizational structure built
around taxpayer needs, (2) balanced performance measures, and (3) new
technology. 


      ORGANIZATIONAL STRUCTURE
      BUILT AROUND TAXPAYER NEEDS
-------------------------------------------------------- Chapter 0:6.1

IRS currently has three separate kinds of organizations, spread over
43 organizational units, that use several separate computer systems
to support their activities.  Under the Commissioner's proposed
changes, IRS would be reorganized into four units, each serving a
different group of taxpayers:  (1) wage earners, (2) sole proprietors
and other small businesses, (3) large corporations, and (4)
tax-exempt entities.  Under the proposal, each group of taxpayers
would be the complete responsibility of a business center, from the
processing of returns to collecting delinquent taxes.  The
Commissioner's proposal is based on the belief that different groups
of taxpayers need very different types of assistance and programs to
be compliant and that tax administration needs to recognize this to
meet those needs. 

While the implementing details of his proposal are not yet in place
and, consequently, we have not evaluated the proposal in detail, this
would appear to make sound business sense.  If implemented, an
organizational focus on taxpayers could bring together different
functions, such as customer service and collections, to target those
taxpayers that are noncompliant and better ensure that IRS is
treating compliant taxpayers fairly. 


      BALANCED MEASURES OF
      PERFORMANCE
-------------------------------------------------------- Chapter 0:6.2

The Commissioner's plan emphasizes the importance of having measures
of organizational performance that balance customer satisfaction,
business results, employee satisfaction, and productivity.  The
intent is to provide incentives for service-oriented, as opposed to
inappropriate, behavior toward taxpayers, which is in line with the
plan's overriding concept.  As IRS refines its performance measures,
getting stakeholder involvement is important.  Stakeholders,
including the Congress, the executive branch, and other interested
parties, could help IRS as it devises performance measures. 
Conceived in this way, the measures would enhance IRS' ability to
make informed decisions about how to allocate its resources between
the competing demands of taxpayer assistance and enforcement. 


      NEW TECHNOLOGY
-------------------------------------------------------- Chapter 0:6.3

The Commissioner's plan notes that a key factor limiting IRS' ability
to modernize its business practices is the extent of deficiencies
that exist in IRS' computer systems, which significantly affect the
ability of these systems to support IRS' mission and goals.  The plan
points out, however, that the new business practices and
organizational structure provide a basis for completing and
implementing the modern systems outlined in IRS' recently issued
technology modernization blueprint. 

As we have reported many times, existing IRS systems do not provide
ready access to needed information and, consequently, do not
adequately support modern work processes.  Modernized systems would
significantly assist IRS in carrying out its mission.  However, it is
important to note that the systems architecture and sequencing plan
outlined in the modernization blueprint issued by IRS in May 1997
were premised on the agency's concept of business operations and
related business requirements that existed at that time.  To the
extent that the Commissioner's organizational restructuring alters
these business operations and functions, the architecture and
sequencing plan may need to be modified. 

Moreover, as we reported in February 1998,\20 the modernization
blueprint's business requirements, systems architecture, and
sequencing plan have yet to be validated using defined, implemented
systems life cycle processes.  Such validation is essential to ensure
that IRS' modernization plans are complete and correct.  In light of
the Commissioner's planned restructuring of the agency, the need for
such validation of the blueprint is even more acute.  Therefore, we
reiterate our recommendation that IRS validate the business
requirements, architecture, and sequencing plan using the completed
and implemented systems life cycle processes. 


--------------------
\20 Tax Systems Modernization:  Blueprint Is a Good Start But Not Yet
Sufficiently Complete to Build or Acquire Systems
(GAO/AIMD/GGD-98-54, February 24, 1998). 


      LONG-STANDING FINANCIAL
      MANAGEMENT ISSUES MUST STILL
      BE ADDRESSED
-------------------------------------------------------- Chapter 0:6.4

The Commissioner has brought in the consulting firm of Booz-Allen &
Hamilton to validate the concept of his proposed restructuring plan
in terms of risk, cost and impact on customers, both external and
internal.  However, it is important to note that a key to the IRS'
ability to effectively carry out its mission is sound financial
management.  This requires strong financial management systems and
internal controls to ensure that information used in decision-making
is routinely available and reliable.  This holds true under IRS'
existing structure as well as the focus and structure of the
organization as envisioned in the Commissioner's plan.  Consequently,
for the Commissioner's restructuring plan to be successful, it is
critical that the longstanding internal control and systems
weaknesses we have identified in our audits, as well as the new
issues identified during our fiscal year 1997 audit, be fully
addressed and corrected.  It is only through such actions that IRS
will be able to routinely and promptly produce reliable information
necessary to fulfill its mission.  This will prove to be a
significant challenge for IRS, as many of these issues are complex
and do not lend themselves to short-term solutions. 


-------------------------------------------------------- Chapter 0:6.5

Our hope is that the business goals of the new IRS Commissioner
coupled with continued congressional oversight will change the agency
culture to recognize the critical importance of resolving IRS'
financial management issues.  Commissioner Rossotti recently
testified that IRS has a new focus and fundamental commitment to
customer service and his proposed plan to restructure the IRS
emphasizes this new focus and commitment.  However, IRS cannot
achieve excellence in customer service without lasting improvements
in its financial management.  We look forward to continuing to work
with IRS on long-term solutions to these problems. 

Mr.  Chairman, this concludes my prepared statement.  I would be
pleased to answer any questions. 


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