August 1998 Issue

How do you audit the largest entity in the world?

Audit of the Federal Government's
Financial Statements

By Robert A. Dyson and David J. Hasso

In Brief

A Major Effort Produces a Disclaimer of Opinion

The GAO issued a first ever report on the consolidated financial statements of the U.S. Government on March 31, 1998. It audited specific agencies and funds as well as the consolidation and made use of audit work performed by agency inspector generals and public accounting firms.

Because many agencies were not able to deliver audited financial statements and others received qualified reports, GAO had to issue a disclaimer of opinion. The GAO also reported a number of deficiencies in internal control, several of which were considered material weaknesses. GAO also reported widespread noncompliance with laws and regulations governing financial operations and reporting.

The statements were prepared in conformity with statements issued by the Federal Accounting Standards Advisory Board. The authors discuss three differences in these standards from those of GASB and note that efforts are being made to have these standards recognized as GAAP.

n March 31, 1998, the United States Government issued consolidated financial statements subjected to independent audit for the first time in the nation's history. The United States General Accounting Office (GAO) served as the principal independent auditor and issued a combined report on the financial statements for the fiscal year ended September 30, 1997, internal control, and compliance with laws and regulations.

GAO disclaimed an opinion on the financial statements and reported several material weaknesses in internal control and noncompliance with the Federal Financial Management Improvement Act (FFMIA) of 1996. The disclaimer was issued because the government's financial systems did not provide sufficient evidence to support the amounts and disclosures presented. The financial systems deficiencies included record keeping problems, incomplete documentation, and weak internal controls. GAO concluded that these deficiencies represented noncompliance with FFMIA's requirement that each system comply with Federal accounting standards, financial system requirements, and the Federal standard general ledger.

Audit Methodology

As can be expected, the audit of consolidated financial statements presenting total assets of $1.6 trillion and liabilities of $6.6 trillion was a major effort. GAO's basic approach was to audit specific agencies or funds within those agencies that represented significant concentrations within the government, make use of audit work performed by agency Inspector Generals (IGs) and public accounting firms, and audit the government-wide consolidation prepared by the Department of the Treasury (Treasury). GAO expended approximately 250 staff years (over 400,000 hours) in performing its procedures and resolving first-year implementation issues. The time expended by the IGs and public accounting firms was not estimated.

The audit was complicated by the disaggregated nature of the government's financial operations. The government included approximately 2,000 reporting entities from the executive, legislative, and judicial branches, as well as government corporations. Many of these entities operated their own financial systems that did not comply with FFMIA's requirements.

Despite this general disaggregation in operations, certain concentrations and audit requirements exist within the government that facilitated the audit. Approximately 80% of Federal funds are expended by four agencies (the Social Security Administration and the Departments of Defense, Health and Human Services, and the Treasury), with much of the remaining amount expended by 20 others. In addition, Treasury is responsible for the government's cash management, which includes collecting taxes and most other revenue, disbursing payments, and managing the public debt.

GAO concentrated its efforts on those agencies or funds within agencies that were material to the consolidated financial statements. For example, GAO audited directly the Internal Revenue Service (IRS), which collected 98% of Federal revenue; the Schedule of Federal Debt, which reported all the public debt held by nonfederal entities ($3.8 trillion) and included all interest costs; and all cash receipts and disbursements processed by Treasury.

In addition, GAO relied on the audits of certain reporting agencies that had audit requirements imposed by various laws and regulations. The Chief Financial Officers (CFO) Act of 1990, as amended by the Government Management Reform Act (GMRA) of 1994, requires annual audits of agency-wide financial statements of 24 major agencies ("CFO agencies") in accordance with Government Auditing Standards. These agencies expended 99% of the government's net budget expenditures in fiscal 1996. The individual agency IGs either performed the audits or contracted the work to public accounting firms. The IGs or their outside auditors issued reports on the agencies' financial statements, internal controls, and compliance with laws and regulations affecting material amounts presented in the financial statements. Additionally, the Government Corporation Control Act requires audits of government corporations, such as the Federal Deposit Insurance Corporation. Still other agencies, such as the Postal Service, have audit requirements written directly in their enabling legislation. Many of these audits were performed by public accounting firms.

GAO's involvement with the IG and public accounting firms' audits included active participation in planning, performing additional procedures on balances material to the financial statements, as necessary, and reviewing workpapers after completion of the audit. Its role in planning included concurrence with the audit plans and audit programs.

Audit Report

As noted above, GAO disclaimed an opinion on the financial statements and reported several material internal control weaknesses and noncompliance with Federal laws and regulations. They concluded that widespread deficiencies in the financial management systems employed by most major agencies prevented them from supporting the amounts and disclosures reported in their financial statements that were consolidated into the government-wide financial statements.

Widespread Noncompliance. The widespread noncompliance with various laws and regulations governing financial operations and reporting, such as FFMIA, is illustrated by the fact that only eight of the 24 CFO agencies, representing approximately 26% of net budget expenditures in fiscal 1996, received an unqualified report on their financial statements. In addition, only four CFO agencies complied with the FFMIA's provisions on financial systems. Thus, 20 CFO agencies, including four of the eight agencies receiving unqualified opinions on their financial statements, did not comply with FFMIA. Despite a legal requirement to issue audited financial statements for the fiscal year ended September 30, 1997, no later than March 1, 1998, seven CFO agencies had not issued their audited financial statements as of March 31, 1998, including the Department of Health and Human Services, which represented 19% of net budget expenditures in fiscal 1996. These seven agencies indicated that additional time was needed to determine accurate amounts and disclosures. Their reported, but unaudited, information was included in the consolidated financial statements. The nine remaining CFO agencies received either a qualified opinion or disclaimer of opinion. Some of these agencies, such as the Department of Defense, with 17% of net budget expenditures in fiscal 1996, accepted a disclaimer of opinion on the basis that they would prefer to focus their efforts on improving their financial systems in order to receive unqualified opinions in future audits.

Reporting on legal compliance, GAO indicated that noncompliance with the FFMIA resulted from the use of financial systems that were not designed to meet current accounting standards and system requirements. The majority of Federal agencies did not use systems that could provide reliable financial information for managing government operations, safeguarding assets, and holding managers accountable. These instances of significant noncompliance also contributed to the disclaimer of opinion on the consolidated financial statements.

Disclaimer of Opinion. The sheer volume of unaudited or disclaimed financial information prevented GAO from achieving its audit objectives based on reliance on other auditors' reports. As required by AU Section 543.15, Part of Audit Performed by Other Independent Auditors (which is incorporated into Government Auditing Standards), GAO, upon receiving other than a standard report from other auditors, was required to decide whether the reasons for the departures from the standard reports were of such nature and significance in relation to the primary financial statements that they would require recognition in their own report. The extensive amount of unaudited information and financial statements receiving disclaimers of opinion contributed to GAO's disclaimer on the government-wide consolidated financial statements.

Material Internal Control and Financial System Weaknesses. The widespread material internal control and financial system weaknesses not only significantly impaired the Federal government's ability to ensure proper recording of transactions and compliance with laws and regulations, but also its ability to adequately safeguard assets. As a result, taxpayer funds or purchased assets were at risk of misappropriation either through theft or error. In addition, material control weaknesses affected the government's ability to account for its tax collection activities, and serious control weaknesses exposed the government's financial information to inappropriate disclosure, destruction, modification, or fraud.

GAO reported the following material deficiencies that limited the scope of the audit work and resulted in the disclaimer of opinion:

    * Property, plant, equipment, inventories, and related property, totaling hundreds of billions of dollars out of a reported total of $1.2 trillion, were not adequately supported by financial and logistical records. These assets included military supplies, such as ammunition and aircraft parts; buildings; and assets used by private sector contractors. As a result, the government could not verify the existence of all reported assets, substantiate their reported value, or determine whether all assets were reflected in the financial statements. These problems impaired the government's ability to know the location and condition of all assets, including those used for military deployment; safeguard them from physical deterioration, theft, or loss; prevent redundant asset purchases and related storage and maintenance costs; and determine the full costs of government programs using long-lived assets.

    * Loan receivables expected to be collected and loan guarantee payables expected to be paid out could not reasonably be estimated. These direct loan receivables and loan guarantees, reported at $156 billion and $37 billion, respectively, pertain to Federal credit programs regarding farms, rural utilities, low and moderate housing, small businesses, veterans' mortgages, and student loans. These problems impair the government's ability to make future budget decisions, manage program costs, and measure performance of credit activities.

    * Environmental liabilities, reported at $212 billion, are related to the disposal of hazardous waste and remediation of environmental contamination. These liabilities were materially understated due to failure to reserve for the disposal of weapon systems and ammunition. As a result, the government's ability to set cleanup priorities and estimate future budgetary resources is impaired.

    * Federal employee and veterans' benefit liabilities, reported at $2.2 trillion, could not be accurately estimated because reliable data was not available and some agencies' systems could not ensure the accuracy and completeness of information used to estimate the liabilities. As a result, the government's ability to determine the full cost of its current operations and extent of actual liabilities is impaired.

    * The cost of current government operations, reported at $1.6 trillion, could not be supported. Certain specific costs, such as Social Security benefit expenditures totaling over $350 billion and interest costs totaling $246 billion were confirmed, but a material amount of other costs were not. As a result, the government's ability to control and reduce costs, measure performance, evaluate programs, and assess user fees is limited. In addition, the government has been unable to prevent improper payments (e.g., payments made for other than valid, authorized purposes), which are estimated at billions of dollars for major Federal programs.

    * Cash disbursement activity was not effectively recorded. Several major agencies did not effectively reconcile their disbursements (in a process similar to a bank reconciliation), resulting in hundreds of billions of dollars of unresolved differences between the agencies' and Treasury's records of cash disbursements. In addition, some agencies, without determining whether their records were correct, arbitrarily wrote off large unresolved differences.

    * Unreconciled transactions, reported at $12 billion, resulted from the government's inability to identify and eliminate transactions between government entities and to agency adjustments affecting net position. For example, some agencies did not comply with FFMIA's requirements relative to Federal general ledger regulations and reported intragovernmental transactions as being with outside parties, while others reported these transactions correctly.

    * The preparation of the consolidated financial statements was hindered by information that did not agree with agency financial statements or was otherwise not recorded properly, resulting in correcting journal entries totaling hundreds of billions of dollars.

    * The reconciliation of the change in net position with budget results could not be accurately performed. GAO believes the preparation of reliable financial statements would provide additional assurance in reporting of budget results.

GAO also reported several material weaknesses, pertaining to the issues discussed above and to computer controls and tax collection in its internal control report. The most serious computer control problem was inadequate restriction of access to sensitive data. As a result, government information was vulnerable to exploitation, such as inappropriate disclosure, destruction, modification, or fraud, by both unauthorized outsiders and for unauthorized purposes by users with malicious intent. For example, the audit of the Social Security Administration (SSA), which resulted in an unqualified report for fiscal 1997, revealed weaknesses in the following computer operations:

    * Mainframe computer access,

    * Access to control software,

    * Configuration of the mainframe operating system,

    * Audit trail facilities,

    * Password controls,

    * Certifying and accrediting certain general support and major application systems, and

    * Security awareness and training programs.

To avoid further compromising computer security, the auditors did not provide specific information on the above in its public report. The auditors did note that the above weaknesses increase the risk of unauthorized access to, and modification or disclosure of, sensitive information. In addition, the unauthorized access to sensitive data can result in loss of data, loss of assets, and compromised privacy of information reported by or on individuals regarding their earnings, retirement, and/or disabilities. One possible example of misuse of computerized information would be press reports of SSA employees selling income data to credit card companies that want to focus their marketing efforts on high-income individuals.

The material weaknesses related to tax collection activities affected the government's ability to account for and collect the government's tax revenue. As a result, the government could not separately report revenue from three of its four largest revenue sources: Social Security, hospital insurance, and individual income taxes. In addition, the government had problems in tracking its taxes receivable and other unpaid assessments, resulting in recently publicized incidents where the IRS pursued taxpayers and collected taxes already paid. In addition, the government was vulnerable to underpayments of tax and overpayments of tax refunds.

In reviewing the GAO report, readers should recognize that the deficiencies cited are not government-wide, but rather pertain to material amounts and disclosures in the consolidated financial statements taken as a whole. Some agencies received unqualified reports, with or without material weaknesses and reportable conditions in their internal control reports. As noted above, the IRS Custodial Funds, representing virtually all the government's revenue, and the Schedule of Federal Debt, received unqualified opinions on their 1997 financial statements. In addition, eight of 24 CFO agencies, representing 26% of fiscal 1996 net budget expenditures, also received unqualified opinions. However, the amounts and disclosures not supported by appropriate evidence were so significant that GAO could not issue an opinion on the consolidated financial statements. The problems will be solved over time as each agency improves its financial reporting system and internal controls.

Basis of Accounting

The financial statements are prepared in conformity with Statements of Federal Financial Accounting Standards (SFFAS), which are issued by the Federal Accounting Standards Advisory Board (FASAB) (see sidebar). Using this basis, the financial statements include a consolidated balance sheet, a consolidated statement of net cost, a consolidated statement of changes in net position, and various disclosures followed by a stewardship section disclosing information excluded from the basic financial statements. Users should recognize that these financial statements will be different from the widely reported budget figures. Budgetary information is essentially on a cash basis, whereas financial statements prepared in conformity with FASAB pronouncements include certain accruals. In addition, the financial statement presentation and the recognition and measurement of revenues, expenditures, assets, and liabilities are different from financial statements prepared in conformity with pronouncements issued by the Governmental Accounting Standards Board (GASB), which are applicable to state and local governments, and the Financial Accounting Standards Board (FASB), which are applicable to commercial and not-for-profit entities. Some of these differences are discussed below.

Stewardship Reporting. The Federal Government has adopted an "off-balance-sheet approach," wherein certain information is excluded from the face of financial statements and disclosed in a stewardship section. The information presented in the stewardship section is fully audited. This approach differs from the proposed GASB reporting model for state and local governments that would include all assets and obligations within the financial statements. The most prominent item omitted from the face of the financial statements is the net combined Social Security and Medicare obligation, which is estimated to exceed $3.5 trillion. Another is land that is not used by general government operations, such as property held by the U.S. Forest Service, National Park Service, U.S. Fish and Wildlife Service, and Bureau of Land Management. No value is allocated to this property, which totals 621 million acres. Although much of this land is used for recreational purposes, some of the property held by the Forest Service and Bureau of Land Management is leased or otherwise made available to private concerns for harvesting of timber, livestock grazing, etc. The government believes this presentation is appropriate because the stewardship section is a required part of the basic financial statements and is audited.

The trend in Federal accounting standards appears to be the expansion of such disaggregation of information. For example, FASAB is proposing that national defense assets, such as weapon systems and support property used in military missions (i.e., aircraft, tanks, ships and ammunition) be removed from the balance sheet and reported in the stewardship section. These assets were reported at $636 billion in the 1997 financial statements.

Restricted Assets and Liabilities. Assets, liabilities, and activities that are restricted either by laws and regulations or by purpose are not presented separately on the face of the financial statements. Rather, these items are either combined with the general government operations or disclosed in the stewardship section. Certain legally restricted assets and revenues, which are disclosed in Note 16 to the consolidated financial statements, include the Federal Old Age and Survivors Insurance Trust Fund (Social Security), Unemployment Trust Fund, and Highway Trust Fund. Trust funds, as defined by law, are to be accounted for separately, and can be used only for specific purposes. None of these funds are reflected separately on the face of the financial statements. The assets of these funds, which are substantially all Federal debt securities and related obligations, are eliminated in consolidation.

In addition, government corporations, which are conceptually similar to discretely presented component units under GASB standards, are not presented in a separate column in the financial statements. For example, the Federal government presented the results of operations of the U.S. Postal Service and deposit insurance operations, with $1.5 billion and $8.4 billion in profits, respectively, as reductions in net costs incurred for government operations, even when the use of these assets for general government operations is restricted.

Statement of Net Cost. Total revenues and other financing sources are presented in the consolidated statement of changes in net position, and total expenditures are presented separately in the consolidated statement of net cost. The consolidated statement of changes in net position presents the specific amounts collected as taxes or borrowed. The consolidated statement of net cost presents, by functional area, gross cost less earned revenue to arrive at net cost. Major functional areas are national defense, human resources, physical resources, interest costs, and miscellaneous functions, such as international affairs and general government. Gross cost is defined as the full cost of each function; earned revenue are those earned by providing goods and services; and net cost is gross cost less earned revenues. This presentation, while currently being considered by GASB for state and local governments, differs from the current governmental financial statement presentation that shows the sources of different revenue as well as functional expenses in the same financial statement.

FASAB Statements as GAAP

Currently, FASAB pronouncements are not recognized as generally accepted accounting principles (GAAP) by the American Institute of Certified Public Accountants (AICPA). The AICPA Council (the governing body of the AICPA) has designated GASB and FASB as bodies to establish accounting principles for state and local governments and for nongovernmental bodies, respectively. Currently, the AICPA Council has not designated a body to establish accounting standards for the Federal government and recognizes FASAB standards as another comprehensive basis of accounting.

GAO is attempting to have FASAB pronouncements recognized as GAAP applicable to the Federal government. Recently, the AICPA Government Accounting and Auditing Committee established a subcommittee to address issues related to Federal government auditing. On April 28, 1998, this subcommittee, along with GAO, made a presentation to the Audit Issues Task Force of the Auditing Standards Board outlining its intent to obtain AICPA Council recognition of the Federal accounting standards process as a source of GAAP applicable to the Federal government. Such recognition would clear the way for the amendment of Statement on Auditing Standards (SAS) No. 69 (AU 411), The Meaning of Present Fairly in Conformity with Generally Accepted Accounting Principles in the Independent Auditor's Report, to establish a hierarchy of standards for Federal reporting purposes similar to that for state and local governments and for nongovernmental entities.

Value of Audit

The authors believe that statements made by some Federal Government officials predicting that an unqualified report will be issued on the fiscal 1999 financial statements should be greeted with some skepticism. Many government agencies still have difficulty in providing auditable financial statements. Resolution of underlying problems with financial systems within the next year is a monumental task, which the Federal Government may not be able to achieve by the beginning of fiscal 1999, which is October 1, 1998.

GAO and the authors view this audit to be more of a first step rather than the culmination of the process. GAO officials note that several Federal agencies that had received disclaimers and qualified reports in prior years are now issuing financial statements receiving unqualified audit reports. In fiscal 1996, six CFO agencies received unqualified opinions; the number increased to eight in fiscal 1997. From this start, GAO recognizes the Federal Government is working toward the quality financial systems that will permit it to achieve the objectives of good internal control and reliable financial statements.

A complete copy of the consolidated financial statements, along with the GAO's report, can be obtained from GAO's website, *


* No other entity in the world compares in size and scope to the United States government.

* The Federal budget deficit declined significantly in 1997, falling to $22 billion from $107 billion in 1996.

* Nonexchange revenue totaled $1,577 billion in 1997, with more than 95% of this amount coming from tax receipts.

* The net cost of government operations was $1,603 billion.

* There were $1,602 billion in Federal assets at the end of 1997, offset by $6,605 billion in liabilities.

* 7,850 "mission critical" systems will be impacted by the year-2000 problem, with an anticipated cost of nearly $5 billion to make them compliant.

* Without a change in policy, cash disbursements for Social Security programs will exceed cash receipts by Federal fiscal year 2012; and by 2029 the combined trust funds' assets will likely be exhausted.

* It is recommended by FASAB that $636 billion in national defense property, plant, and equipment be removed from the balance sheet and reported in the stewardship section of the financial statements.

* Net costs rather than profit are used as the primary financial measure in the operating statement because this is the measure used for assessing efficiency and effectiveness of government operations. *


Which organization provides the accounting standards for the United States government to follow in the preparation of its consolidated financial statements? FASB? GASB? No, the standards established for this purpose are those promulgated by the FASAB (The Federal Accounting Standards Advisory Board). The Government Management Reform Act of 1994 established the foundation for the preparation and audit of consolidated financial statements for the United States Government.

In recognition of the unique nature of the United States Government, it was decided that a unique set of accounting standards should be developed for its financial statements. The Secretary of the Treasury, the director of the Office of Management and Budget (OMB), and the Comptroller General established the Federal Accounting Standards Advisory Board (FASAB) in October 1990 in order to provide a mechanism to generate these standards. The initial basic set of Federal Financial Accounting Standards (FFAS) were completed by the board in 1996.

The board is composed of one member each from the Department of the Treasury, OMB, the General Accounting Office (GAO), and the Congressional Budget Office; one member representing the defense and international agencies; another representing the civilian agencies; and three non-Federal members representing the general financial community, the accounting and auditing community, and academia. Board members are appointed for initial terms of two years and may be reappointed for subsequent terms. The chairperson is selected by the board's principals--the OMB Director, the Comptroller General, and the Secretary of the Treasury.

The board's primary mission is the establishment of Federal accounting standards which meet user needs and enhance the understandability, relevance, and reliability of Federal financial reporting. In addition, the board is responsible for providing advice on how to implement the standards, helping to improve understanding of information reflected in financial reports, relating standards and principles to associated benefits and costs, reviewing the impact of current and revised standards, developing rules of procedures to allow for the review of financial reporting and accounting issues, and being objective and neutral in order to most appropriately represent the effects of Federal Government activities.

In considering new accounting standards, the board identifies accounting and agenda issues, then holds preliminary deliberations, prepares initial due process documents, releases documents such as exposure drafts to the public, holds public hearings and considers comments, holds further deliberations, and reaches a general consensus before submitting final documents to the OMB Director and the Comptroller General, who retain the final authority for promulgating Federal accounting rules. The FASAB has issued eight statements and two concepts, but some of the statements will not become effective until fiscal years 1998 and 1999. The board is also working on standards relating to management's discussion and analysis of Federal financial statements, social insurance, cost of capital, natural resources, and computer software costs.

FASAB Statement #1 provides guidance for accounting for selected assets and liabilities, Statement #2 discusses accounting for direct loans and loan guarantees, Statement #3 concerns accounting for inventory and related property, while Statement #4 provides guidance relative to managerial cost accounting concepts and standards. In addition, Statement #5 discusses liabilities of the Federal Government; Statement #6 involves accounting for property, plant, and equipment; Statement #7 helps with accounting for revenue and other financing sources; and Statement #8 addresses supplementary stewardship reporting. Concepts #1 presents the objectives of Federal financial reporting and Concepts #2 discusses entity and display issues. OMB Bulletin 97-01 provides a listing of the hierarchy of GAAP for the Federal Government.

The financial statements of the United States Government are prepared in accordance with applicable FFAS, which means that they are prepared on an accrual basis, while the Federal budget is essentially prepared on a cash basis. Net costs, as opposed to net profit, become the major tool for assessing economy and efficiency relative to Federal Government operations. The establishment of FASAB and its promulgation of statements and concepts goes a long way toward providing useful, structured guidance for the Federal Government. As additional components of FFAS become effective in the next few years, they may facilitate broader compliance and lead to an unqualified audit opinion, making the financial statements even more useful.

For more information, visit FASAB's web site at *

Robert A. Dyson, CPA, is a senior manager at Grant Thornton, LLP.
David J. Hasso, CPA, is with the Office of the (New York) State Comptroller. Both are members of the Governmental Accounting and Auditing Committee of the NYSSCPA.

The authors wish to thank Philip T. Calder, GAO chief accountant; Robert F. Dacey, director, consolidated audit and computer security issues, GAO; and Michele Mark Levine, CPA, New York City Office of Management and Budget, for their assistance and invaluable insights in preparing this article.

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