FEDERAL MANAGER'S ACCOUNTABILITY ACT OF 1981 A HEARING BEFORE THE SUBCOMMITTEE OF THE COMMITTEE ON GOVERNMENT OPERATIONS HOUSE OF REPRESENTATIVES NINETY-SEVENTH CONGRESS FIRST SESSION ON H.R. 1526

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• Publication Date: March 11, 1981
• Content Type: OPEN SOURCE

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FEDERAL MANAGERS' ACCOUNTABILITY ACT OF 1981
HEARING
SUBCOMMITTEE OF THE
COMMITTEE ON
GOVERNMENT OPERATIONS
HOUSE OF REPRESENTATIVES
NINETY-SEVENTH CONGRESS
FIRST SESSION
ON
H.R. 1526
TO AMEND THE ACCOUNTING AND AUDITING ACT OF 1950 TO
REQUIRE ONGOING EVALUATIONS AND REPORTS ON THE
ADEQUACY OF THE SYSTEMS OF INTERNAL ACCOUNTING AND
ADMINISTRATIVE CONTROL OF EACH EXECUTIVE AGENCY,
AND FOR OTHER PURPOSES
U.S. GOVERNMENT PRINTING OFFICE
77-6770 WASHINGTON : 1981
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L. H. FOUNTAIN, North Carolina
DANTE B. FASCELL, Florida
BENJAMIN S. ROSENTHAL, New York
DON FUQUA, Florida
JOHN CONYERS, JR., Michigan
CARDISS COLLINS, Illinois
JOHN L. BURTON, California
GLENN ENGLISH, Oklahoma
ELLIOTT H. LEVITAS, Georgia
DAVID W. EVANS, Indiana
TOBY MOFFETT, Connecticut
HENRY A. WAXMAN, California
FLOYD J. FITHIAN, Indiana
TED WEISS, New York
MIKE SYNAR, Oklahoma
EUGENE V. ATKINSON, Pennsylvania
STEPHEN L. NEAL, North Carolina
DOUG BARNARD, JR., Georgia
PETER A. PEYSER, New York
BARNEY FRANK, Massachusetts
HAROLD WASHINGTON, Illinois
TOM LANTOS, California
FRANK HORTON, New York
JOHN N. ERLENBORN, Illinois
CLARENCE J. BROWN, Ohio
PAUL N. McCLOSKEY, JR., California
THOMAS N. KINDNESS, Ohio
ROBERT S. WALKER, Pennsylvania
M. CALDWELL BUTLER, Virginia
LYLE WILLIAMS, Ohio
H. JOEL DECKARD, Indiana
WILLIAM F. CLINGER, JR., Pennsylvania
RAYMOND J. McGRATH, New York
HAL DAUB, Nebraska
JOHN HILER, Indiana
DAVID DREIER, California
WENDELL BAILEY, Missouri
LAWRENCE J. DENARDIS, Connecticut
JUDD GREGG, New Hampshire
WILLIAM M. JONES, General Counsel
JOHN E. MOORE, Staff Administrator
ELMER W. HENDERSON, Senior Counsel
JOHN M. DUNCAN, Minority Staff Director
DANTE B. FASCELL, Florida
DON FUQUA, Florida
ELLIOTT H. LEVITAS, Georgia
DAVID W. EVANS, Indiana
HENRY A. WAXMAN, California
FRANK HORTON, New York
JOHN N. ERLENBORN, Illinois
M. CALDWELL BUTLER, Virginia
WILLIAM F. CLINGER, JR., Pennsylvania
RICHARD C. BARNES, Staff Director
(II)
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CONTENTS
Page
Hearing held on March 11, 1981 ................................................................................... 1
Text of H.R. 1526 .............................................................................................................. 2
Statement of-
Abbadessa, John P., executive vice president, Association of Government
Accountants, accompanied by Gilbert Simonetti, chairman, Congres-
sional Affairs Committee .................................................................................... 83
Brooks, Hon. Jack, a Representative in Congress from the State of Texas,
and chairman, Legislation and National Security Subcommittee: Open-
ing statement ........................................................................................................ 1
Hyde, Hon. Henry J., a Representative in Congress from the State of
Illinois ..................................................................................................................... 16
Lordan, John J., Chief, Financial Management Branch, Office of Manage-
ment and Budget .................................................................................................. 58
Watsen, John K., on behalf of the Institute of Internal Auditors .................. 103
Letters, statements, etc., submitted for the record by-
Abbadessa, John P., executive vice president, Association of Government
Accountants:
Excerpts from a document entitled "Executive Reporting on Internal
Controls in Government" ........................................................................... 87-96
Responses to Chairman Brooks' and Congressman Horton's questions 98-
100
Hyde, Hon. Henry J., a Representative in Congress from the State of
Illinois:
Information concerning the Budget and Accounting Act ......................... 54
Study on management reports published by Ernst & Whinney ............. 18-52
Lordan, John J., Chief, Financial Management Branch, Office of Manage-
ment and Budget:
Responses to Chairman Brooks' questions .................................................. 66-70
Responses to Congressman Horton's questions .......................................... 71-78
Staats, Elmer B., Comptroller General of the United States: February 25,
1981, statement before the subcommittee ......................................................... 8-14
Watsen, John K., on behalf of the Institute of Internal Auditors:
Document entitled "A Focus on the Role of the Internal Auditor" .... 106-
148
Submissions to additional subcommittee questions .............................. 149-150
APPENDIX
Material submitted for the record ................................................................................ 153
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FEDERAL MANAGERS' ACCOUNTABILITY ACT
OF 1981
HOUSE OF REPRESENTATIVES,
LEGISLATION AND NATIONAL SECURITY SUBCOMMITTEE
OF THE COMMITTEE ON GOVERNMENT OPERATIONS,
Washington, D.C.
The subcommittee met, pursuant to notice, at 1:45 p.m., in room
2247, Rayburn House Office Building, Hon. Jack Brooks (chairman
of the subcommittee) presiding.
Present: Representatives Jack Brooks, Frank Horton, and M.
Caldwell Butler.
Also present: subcommittee staff: Cynthia Meadow, professional
staff member; Linda Shelton, office manager; full committee staff:
William M. Jones, general counsel; Elmer W. Henderson, senior
counsel; John M. Duncan, minority staff director; and Thomas
Houston, minority professional staff, Committee on Government
Operations.
OPENING STATEMENT OF CHAIRMAN BROOKS
Mr. BROOKS. Today's hearing is on H.R. 1526, the Federal Manag-
ers' Accountability Act of 1981.
Over the years studies done by the GAO and others have uncov-
ered waste in Federal resources, funds, and property, which appar-
ently could have been avoided by more stringent and more effec-
tive internal controls. The bill which is before us today would
improve those controls by requiring top agency management offi-
cials to certify the effectiveness of the system of internal controls
and outline a plan and schedule for strengthening any weaknesses
in the system.
In addition, the bill establishes the Office of Inspector General as
the recipient of any allegations of false or misleading statements in
connection with the certification process or the certification state-
ment itself.
[The bill, H.R. 1526, follows:]
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97TH CONGRESS He R? 1526
tsT SESSION
To amend the Accounting and Auditing Act of 1950 to require ongoing evalua-
tions and reports on the adequacy of the systems of internal accounting and
administrative control of each executive agency, and for other purposes.
IN THE ROUSE OF REPRESENTATIVES
FFBRIJARY 2, 1981
Mr. BROOKS introduced the following bill; which was referred to the Committee
on Government Operations
A BILL
To amend the Accounting and Auditing Act of 1950 to require
ongoing evaluations and reports on the adequacy of the
systems of internal accounting and administrative control of
each executive agency, and for other purposes.
1 Be it enacted by the Senate and House of Representa-
2 tives of the United States of America in Congress assembled,
3 SECTION 1. This Act may be cited as the "Federal
4 Managers' Accountability Act of 1981".
5 SEC. 2. Section 113 of the Accounting and Auditing
6 Act of 1950, as amended (31 U.S.C. 66a), is amended by
7 adding at the end thereof the following new subsection:
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2
1 "(d)(1) To ensure that the requirements of subsection
2 (a)(3) of this section are fully complied with, the head of each
3 executive agency which the Director of the Office of Manage-
4 ment and Budget determines to be covered by this subsection
5 shall prepare a report stating an opinion on the adequacy of
6 the agency's systems of internal accounting and administra-
7 tive control by December 31, 1982, and by December 31 of
8 the succeeding year.
9 "(2) The reports shall be signed by the head of each
10 executive agency and addressed to the President. Such re-
11 ports shall also be made available to Congress and the public.
12 "(3) By December 31, 1981, the Comptroller General,
13 in consultation with the Director of the Office of Management
14 and Budget, shall establish a system of reporting and guide-
15 lines for the agencies in performing evaluations on their sys-
16 tems of internal accounting and administrative control. The
17 Comptroller General, in consultation with the Director, may
18 modify the system for reporting or the guidelines for
19 conducting the evaluations from time to time as deemed
20 necessary.
21 "(4) Internal accounting and administrative controls
22 shall be established in accordance with standards prescribed
23 by the Comptroller General, and shall provide reasonable
24 assurances that-
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1 "(i) all obligations and costs were in compliance
2 with applicable law;
3 "(ii) all funds, property, and other assets were
4 safeguarded against waste, loss, unauthorized use, or
5 misappropriation; and
6 "(iii) all revenues and expenditures applicable to
7 agency operations were properly recorded and account-
8 ed for to permit the preparation of accounts and reli-
9 able financial and statistical reports and to maintain
10 accountability over the assets.
11 Any inadequacy or material weaknesses in an agency's sys-
12 tems of internal accounting and administrative control which
13 prevents the head of the agency from stating that the
14 agency's systems of internal accounting and administrative
15 control provided reasonable assurances that each of the ob-
16 jectives specified above were achieved shall be identified and
17 the plans and schedule for correcting any such inadequacy
18 described in detail.
19 "(5)(A) The Inspector General of an executive agency
20 or, if no Inspector General exists for an agency, the head of
21 the internal audit staff, shall receive and investigate any alle-
22 gation that an employee of the agency provided false or mis-
23 leading information in connection with the evaluation of the
24 agency's systems of internal accounting and administrative
25 control or in connection with the preparation of the annual
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4
1 report on the systems of internal accounting and administra-
2 tive control.
3 "(B) If, in connection with any investigation under sub-
paragraph (A), the Inspector General or the head of the in-
ternal audit staff, as appropriate, determines that there is
reasonable cause to believe that false or misleading informa-
tion was provided, he shall report that determination to the
head of the agency.
"(C) The head of the agency shall review any matter
referred to him under subparagraph (B) and shall take action
under chapter 75 of title 5, United States Code, or such other
disciplinary or corrective action as he deems necessary.".
SEC. 3. Section 201 of the Budget and Accounting Act,
1921 (31 U.S.C. 11), is amended by adding at the end there-
of the following new subsection:
"(k) The President shall include in the supporting detail
17 accompanying each budget submitted on or after January 1,
18 1982, a statement with respect to each department and es-
19 tablishment of-
20 "(1) the original amount of appropriations re-
21 quested by the Office of the Inspector General of such
22 department or establishment, if any;
23 "(2) the changes made in such request by the
24 head of such department or establishment prior to the
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1 submission of such request to the Director of the Office
2 of Management and Budget;
3 "(3) any further changes made in such request
4 prior to the submission of such Budget to the
5 Congress.".
6 SEc. 4. Section 215 of the Budget and Accounting Act,
7 1921 (31 U.S.C. 23), is amended by inserting immediately
8 after the first sentence thereof the following new sentence:
9 "The head of each department and establishment shall in-
10 elude with any such requests for appropriations a statement
11 certifying that the request is based on an accounting system
12 that has been approved by the Comptroller General pursuant
13 to section 112 of the Budget and Accounting Act of 1950.".
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Mr. BROOKS. Such requirements focus attention on an area which
has had low priority in recent years. The lack of strong and effec-
tive controls has created opportunity for waste, misuse, and mis-
management, as well as fraudulent transactions. If these opportu-
nities were lessened-if not altogether eliminated-Federal pro-
grams would automatically experience an expansion of funds as
more of the taxpayers' hard-earned dollars would be available for
use in implementing program objectives as intended by the Con-
gress. The type statement of effectiveness required by this legisla-
tion is voluntarily in use today in the private sector. It is just
sound business practice to require that the Federal Government
also maintain tight control over all its resources.
In hearings on February 25, the then Comptroller General,
Elmer Staats of the General Accounting Office, strongly supported
this legislation. A copy of Mr. Staats' statement will be included in
the record at this point.
[The statement follows:]
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UNITED STATES GENERAL ACCOUNTING OFFICE
FOR RELEASE ON DELIVERY
EXPECTED AT 10:00 AM
WEDNESDAY, FEBRUARY 25, 1981
STATEMENT OF
ELMER B. STAATS, COMPTROLLER GENERAL
UNITED STATES GENERAL ACCOUNTING OFFICE
BEFORE THE
SUBCOMMITTEE ON LEGISLATION AND NATIONAL SECURITY
COMMITTEE ON GOVERNMENT OPERATIONS
HOUSE OF REPRESENTATIVES
CONCERNING IMPROVING FEDERAL AGENCIES'
SYSTEMS OF INTERNAL FINANCIAL CONTROL
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We are here today to testify on the merits of the pro-
posed bill H.R. 1526 entitled the "Federal Managers' Account-
ability Act of 1981." This bill, if enacted, will require
ongoing evaluations and reports on the systems of internal con-
trol of each executive agency. I am grateful for the opportunity
to offer our support for the bill and to provide some insight
as to why the legislation has our enthusiastic support.
Broadly speaking, the bill deals with the area of account-
ability, a subject receiving a lot of attention in the past
several years. A seemingly unending disclosure of fraud, waste,
abuse, and mismanagement in Government during the 1970s has
surfaced a serious crisis of confidence in Federal Government
programs and agencies. Moreover, the ability of Government
officials to effectively, efficiently, and honestly administer
programs was a major issue in the recent national election and,
as a result, has intensified the need to improve accountability
at all levels of management. Federal departments and agencies
cannot maintain a level of accountability expected by the public
unless they can be assured that strong and effective control over
operations exists. Internal control systems properly conceived,
soundly based, and effectively monitored are the front-line
defense against fraud, waste, and abuse. The proposed "Federal
Managers' Accountability Act of 1981" was designed for the purpose
of strengthening controls by requiring management to periodically
analyze, monitor, and report on the adequacy of their systems of
internal control.
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The proposed bill deals with internal accounting and
administrative controls which essentially are plans of opera-
tions, procedures, and records designed to lead to the most
effective and efficient management decisions, the safeguard of
assets, and the maintenance of reliable financial records. Such
controls include for example: (1) a routine in a computer sys-
tem that prevents issuance of a salary check to any individual
that the personnel department has not approved as a bonafied
employee, (2) a separation of duties and responsibilities be-
tween persons authorized to purchase materials and approve pay-
ment for them to minimize the chances of error or embezzlement,
and (3) a requirement to do a periodic reconciliation between
actual property on hand and quantities per accounting records
to insure that financial reports are reliable.
The requirements for Federal agencies to maintain internal
administrative and accounting control systems have been mandated
by law for over 30 years; however, most agencies have not always
given adequate priority to their internal control systems. The
General Accounting Office (GAO) has issued literally hundreds
of reports and studies that disclose the fact that most agencies
are operating systems vulnerable to physical losses and waste of
Federal property and money as well as susceptible to fraudulent
or otherwise improper use of Federal resources. Examples of
findings disclosed in GAO's reports include:
--About $198,000 was returned by vendors because duplicate
payments were made by one department as a result of in-
adecuate control over processing invoices submitted by the
vendors.
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--A ru;,;.er of Federal agencies were found to incur
connitnents for future cash outlays without first
verifying availability of appropriated funds.
--A number of agencies did not effectively analyze
receivables to identify overdue accounts in order to
take necessary action to receive payment.
--A Defense Department employee embezzled over $2 million
because he was allowed to both process claim adjustments
as well as approve claim payments.
Although agency management has generally concurred with the
internal control weaknesses reported by GAO and has agreed to
implement appropriate corrective actions, the weaknesses that are
left undetected by management, GAO auditors, or other Federal
auditors is reason for greater concern.
The proposed Federal Managers' Accountability Act of 1981
would supplement existing legislation by requiring management to
periodically monitor and report on the adequacy of their systems
of internal control to provide reasonable assurance that (1) all
financial commitments and obligations were in compliance with
applicable laws; (2) all funds, property, and other assets were
safeguarded against waste, loss, unauthorized use or misappropria-
tion; and (3) all revenues were properly recorded and accounted
for. Specifically, the Act requires each agency head to conduct
annual evaluations of internal accounting and administrative control
and to prepare an annual report, addressed to the President and
made available to the Congress and the public, stating an opinion
on the adequacy of the agency's systems of internal control. The
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correcting such weaknesses, and (3) a narrative on any un-
resolved findings disclosed in audit or management reports.
In addition, these reports are subject to review and audit
by Federal auditors (both GAO and agency Inspector Generals
or the chief of internal audit) to determine their accuracy
and validity.
Although we actively support the passage of this bill, we
do have one minor concern related to section 4 of the bill.
Section 4 requires the head of each agency to include with
appropriation requests a statement certifying that the request
be based on an accounting system that has been approved by the
Comptroller General. Since no penalty or action is specified
if certification could not be made, this provision seems to con-
clude that a possibility exists for appropriation request to go
unapproved, in which case operations of Government activities
can be at least temporarily halted. All agencies' accounting
systems have not yet been approved although we continue to work
closely with agencies and provide the assistance they need. We
believe a better approach might be for the legislation to pro-
vide that, when an appropriation is requested, the head of an
agency be required to report to the Congress on the status and
progress made in having its accounting system(s) approved. This
would give the Congress an opportunity to exercise its oversight
authority with individual agencies to see that their systems
get approved.
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Notwithstanding this concern which needs only minor mod-
ification, we believe the importance of this proposed legislation
cannot be understated. Effective internal controls help ensure
that Government managers know what their monetary and physical
assets and resources are at all times; know how the assets are
being used, dispensed, and disposed of and for what purposes;
know that such purposes are authorized; and know that fraud,
waste, and abuse are minimized and discouraged. This proposed
legislation establishes a badly needed mechanism which forces
management to pay closer attention to the quality of internal
controls in its agency and, more importantly, it establishes a
vehicle to enhance accountability of Federal officials. We be-
lieve passage of the Federal Managers' Accountability Act of
1981 would definitely help bring about strong commitment and
vigilance in the area of accountability.
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SOURCE OF EXAMPLES USED IN
THE FEBRUARY 25, 1981, STATEMENT OF
ELMER B. STAATS, COMPTROLLER GENERAL
BEFORE THE
SUBCOMMITTEE ON LEGISLATION AND NATIONAL SECURITY
COMMITTEE ON GOVERNMENT OPERATIONS
CONCERNING INTERNAL CONTROL WEAKNESSES
Example 1: About $198,000 was returned by vendors because
duplicate payments were made by one department
as a result of inadequate control over processing
invoices submitted by the vendors.
A completed General Accounting Office (GAO) review.
The written report is in final processing and should
be released in the near future.
A number of Federal agencies were found to incur
commitments for future cash outlays without first
verifying availability of appropriated funds.
GAO report No. FGMSD 80-65, "Continuing and Wide-
spread Weaknesses in Internal Controls Result in
Losses Through Fraud, Waste, and Abuse," August 22,
1980, pages 19-21 (copy of report attached).
Example 3: A number of agencies did not effectively analyze
receivables to identify overdue accounts in order
to take necessary action to receive payment.
Source: GAO report No. FGMSD 80-65, "Continuing and Wide-
spread Weaknesses in Internal Controls Result in
Losses Through Fraud, Waste, and Abuse," August 22,
1980, pages 4-6 (copy of report attached).
Example 4: A Defense Department employee embezzled over $2
million because he was allowed to both process
claim adjustments as well as approve claim payments.
Source: A completed GAO review. The written report is in
final processing and should be released in the
near future.
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Mr. BROOKS. I talked with Elmer Staats at another meeting this
morning and he restated his conviction that this legislation can be
of substantial help to the Government.
Congressman Hyde and representatives of the Office of Manage-
ment and Budget, the Association of Government Accountants, and
the Institute of Internal Auditors will testify today.
I will first see whether Mr. Horton has a statement and then I
shall introduce the witnesses.
Mr. HORTON. For a couple reasons I am especially pleased we are
here today to consider H.R. 1526.
First, I believe that we at this end of Pennsylvania Avenue must
do whatever we can do to see to it that Federal programs are
administered as efficiently as possible.
Second, this is only March 11, Congress is still trying to get
organized, and this subcommittee is meeting for the second time
this year to discuss financial accountability.
Two weeks ago, under the chairman's leadership, we examined
the need for more effective audit followup in the executive depart-
ments and agencies. Today I understand we will discuss the possi-
bility of tightening the internal accounting and administrative con-
trols at the same departments and agencies.
That is a good beginning, Mr. Chairman, and I encourage you to
continue to pursue the kind of legislation and oversight that will
increase Government efficiency and decrease fraud, abuse, waste,
and mismanagement of programs throughout the Federal Govern-
ment.
The bill before us today, H.R. 1526, if enacted, would require
ongoing evaluations and reports on the systems of internal control
of each executive agency. I understand that this legislation is fa-
vored by accountants, auditors, and professional organizations rep-
resenting CPA's and auditors. I appreciate their presence here
today and look forward to their testimony later in this hearing.
I must, however, at the outset confess my instinctive 'reluctance
to require yet another congressionally mandated report unless that
report will result in either a long-term decline of Federal paper-
work or a long-term increase in administrative efficiency. That is
the kind of yardstick we must use, Mr. Chairman, if we are to
continue passing legislation that requires new reports or new pa-
perwork.
I do have some questions and concerns about various parts of the
bill, but I will reserve those questions for the witnesses. Like you,
Mr. Chairman, I welcome our colleague from Illinois, Mr. Hyde, as
well as the witness from the Office of Management and Budget and
the various accounting and auditing organizations.
I look forward to this hearing and congratulate you once again
for introducing this legislation.
Mr. BROOKS. Thank you, Mr. Horton.
Our first witness is Congressman Henry J. Hyde. He represents
the Sixth District of Illinois and has represented that district since
November of 1974. He has introduced a lot of legislation and many
amendments, but he also has introduced legislation similar to the
bill we are considering in these hearings.
Congressman, I look forward to having your comments and I
welcome you before the committee.
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STATEMENT OF HON. HENRY J. HYDE, A REPRESENTATIVE IN
CONGRESS FROM THE STATE OF ILLINOIS
Mr. HYDE. Thank you, Mr. Chairman, Mr. Horton, and Mr.
Butler.
I think the context for this legislation is established by two GAO
reports. The first one is dated August 28, 1980. It states simply
billions of Federal dollars are lost annually through fraud, waste,
and abuse.
This report to which I have referred covers only 11 Federal
agencies, a cross section of all Government activities appearing
within that figure.
A more recent GAO report of January 23, 1981, which was made
at the request of this committee, states similarly that the Govern-
ment is losing billions of dollars because agencies are not acting on
audit recommendations to recover funds, avoid costs, and improve
operation.
If there is anything that distresses and angers the electorate, the
taxpaying electorate, it is reading documents like these that talk
about billions of dollars lost through fraud, waste, and abuse. A
solution has to be found.
I do appreciate the opportunity to appear here today to discuss
H.R. 1526, a bill which would require continuing evaluations and
reports to Congress on the internal control systems of Federal
agencies and departments. I wholeheartedly support this bill.
As we seek ways to reduce the Federal budget, legitimate con-
cerns are being voiced about program cutbacks or their total elimi-
nation. One way some of these programs can be salvaged, or even
enhanced, is to provide assurance that fraud, waste and other
abuses have been eliminated as far as humanly possible.
Nothing brings an aroused taxpayer's blood to a quick boil faster
than reading about waste or fraud or abuse in government. This
bill is an overdue antidote to this major problem.
The bill's primary goal of strengthening the internal control
systems within each agency, coupled with requiring senior agency
officials to pay more serious attention to these systems in orderly
fashion, will have important ancillary benefits as well. Not only
will the agency's programs and their administration be more cost-
effective, but public confidence can be restored in the belief that
agencies of Government are honestly and effectively serving the
people. We ought not underestimate the confidence factor as we try
to balance the need to cut spending and preserve necessary pro-
grams and services.
Legislation requiring Federal agencies to maintain effective in-
ternal controls has been mandated for over 30 years by the Ac-
counting and Auditing Act of 1950. I believe internal controls
require a commitment from top management and constant vigi-
lance to be effective, let alone the legal mandate. Yet management
has not always given adequate priority nor emphasis to the impor-
tance of good internal controls.
The General Accounting Office has constantly reminded us of
the lack of management's attention to internal controls through
the many reports it has issued to us annually. The proposed Feder-
al Managers' Accountability Act of 1981 supplements the existing
legislation by providing the missing link of assurance that strong
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internal controls will exist. It requires management to periodically
analyze, monitor, and report on the adequacy of their systems of
internal control.
Specifically, the act requires each agency head to conduct annual
evaluations of internal accounting and administrative control and
to prepare an annual report, addressed to the President, and made
available to the Congress and the public, stating an opinion on the
adequacy of the agency's systems of internal control.
The opinion, as a minimum, shall contain: (1) A description of
material weaknesses in internal control; (2) a plan for correcting
such weaknesses; and (3) a narrative of any unresolved findings
disclosed in audit or in management reports.
In addition, these reports are subject to review and audit by
Federal auditors, both GAO and agency Inspectors General or the
chief of internal audit, to determine their accuracy and validity.
Reporting on the adequacy of internal controls by management
will not be unique in the Federal Government. As you know, the
Foreign Corrupt Practices Act of 1977 requires private companies
filing with the Securities and Exchange Commission to maintain
effective systems of internal control.
Since then, with the encouragement of the Securities and Ex-
change Commission, management of private companies have begun
to include statements on their internal control systems in their
annual reports to stockholders. This practice is becoming more
prevalent.
The international accounting firm of Ernst and Whinney recent-
ly published a study on management reports and included numer-
ous examples of actual statements appearing in annual reports.
Such companies include, for example, Xerox Corp., Westinghouse
Electric Corp., and others. The study by Ernst and Whinney points
out the growing trend of management in private business reporting
on internal controls, and to highlight that trend and capability I
would like to submit their study for the record.
[The material follows.]
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18
MANAGEMENT REPORTS IN
ANNUAL REPORTS TO SHAREHOLDERS
1980
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Related E&W Publications and Seminar
Ernst & Whinney publications on the Foreign Corrupt Practices Act
and evaluating internal control and information on our internal
control seminar are listed below. The publications and informa-
tion on the seminar may be obtained from any E&W executive.
Foreign Corrupt Practices Act of 1977--An Overview of the Law
and Its Implications (E&W No. 38748)--This Financial Report-
ing Developments pamphlet issued in February 1978 analyzes
the provisions of the Act. It summarizes the existing
responsibilities of management and independent auditors for
internal control and explains why a normal audit will not
ensure compliance with the Act. Included are our suggestions
for management actions--particularly in dealing with the
Act's bribery provisions.
Evaluating Internal Control--A Guide for management and
directors and a supplementary set of preprinted forms for
documenting and evaluating internal accounting control
(including our Guide to Flow Charting--E&W No. 39080) for the
following types of businesses:
Commercial or Industrial (E&W No. 39078)
Banking (E&W No. 38905)
Life Insurance (E&W No. K58145)
Property/Casualty Insurance (E&W No. K58146)
Hospitals (E&W No. J58320)
Blue Cross/Blue Shield Plans (E&W No. K58166)
Internal Control Seminar--To help companies improve their
review and monitoring of their systems, we have developed a
seminar on the E&W approach to evaluating internal control
for commercial or industrial companies. The complete "how
to" seminar takes approximately four hours including time for
questions and answers and a case study.
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Contents
2 RECENT DEVELOPMENTS--SEC ACTIONS AND EXPECTATIONS . . . . . . 2
SEC Views on Content of Management Reports. . . . . . . . . . 2
Materiality . . . . . . . . . . . . . . . . . . . . . . . . 3
Point in Time Reporting . . . . . . . . . . . . . . . . . . 3
Objectives of Internal Control . . . . . . . . . . . . . . . 4
Reasonable Assurance . . . . . . . . . . . . . . . . . . . . 4
Comprehensive Management Reports . . . . . . . . . . . . . . 4
Compliance with the FCPA . . . . . . . . . . . . . . . . . . . 5
Review and Evaluation of Internal Accounting Controls . . . 5
Control Environment . . . . . . . . . . . . . . . . . . . . 6
Documentation . . . . . . . . . . . . . . . . . . . . . . . 6
E&W Recommendation for Future Action . . . . . . . . . . . . . 7
3 CONTENT OF A MANAGEMENT REPORT . . . . . . . . . . . . . . . . 8
Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Comparison of the Recommendations . . . . . . . . . . . . . . 8
Summary of Ernst & Whinney Survey . . . . . . . . . . . . . . 10
Management's Responsibility for the Financial Statements. . . 11
Material Uncertainties . . . . . . . . . . . . . . . . . . . 11
E&W Survey Results . . . . . . . . . . . . . . . . . . . . . 12
Specific Examples . . . . . . . . . . . . . . . . . . . . . 12
Internal Accounting Control . . . . . . . . . . . . . . . . . 13
Concept of Reasonable Assurance . . . . . . . . . . . . . . 13
Explicit vs. Implicit Assessments . . . . . . . . . . . . . 14
Objectives of Internal Control . . . . . . . . . . . . . . . 14
Period Covered . . . . . . . . . . . . . . . . . . . . . . . 15
Internal Audit . . . . . . . . . . . . . . . . . . . . . . . 15
Additional SEC Recommendations . . . . . . . . . . . . . . . 16
Specific Examples of Discussions of Internal Accounting
Control . . . . . . . . . . . . . . . . . . . . . . . . . 16
Role of Board of Directors/Audit Committee. . . . . . . . . . 17
E&W Survey Results . . . . . . . . . . . . . . . . . . . . . 18
Specific Examples . . . . . . . . . . . . . . . . . . . . . 18
Role of Independent Accountants . . . . . . . . . . . . . . . 19
E&W Survey Results . . . . . . . . . . . . . . . . . . . . . 20
Specific Example . . . . . . . . . . . . . . . . . . . . . . 21
Other Disclosures or Information . . . . . . . . . . . . . . . 21
E&W Survey Results . . . . . . . . . . . . . . . . . . . . . 22
Specific Example . . . . . . . . . . . . . . . . . . . . . . 22
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21
1 Summary
It is becoming more common for companies to include a "management
report" in their annual report to shareholders. Such reports
typically affirm management's responsibility for the financial
statements, comment on the adequacy of the system of internal
accounting controls and discuss the roles of the board of direc-
tors, audit committee and independent and internal auditors. This
pamphlet is intended to assist those who include a management
report in their annual report to shareholders or are considering
including one.
Section 2 of the pamphlet discusses the SEC's recent withdrawal of
its proposals to require public reporting on internal accounting
control, its expectations for voluntary provision of management
reports and its plans to monitor the results of company initia-
tives over the next three years. It also analyzes the SEC's pub-
lished views regarding the conte't of management reports and
compliance with the internal accounting control provisions of the
Foreign Corrupt Practices Act (FCPA).
Section 3 compares the recommendations of the Financial Executives
Institute, Cohen Commission, AICPA and the SEC regarding the con-
tent of management reports. The discussion also incorporates the
results of an Ernst & Whinney survey of 1979 annual reports of
Fortune 1,000 industrial companies. The Section is organized by
the major subject areas typically addressed in a management report.
The final Section of the pamphlet includes the full text of ten
published management reports as examples of some of the comprehen-
sive reports companies have presented.
The SEC is still very interested in public reporting on internal
accounting controls and could reconsider rule making in this
area. The private sector can preempt that possibility--by contin-
uing the trend of significantly increasing management reports and
experimenting with reporting on internal accounting controls by
independent accountants. Now the AICPA has issued Statement on
Auditing Standards No. 30, "Reporting on Internal Accounting Con-
trol," which allows independent accountants to publicly report on
a company's system of internal accounting controls when a special
study has been performed for that purpose. Ernst & Whinney pro-
fessionals are available to assist you in reviewing and testing
your system of internal accounting controls and in making your
management report an informative and effective communication to
shareholders.
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22
2 Recent Developments-SEC Actions and Expectations
The subject of management reports has been discussed frequently in
the past few years. Since 1978, the Financial Executives Insti-
tute (FEI) has encouraged its members to include a management
report in their companies' annual reports and has published sug-
gested guidelines. The FEI's current suggestions on the content
of a management report and those of other organizations are sum-
marized in Section 3.
The SEC had stated for some time that it planned to require
reporting on internal accounting control. Its 1979 proposal would
have required management's opinion as to whether a company's sys-
tem of internal accounting controls provided reasonable assurance
that the broad objectives of internal accounting control included
in the FCPA were achieved throughout the year. Response to the
proposal was massive and overwhelmingly negative with a record
number of comment letters (950) received.
In withdrawing the proposal in June 1980, the SEC issued Account-
ing Series Release (ASR) No. 278 explaining its action and its
expectations regarding voluntary management reporting and auditor
association. The SEC said that its preliminary analysis showed
that the trend of increasing numbers of companies presenting man-
agement reports in their annual reports to shareholders had con-
tinued in 1979 and it expects management reports to become a
common disclosure within three years.* It also expects companies
to experiment with auditor reports on internal accounting con-
trols. The SEC intends to monitor the progress that is made vol-
untarily in these areas and to reconsider the need for rules based
on that monitoring.
The SEC will monitor the content of management reports as well as
the number of companies that provide them. Its present views
about the content of management reports differ in certain key
respects from the proposed rules.
Because the proposals directly paralleled the FCPA, they were more
controversial than they might otherwise have been. Many commenta-
tors stated that the proposals would effectively require companies
to make a statement of compliance with the law. In addition, many
* We do not believe the SEC expects companies to include a manage-
ment report in their Form 10-K, registration statements, or
other SEC filings. Before including management reports in SEC
filings, we recommend that management review with its counsel
the legal consequences of such reports becoming "filed" material.
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23
2 Recent Developments-SEC Actions and Expectations
challenged the SEC's statutory authority to impose such a require-
ment and questioned its motives. There was concern that the pro-
posals were not intended to inform shareholders, but rather to
influence corporate conduct.
The FCPA also made it more difficult for the SEC to deal with cer-
tain major issues raised in the comment process--more difficult
because of a concern that the scope of an SEC requirement for a
management report would effectively define the scope of the inter-
nal accounting control provisions of the FCPA. The SEC believes
that withdrawing its proposals permits flexibility to experiment
with various approaches to public reporting on internal accounting
control. This approach--basically persuasion rather than regula-
tion--also allows the SEC to be more flexible about the scope and
content of management reports.
Materiality
Many commentators, including those few who supported an SEC
requirement for management reports, suggested that any requirement
should contain a materiality limitation. They contended that
investors and other users of management reports are not concerned
about nonmaterial weaknesses in internal accounting controls.
Indeed, they maintained that disclosure of immaterial weaknesses
could be confusing and possibly misleading.
The SEC continues to emphasize that the internal accounting con-
trol provisions of the FCPA are not limited by a materiality stan-
dard. However, for purposes of encouraging management reports, it
recognizes that some weaknesses in internal accounting control are
more significant than others. It recommends that a management
statement cover the adequacy of controls "over matters about which
shareholders reasonably should be informed"--i.e., matters which
are material.
Point in Time Reporting
The SEC had proposed that management report on conditions that
existed throughout the year. Many commentators disagreed, recom-
mending instead that a management report be limited to conditions
existing as of a point in time (e.g., the fiscal year end or
report date). They questioned the value of disclosing weaknesses
that existed during the year, but were subsequently corrected.
They also pointed out that such disclosure could discourage system
improvements because a change in the system might imply a prior
deficiency. And it could hinder open discussion between auditors
and their clients about potential system improvements and impair
client receptivity to suggestions by their auditors.
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24
2 Recent Developments-SEC Actions and Expectations
Naturally, the SEC does not believe that the FCPA requires effec-
tive controls only at year end. But it now accepts management
reporting as of a point in time: "For disclosure purposes, the
Commission believes there is value in providing management state-
ments which address the effectiveness of internal accounting con-
trol systems as of a recent date."
Objectives of Internal Control
Although compliance with the law need not be discussed, the SEC
still expects management reports to address each of the internal
accounting control objectives of the FCPA. Taken almost verbatim
from generally accepted auditing standards, these objectives state
that a system of internal accounting control should provide rea-
sonable assurance that: transactions are executed in accordance
with management's authorization; recorded transactions permit pre-
paration of financial statements in conformity with generally
accepted accounting principles or other applicable criteria and
maintain accountability for assets; access to assets is permitted
only in accordance with management's authorization; and recorded
assets are compared with existing assets at reasonable intervals.
Recognizing that companies typically paraphrase these objectives
when describing them in a management report, the SEC encourages
companies to continue to describe them in the manner they believe
most informative.
In addition to discussing the objectives of a system of internal
accounting control, the SEC recommends that management reports
address the concept of "reasonable assurance." Basically, this
concept is that the cost of a control procedure should not exceed
its benefit; that is, the reduction in risk of not achieving a
control objective. Of course, these benefits of control proce-
dures usually cannot be quantified and assessing their "value"
requires judgment. Therefore, the SEC recommends that management
reports explain the concept of reasonable assurance and its limi-
tations in management's assessment of the internal accounting con-
trol system.
Comprehensive Management Reports
Rather than just a statement on the effectiveness of internal
accounting controls, the SEC now is encouraging companies to pro-
vide comprehensive reports covering management's responsibilities
for "accounting, control and financial reporting in general," such
as recommended by the FEI and others. Approximately 100 comment
letters supported comprehensive reports, but not as an SEC
requirement.
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2 Recent Developments-SEC Actions and Expectations
ASR No. 278 also discloses the SEC's views about compliance with
the internal accounting control provisions of the FCPA.* We
believe this discussion is significant because it represents pub-
lished views of the SEC as an agency--not just the views of an
individual commissioner or staff member. The following paragraphs
summarize those views.
Review and Evaluation of Internal Accounting Controls
Because internal accounting controls are dynamic and have inherent
limitations, the SEC believes that ongoing review and monitoring
procedures are necessary for a company to have reasonable assur-
ance that its system continues to be effective. It recognizes,
however, that the concept of reasonable assurance includes cost-
benefit judgments as to the extent and timing of the review and
monitoring procedures. In other words, the costs of review and
monitoring must be weighed against the estimated potential reduc-
tion in exposure which they will produce--a very subjective judg-
mental process.
The SEC recognizes that the specific control procedures and tech-
niques that will provide for effective controls, and the specific
methods of reviewing and monitoring control systems, must be
geared to the circumstances of individual companies. However, it
stresses the importance of an organized approach to evaluating
internal accounting controls and suggests that evaluations should
encompass certain "conceptual elements." Basically, these are:
2. Review the system of internal accounting controls by identi-
fying and considering specific control objectives and speci-
fic control procedures to achieve those objectives.
3. Monitor compliance to determine that the system is function-
ing as intended.
4. Determine whether reasonable assurance is achieved by con-
sidering the benefits and costs of additional or alternative
controls.
*For further information regarding the FCPA, refer to our Financial
Reporting Developments pamphlet (E&W No. 38748), Foreign Corrupt
Practices Act of 1977--An Overview of the Law and Its Implica-
tions.
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2 Recent Developments-SEC Actions and Expectations
We believe these "conceptual elements" are sound and are consis-
tent with the guidance provided in the Ernst & Whinney Guides for
Evaluating Internal Control.* Through an organized and thorough
approach to documentation and evaluation of the system of internal
accounting controls, companies can provide a basis for developing
their management report. Many of our clients, often working
together with Ernst & Whinney, already are doing this.
The SEC continues to emphasize the importance of a strong control
environment. Companies need active, effective audit committees;
clear communication of policies, procedures, authority and respon-
sibility; competent personnel of integrity; accountability for
performance and for compliance with policies and procedures; and
objective, effective internal audit functions. The SEC recognizes
that a strong control environment alone will not provide effective
controls--but it believes specific control procedures will not
function effectively in an organization lacking a high level of
control consciousness.
The SEC continues to stress the importance of documenting the sys-
tem; the plans, bases and results of review and monitoring of the
system; and the bases of cost-benefit decisions (which it recog-
nizes may not be quantifiable). It recognizes, however, that the
appropriate level of documentation also will be determined by
cost-benefit decisions.
The SEC also emphasizes the defensive importance of documentation,
pointing out that whether a system provided reasonable assurance
will most likely come under scrutiny after a system failure. It
suggests that management will be in a better position to defend
itself if the bases for its cost-benefit analysis are supported by
documentation of both the system of internal accounting controls
and its review and evaluation.
*For further information on specific publications, refer to the
inside front cover of this pamphlet.
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2 Recent Developments-SEC Actions and Expectations
It would be very unfortunate if the general response to the SEC's
action were only a loud and long sigh of relief. The SEC cer-
tainly has not lost interest in public reporting on internal
accounting control, nor has it abandoned the possibility of rule-
making in this area. The private sector has the opportunity to
preempt that possibility--by continuing the trend of significant
increases in management reports, and by experimenting with report-
ing on internal accounting control by independent accountants. If
this opportunity is lost, companies may be forced to comply with
SEC rules.
The FEI and AICPA deserve recognition for recommending that com-
panies provide management reports. And companies that provided
management reports in 1979 also are to be commended. These
efforts unquestionably were a major factor in the SEC's decision
to withdraw its rule proposals.
More importantly, companies should continue to assess the adequacy
of their system of internal accounting controls, their programs
for ongoing review and monitoring of those systems, and their
related documentation. This is vital to a well managed busi-
ness--whether or not it has provided a management report or plans
to do so. It is very important to keep in mind that the SEC has
withdrawn, for the present time, only its rule proposals for pub-
lic reporting on internal accounting control. The statutory
requirements of the FCPA to maintain effective systems of internal
accounting control are still with us.
Our series of Guides for Evaluating Internal Control and the sup-
plementary sets of documentation forms provide a practical
approach to documenting and evaluating systems of internal
accounting controls that result in clear easy to understand state-
ments of how a company achieves the objectives of the FCPA's
accounting provisions. Our approach is economical yet responsive
to the SEC's views. Ernst & Whinney professionals are available
to assist you in reviewing and testing your system of internal
accounting controls and in preparing a management report.
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3 Content of a Management Report
As guidance in presenting a management report, this Section pro-
vides information concerning what various organizations have sug-
gested and what certain companies have done. It is organized by
major subject areas typically addressed in a management report:
management's responsibility for the financial statements; internal
accounting controls; the role of the board of directors and audit
committee; the role of independent accountants; and other disclo-
sures or information.
For each of the categories, there is a brief discussion of the
views of the Commission on Auditors' Responsibilities (Cohen Com-
mission), Financial Executives Institute (FEI), AICPA Special
Advisory Committee on Reports by Management (AICPA Committee) and
SEC, a summary of the results of an E&W survey of management
reports, and excerpts from published management reports.
The FEI, Cohen Commission, AICPA Committee, and SEC all have sug-
gested that companies provide a management report in the annual
report to shareholders. Each of the private sector organizations
has published suggestions for the contents of such a report and
the SEC generally has endorsed experimentation with their sugges-
tions.
Table 1 below summarizes and compares the recommendations of the
FEI, Cohen Commission and AICPA Committee. These recommendations,
as well as additional ones made by the SEC in ASR No. 278, are
discussed further in the remainder of this Section.
SUBJECTS PROPOSED FOR INCLUSION IN MANAGEMENT REPORTS
Suggested By
FEI Cohen AICPA
Management's Responsibility for the Financial Statements
1. Management's responsibility for the finan-
cial statements and other financial
information X X X
a. Compliance with GAAP X X X
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3 Content of a Management Report
FEI Cohen AICPA
b. Adequacy of judgments and estimates x X X
c. Consistency of other information in
the annual report with the financial
statements x x x
Internal Accounting Control
3. Management responsibility for the sys-
tem of internal accounting controls x X X
4. Assessment of the effectiveness of
internal accounting controls x X X
Role of Board of Directors/Audit Committee
6. Composition of the audit committee x X X
7. Review and oversight of management's
financial reporting responsibility x X X
8. Engagement of and interaction with
independent accountants x X X
Role of Independent Accountants
9. Auditors' responsibilities in relation
to the financial statements and related
opinion x X
10. Reference to change in independent
accountants x x x
Other Disclosures or Information
12. Reference to ethical and legal policies
(code of conduct) X X X
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3 Content of a Management Report
13. Reference to corporate social respon-
sibilities X
14. Signature of chief financial officer
and/or chief executive officer. X X
To measure the trends in both the extent to which management
reports are being provided and their contents, Ernst & Whinney
surveyed the first 305 calendar 1979 annual reports of Fortune
1,000 industrial companies that were available to us.
40% of the companies surveyed included a management report in
1979, compared to 23% for the same companies in 1978. Only one
company that presented a management report in 1978 did not present
one in 1979.
Management reports were presented more frequently by larger com-
panies. As indicated by Table 1 below, 50% of the Fortune 500
industrial companies surveyed included a management report in
1979, compared with 18% of the Fortune Second 500. This compares
to 30% and 6% respectively for 1978.
Fortune
Number of
Management Report Presented
Number
Companies Surveyed
1979
%*
1978
%*
0-100
58
36
62%
24
41%
101-200
47
25
53
13
28
201-300
42
20
48
10
24
301-400
38
16
42
10
26
401-500
25
8
32
6
24
0-500
210
105
50
63
30
501-600
22
5
23
1
5
601-700
19
2
11
2
11
701-800
22
7
32
2
9
801-900
18
1
6
0
0
901-1000
14
2
14
1
7
501-1000
95
17
18
6
6
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3 Content of a Management Report
The communication of management's responsibility for the financial
statements received widespread attention when the Cohen Commis-
sion, in its 1978 report, concluded that some users of financial
statements erroneously assume that the statements are the repre-
sentations of the independent accountants rather than manage-
ment's. It stated, "We encourage boards of directors (or official
bodies, if necessary) to require the company's chief financial
officer or other representative of management to present a report
with the financial statements that acknowledges the responsibility
of management for the representations in the financial informa-
tion."
Similar recommendations were made both by the FEI and the AICPA
Committee. In addition, all three organizations recommended that,
in acknowledging responsibility for the financial information,
management should state that (1) the financial statements were
prepared and presented in conformity with GAAP, (2) management
estimates and judgments are necessary in the preparation and pre-
sentation of certain financial information and, (3) the informa-
tion in the financial statements is consistent with that found in
the remainder of the annual report.
The SEC, in ASR No. 278, did not specifically address these mat-
ters, but encouraged companies to provide comprehensive reports
covering management's responsibilities for "accounting, control
and financial reporting in general."
The Cohen Commission stated that a management report should pro-
vide management's assurances that all material uncertainties have
been appropriately accounted for or disclosed. It also stated
that the report "should indicate that the company's legal counsel
has been consulted regarding the accounting for or disclosure of
legal matters and that those matters have been appropriately dis-
closed in the financial statements."
The FEI also recommended that management discuss the significance
of any uncertainties. The AICPA Committee, however, disagreed
with the Cohen Commission's recommendations as follows: "The Com-
mittee does not believe that a report by management should (a)
confirm that all material uncertainties have been appropriately
accounted for and disclosed or (b) indicate that legal counsel has
been consulted regarding the accounting for or disclosure of legal
matters in the financial statements, and that counsel concurs with
management's presentation."" Basically, the AICPA Committee
believed that implicit in management's responsibility for the
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3 Content of a Management Report
financial statements is an understanding that such matters are
adequately disclosed in the financial statements as required by
generally accepted accounting principles.
Management acknowledged its responsibility for the financial
statements in 100% of the management reports included in our
survey and 89% indicated that the financial statements had been
prepared in conformity with GAAP. 77% discussed the use of esti-
mates or judgments in the preparation of financial data, and 27%
referred to the consistency of other financial information in the
annual shareholders report. None of the management reports sur-
veyed included a discussion of material uncertainties and only one
mentioned consultation with legal counsel.
"We have prepared the accompanying consolidated financial
statements and related information included herein for the
years ended December 31, 1979 and 1978. The opinion of
Ernst & Whinney, the Company's independent auditors, on those
financial statements is included herein. The primary respon-
sibility for the integrity of the financial information
included in this annual report rests with management. Such
information was prepared in accordance with generally
accepted accounting principles appropriate in the circum-
stances, based on our best estimates and judgments and giving
due consideration to materiality."
Monsanto Company
"Monsanto Company management is responsible for the integrity
of all financial data, whether audited or unaudited, included
in this Annual Report. The consolidated financial statements
have been prepared in accordance with generally accepted
accounting principles consistently applied in all material
respects and reflect estimates by management where neces-
sary. Where acceptable alternative accounting principles
exist, as described in the Summary of Significant Accounting
Policies on page 56, management has used its best judgment in
selecting those principles that, in the circumstances,
reflect fairly the consolidated financial position, results
of operations and changes in financial position of Monsanto.
All financial information in this Annual Report is consistent
with that in the consolidated financial statements."
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3 Content of a Management Report
Of the subjects generally mentioned for inclusion in management
reports, internal accounting controls has received the most atten-
tion. This is largely due to the FCPA and the SEC's proposal for
reporting on internal accounting controls. The Cohen Commission,
FEI and AICPA Committee all have recommended that companies
include an assessment of the effectiveness of internal accounting
controls. And, when it withdrew its proposal, the SEC emphasized
that there must be an assessment of the effectiveness of internal
accounting controls in order for discussion of the subject in man-
agement reports to be meaningful.
Management's assessment of the company's system of internal
accounting controls is influenced by a number of important vari-
ables such as cost-benefit considerations, the size and type of
the business, environmental considerations, the degree of central-
ization and sophistication of financial and operating management
and a myriad of other factors. In any system, the cost of a con-
trol procedure should not exceed its benefit--i.e., the reduction
in risk of not achieving a control objective. Therefore, manage-
ment's assessment of the effectiveness of the system of internal
accounting controls should be phrased in terms of reasonable
rather than absolute assurance that the control objectives are
being achieved.
The Cohen Commission stated that the "report by management should
present management's assessment of the company's accounting system
and controls over it, including a description of the inherent
limitations of control systems . . ." (emphasis added). Its
illustrative example uses the concept of reasonable assurance:
"There are inherent limitations that should be recognized in con-
sidering the potential effectiveness of any system of internal
accounting control. The concept of reasonable assurance is based
on the recognition that the cost of a system of internal control
should not exceed the benefits derived and that the evaluation of
those factors requires estimates and judgments by management. The
com an 's system provides such reasonable assurance" (emphasis
added .
The AICPA Committee also endorsed the concept of reasonable assur-
ance and, to a large extent, the FEI's suggested guidelines for
management reporting on internal accounting controls parallel
? those of the Cohen Commission. However, the Cohen Commission's
conclusions were reached before the FCPA was finalized. The FCPA
imposes a requirement for a system of internal accounting controls
sufficient to provide reasonable assurance that the broad objec-
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3 Content of a Management Report
tives of internal accounting control are achieved. The FEI guide-
lines caution management to consult legal counsel regarding the
FCPA's provisions when making representations as to the adequacy
of controls and integrity of the financial statements.
The SEC, in ASR No. 278, recommended that management communicate
its opinion on the system's effectiveness. As discussed on page
3, although the SEC continues to maintain that the FCPA is not
limited by a materiality standard, it accepts the concept of a
materiality limitation for purposes of a management report. In
addition, the SEC believes "that it may be appropriate for manage-
ment statements on internal accounting control to discuss and
explain the concept of reasonable assurance and its limitations in
the context of communicating management's assessment of its system
of internal accounting control" (emphasis added).
As previously discussed, all of the organizations recommended that
management express an opinion on the effectiveness of the system
of internal accounting controls. The E&W Survey disclosed that
all management reports surveyed referred to internal controls
maintained by the company, but some companies did not explicitly
assess the effectiveness of the system. 41% of the management
reports surveyed included some type of representation that the
system of internal accounting controls provided reasonable assur-
ance that the control objectives were met, whereas 52% commented
that the controls were designed to provide reasonable assurance.
(Examples of both types are included below.) The remaining 7% of
the reports simply referred to the existence of a system of inter-
nal accounting controls.
In addition, 27% mentioned the essential cost-benefit relationship
of a system of internal accounting controls. However, only 7%
actually discussed the concept of reasonable assurance as recom-
mended by the Cohen Commission and SEC.
The Cohen Commission, AICPA Committee and FEI all suggested that
management discuss its responsibility for maintaining a system of
internal accounting controls as well as maintaining an atmosphere
or environment in which controls can be effective. However, in
ASR No. 278, the SEC went further and recommended that management
reports specifically address each of the internal control objec-
tives of the FCPA (see page 4), but it recognized that companies
"paraphrase the same broad objectives which were adopted in the
FCPA--often in terms of authorization of transactions, safeguard-
ing of assets, and accounting or preparation of reliable financial
statements."
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3 Content of a Management Report
The management reports surveyed support the SEC's conclusion that
most companies paraphrase the broad objectives into three categor-
ies rather than four. Only 3% of the management reports surveyed
addressed all four of the objectives. However, 57% of the reports
surveyed stated that transactions were executed in accordance with
management's authorization, 73% discussed safeguarding of assets,
and 92% stated that transactions were recorded to permit prepara-
tion of financial statements in conformity with GAAP.
As discussed in Section 2 of this pamphlet, the SEC now accepts
management reporting as of a point in time rather than reporting
on conditions existing throughout the year. The AICPA Committee
and FEI did not specifically address this issue. The Cohen Com-
mission, while not specifically discussing a time period, did sug-
gest that management acknowledge responsibility for the financial
statements as of the balance sheet date.
None of the management reports surveyed by E&W specifically
reported on the system of internal accounting controls as of a
point in time or for a time period. If management were to report
as such, the following is an example of how the report could be
worded:
A system of internal accounting controls has been maintained
which, as of December 31, 19X1, provided reasonable assurance
that . . . .
A system of internal accounting controls has been maintained
which, for the year ended December 31, 19X1, provided reason-
able assurance that . . . .
The internal audit function can be a key element in a system of
internal accounting controls--particularly in monitoring the func-
tioning of the system. The suggested guidelines of each of the
organizations contained little discussion of the internal audit
function, but all concurred that there is a need to discuss the
role of the internal auditors. 44% of the management reports
included in our survey discussed the function and responsibilities
of internal auditors.
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The SEC endorses the initiatives of the Cohen Commission, FEI and
AICPA Committee in recommending appropriate subject matter regard-
ing internal accounting controls in management reports. In addi-
tion to the recommendations of those groups, the SEC suggests that
companies also consider including the following matters in a man-
agement report:
The importance of other elements of the control environment,
including the organization structure, communication of cor-
porate policies and procedures and authority and responsibil-
ity, the competence and training of personnel, and accounta-
bility for performance and for compliance with policies and
procedures.
The general approach applied in reviewing and evaluating
internal accounting controls.
The extent to which internal accounting control review and
monitoring procedures are performed.
The role independent accountants play or have played in
evaluating the issuer's system of internal accounting con-
trol. (See page 19 for a further discussion.)
Specific Examples of Discussions of Internal Accounting Control
Western Electric Company, Incorporated
"...management maintains a highly developed system of inter-
nal accounting controls and supports a program of internal
auditing to monitor compliance with the system. Management
believes that this system provides reasonable assurance at
reasonable cost that the transactions of the Company are exe-
cuted in accordance with management's authorizations and are
recorded properly. This system requires that the recorded
assets be compared with existing assets at reasonable inter-
vals, and it provides reasonable assurance that access to
assets is permitted only in accordance with management's
authorizations.* Management further seeks to assure the
integrity and objectivity of these financial statements by
the careful selection of its managers, by organization
arrangements that provide an appropriate division of respon-
The Western Electric management report was one of only three in
the E&W survey that specifically addressed all four objectives
of internal control as suggested by the SEC in ASR No. 278.
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3 Content of a Management Report
sibility, and by communications programs aimed at assuring
that its policies, standards and managerial authorities are
understood" (emphasis added).
Xerox Corporation
"Xerox maintains a system of internal accounting controls
designed to provide reasonable assurance that assets are
safeguarded against loss or unauthorized use and that the
financial records are adequate and can be relied upon to pro-
duce financial statements in accordance with generally
accepted accounting principles. The concept of reasonable
assurance is based on the recognition that the cost of a sys-
tem of internal control must not exceed the related bene-
fits. There are written internal accounting and operating
control policies and procedures that are communicated to the
Company's worldwide operating units. Adherence to these
policies and procedures is constantly being evaluated by an
extensive coordinated audit effort of our internal audit
staff and independent certified public accountants" (emphasis
added).
The Cohen Commission's Report contained only a short discussion on
reporting the role of the board of directors and audit committee.
It recommended that a management report describe the work of the
company's audit committee and provided an example stating that the
audit committee met regularly with the internal auditors and inde-
pendent auditors and reviewed and approved the scope and timing of
audits and the auditors' findings.
The FEI's guidelines suggested that a discussion of the responsi-
bilities of the board of directors and its audit committee could
include the following:
Seeing that management fulfills its financial reporting
responsibilities.
Reviewing the composition of the audit committee and the
related independence of its members.
Meeting periodically with representatives of the independent
accountants and management to discuss auditing and financial
reporting matters.
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3 Content of a Management Report
Assuring that the independent accountants have free access to
meet with the audit committee, without management present, to
discuss the results of their examination.
The AICPA Committee mentioned all the matters discussed by the FEI
with the exception of the responsibility to engage or nominate
independent accountants. It also suggested an alternative
approach--a separate audit committee report included in the annual
report. The management report could then refer to this separate
report and eliminate a discussion of the audit committee's respon-
sibilities.
The SEC stressed the importance of the board of directors in
"overseeing the establishment and maintenance of a strong control
environment, and in overseeing the procedures for evaluating a
system of internal accounting control." In both ASR No. 278 and
the SEC's report to Congress on the accounting profession, the SEC
has also stressed the importance of audit committees in assisting
the board of directors in fulfilling their oversight responsibili-
ties with regard to a company's accounting, financial reporting,
and control obligations.
E&W Survey Results
All but one of the 1979 management reports surveyed mentioned an
audit committee and 90% discussed the composition of the audit
committee and that its members were not employees of the company.
97% discussed the audit committee's responsibilities, using langu-
age similar to that recommended by the FEI and AICPA Committee,
such as holding regular meetings with the independent accountants,
internal auditors and management to discuss accounting, auditing,
and financial reporting matters. Many of the management reports
surveyed also discussed the audit committee's role in selecting
the company's independent accountants.
"The Directors of TRW have an audit committee currently com-
prised of three Directors who are not members of management.
The committee meets with management, the internal auditors
and the independent auditors in connection with its review of
matters relating to the Company's annual financial state-
ments; the Company's internal audit program; the Company's
system of internal accounting controls; and the services of
the independent auditors. The Committee meets with the
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3 Content of a Management Report
internal auditors as well as the independent auditors, with-
out management present, to discuss appropriate matters. The
Committee also recommends to the Directors the designation of
the independent auditors."
"The members of the Audit Committee of the Board of Direc-
tors, none of whom are employees of the Company, are identi-
fied on page 46 of this annual report. The Audit Committee
recommends independent accountants for appointment by the
Board of Directors, reviews the services to be performed by
the independent accountants, and receives and reviews the
reports submitted by them. It makes a determination regard-
ing the possible effect of the performance of non-auditing
services on the independence of the principal independent
accountants. It also determines the duties and responsibili-
ties of the internal auditors, reviews the internal audit
program, and receives and reviews reports submitted by the
internal auditing staff. In the exercise of its responsibil-
ities the Audit Committee meets with management, with the
internal auditors, and with the independent accountants."
The FEI's guidelines for the content of a management report state
that a discussion of the independent accountants' responsibilities
could include the following:
An independent examination of the company's financial state-
ments conducted in accordance with generally accepted audit-
ing standards.
An expression of an opinion as to whether the company's
financial statements fairly present the financial position,
operating results, and changes in financial position.
The AICPA Committee also recommended that management clarify the
role of the independent accountant. And now the AICPA has issued
Statement on Auditing Standards (SAS) No. 30 which provides guid-
ance for independent accountants to perform and report on a spe-
cial study of a system of internal accounting controls. The inde-
pendent accountants' report would express positive assurance on
achievement of the broad objectives of internal accounting con-
trols and could be included in the company's annual report. How-
ever, companies engaging their independent accountants to perform
a special study may not want to include the report in the annual
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3 Content of a Management Report
report. Rather, they may wish to comment on the special study in
the management report, especially because ASR No. 278 states that
". . . management should also consider discussing the role which
independent accountants play or have played in the internal
accounting control system of the issuer."
To accomplish this, a management report could be expanded as
follows:
During 19X1, Ernst & Whinney, the Company's independent
accountants, performed a comprehensive study of the Company's
system of internal accounting controls. Based on this study,
Ernst & Whinney reported that at December 31, 19X1 the Com-
pany's overall system of internal accounting controls was
sufficient to provide management with reasonable assurance
that the foregoing internal accounting control objectives
were met insofar as they relate to the prevention or detec-
tion of errors or irregularities that would be material to
the financial statements.
When the independent accountants have not performed a special
study of internal accounting controls and their work was limited
to that deemed necessary for the audit, a management report could
include the following language:
The financial statements were audited by Ernst & Whinney, the
Company's independent auditors. As part of their audit,
Ernst & Whinney evaluated the system of internal accounting
control to the extent they deemed necessary to determine
their auditing procedures. Their audit would not necessarily
disclose all internal accounting control weaknesses because
it was based on selective tests. And, although Ernst &
Whinney did not express an opinion on the overall system of
internal accounting control, they reported that their proce-
dures disclosed no conditions which they consider to be a
material internal accounting control weakness.
E&W Survey Results
Nearly 87% of the management reports surveyed included some discus-
sion of the independent accountants' role. The reports generally
included a brief description of the audit and the accountants'
report, as recommended both by the FEI and AICPA Committee.
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3 Content of a Management Report
Westinghouse Electric Corporation
"The independent accountants provide an objective assessment
of the degree to which management meets its responsibility for
fairness of financial reporting. They regularly evaluate the
system of internal accounting controls and perform such tests
and other procedures as they deem necessary to reach and
express an opinion on the fairness of the financial state-
ments."
Several other topics were recommended for discussion in management
reports by the Cohen Commission, AICPA Committee or FEI including
the following:
In addition, the Cohen Commission and FEI suggested that including
the signatures of the chief financial officer and/or the chief
executive officer may add stature to a management report.
The Cohen Commission recommended that a management report describe
the extent of nonaudit services provided by the independent
accountant. The SEC subsequently required such disclosures in
proxy statements. The AICPA Committee reasoned that such informa-
tion is readily available and need not be repeated in a management
report.
The AICPA Committee took exception to the Cohen Commission's recom-
mendation that the report be signed by a representative of manage-
ment and include a statement about whether management or the
independent accountants prepared the financial statements. The
AICPA Committee believed that these were issues of "form rather
than substance" and that the most important representations con-
cerned management's responsibility for the financial statements.
As a result, the AICPA Committee did not specifically recommend
that these matters be addressed in a management report, instead
deferring to the individual practices and preferences of management.
The SEC's 1979 proposal asked for comments on whether management
reports should be signed and, if so, by whom. However, ASR No. 278
does not address signatures, indicating that the SEC has no strong
opinion that the reports should be signed.
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3 Content of a Management Report
E&W Survey Results
22% of the surveyed management reports discussed compliance with
corporate codes of conduct. 3% included a discussion of the non-
audit services provided by the independent accountants. As indi-
cated by Table 3, 54% of the surveyed management reports were
signed by an officer in 1979, a slight increase from 51% in 1978.
The "typical" signed report included two signatures, most fre-
quently those of the chief executive and chief financial officers.
TABLE 3
SIGNATURES
1979
%
1978
%
Signed reports:
1 signature
19
15%
7
10%
2 signatures
45
37
27
39
3 signatures
2
2
1
2
Total signed reports
66
54
35
51
Unsigned reports
56
46
34
49
Total reports
122
100%
69
1007
In addition to these recommended topics, it is interesting to note
that two management reports mentioned that the company's indepen-
dent accountants had received a peer review and were members of
the SEC Practice Section of the AICPA. In a recent speech, SEC
Chairman Williams stated that the SEC will consider a proposal to
require this disclosure.
The following excerpt from a published management report illu-
strates management reporting on compliance with a corporate code
of conduct:
"The Company has policy statements regarding, among other
things, potentially conflicting outside business interests of
employees, and proper conduct of domestic and international
business activities. We have developed and instituted addi-
tional internal controls and internal audit procedures
designed to prevent or detect violations of these policies.
We believe that this provides reasonable assurance that our
operations are conducted in conformity with the law and with
a high standard of business conduct."
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4 Examples of Published Management Reports
Eaton Corporation
Report of Management
We have prepared the accompanying
consolidated financial statements and
related information included herein for the
years ended December 31, 1979 and 1978.
The opinion of Ernst & Whinney, the
Company's independent auditors, on those
financial statements is included herein. The
primary responsibility for the integrity of the
financial information included in this annual
report rests with management. Such infor-
mation was prepared in accordance with
generally accepted accounting principles
appropriate in the circumstances, based
on our best estimates and judgements and
giving due consideration to materiality.
The Company maintains high standards
when selecting, training and developing
personnel, to insure that management's
objectives of maintaining strong, effective
internal accounting controls and unbiased,
uniform reporting standards are attained.
We believe our policies and procedures
provide reasonable assurance that operations
are conducted in conformity with law and
with our Company commitmerit to a high
standard of business conduct.
Eaton maintains internal accounting control
systems which are adequate to provide
reasonable assurance that assets are safe-
guarded from loss or unauthorized use and
which produce records adequate for prepara-
tion of financial information. There are
limits inherent in all systems of internal
accounting control based on the recognition
that the cost of such system should not
exceed the benefits to be derived. We believe
the Company's system provides this
appropriate balance.
The system and controls and compliance
therewith are reviewed by an extensive
program of internal audits and by our
independent auditors. Their activities are
coordinated to obtain maximum audit
coverage with a minimum of duplicate
effort and cost. The independent auditors
receive copies of all reports issued by the
internal auditors at the same time they are
released to management and have access
to all internal audit work papers.
In an attempt to assure objectivity and remove
bias, the financial data contained in this
report is subject to review by the Audit
Committee of the Board of Directors. The
Audit Committee is composed of outside
directors who meet regularly with manage-
ment, internal auditors and independent
auditors to review the audit scope, timing
and fee arrangements.
Stephen R. Hardis
Executive Vice President -
Finance and Administration
and Treasurer
Frank C. Roberts
Vice President -Accounting
Ronald L. Leach
Vice President and Controller
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4 Examples of Published Management Reports
Monsanto Company
Responsibiities for Integrity of
Financial Data
Monsanto Company management is responsible for
the integrity of all financial data, whether audited or
unaudited, included in this Annual Report. The
consolidated financial statements have been prepared
in accordance with generally accepted accounting
principles consistently applied in all material respects
and reflect estimates by management where
necessary. Where acceptable alternative accounting
principles exist, as described in the Summary of
Significant Accounting Policies on page 56,
management has used its best judgment in selecting
those principles that, in the circumstances, reflect
fairly the consolidated financial position, results of
operations and changes in financial position of
Monsanto. All financial information in this Annual
Report is consistent with that in the consolidated
financial statements.
In order to gather financial data and safeguard
assets, Monsanto establishes accounting and
reporting systems supported by internal accounting
controls. Internal accounting controls are maintained
by: (1) the selection and training of personnel;
(2) a division of responsibility in all organizational
arrangements; (3) the establishment and communi-
cation of accounting and business policies; and,
(4) a program of internal audits with follow-up, when
necessary, by management. In establishing internal
accounting controls, the cost of such controls is
weighed against the benefits to be derived.
Management believes that Monsanto's internal
accounting controls provide reasonable assurance
that assets are safeguarded against material loss from
unauthorized use or disposition and that the financial
records are reliable for preparing financial statements
and other data and maintaining accountability for
assets.
As ratified by shareowner vote at the 1979 Annual
Meeting, Deloitte Haskins & Sells, an international
firm of independent auditors, examined the
consolidated financial statements contained in this
Annual Report. Their examination was made in
accordance with generally accepted auditing
standards, which provide for a review of internal
accounting controls and tests of a limited number of
transactions. The principal result of this examination
is the expression of an opinion, which appears on
page 69, as to the fairness of the presentation of the
consolidated financial statements in accordance with
generally accepted accounting principles consistently
applied.
The Audit Committee of the Board of Directors is
responsible for reviewing Monsanto's financial reports
and monitoring the Company's accounting practices.
The membership of the Committee consists of three
non-employee directors. At periodic meetings,
the Committee discusses audit and financial reporting
matters with representatives of financial
management, the internal audit function and Deloitte
Haskins & Sells. The independent auditors and the
director of the internal audit function have full and
free access to meet with the Audit Committee -
with or without the presence of management
representatives - to discuss the results of their
examinations, the adequacy of internal accounting
controls and the quality of financial reporting.
John W. Hanley James J. Kerley
Chairman and Chairman of the Finance
Chief Executive Officer Committee
(Chief Financial Officer)
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4 Examples of Published Management Reports
Eli Lilly and Company
Responsibility
for Accounting
Controls and
Financial
Statements
Eli Lilly and Company
and Subsidiaries
The precedingconsolidated finan-
cial statements, including the notes
thereto, have been prepared by the
Company in accordance with gener-
ally accepted accounting principles
and necessarily include amounts
based on judgments and estimates
by management. The other financial
information in this annual report is I
consistent with that in the financial
statements.
The financial statements have
been audited by Ernst & Whinney,
independent accountants, whose re-
port appears on the preceding page.
Their responsibility is to examine
the Compare 's financial statements
in accordance with generally ac-
cepted auditing standards and to
express their opinion with respect
to the fairness of presentation of
the statements.
The Company maintains internal
accounting control systems that are
designed to provide reasonable as-
surance that assets are safeguarded,
that transactions are executed in
accordance with management's atr
thorization and are properly record-
ed, and that accounting records are
adequate for preparation of finan-
cial statements and other financial
information. The design, monitor-
ing, and revision of internal account-
ing control systems involve, anions.,
other things, management's judg-
ments with respect to the relative
cost and expected benefits of spe-
cific control measures.
The members of the Audit Conn
mince of the Board of Directors,
none of whom are employees of the
Company, are identified on page 46
Of this annual report. The Audit
Committee recommends independ-
ent accountants for appointment
b~ the Board of Directors, reviews
the services to be performed by the
independent accountants, and re-
ceives and reviews the reports sub-
mitted by them. It makes a deter-
mination regarding the possible
effect of the performance of non
auditing services on the independ-
ence of the principal independent
accountants. It also determines the
duties and responsibilities of the
internal auditors, reviews the inter-
nal audit program, and receives and
reviews reports submitted by the
internal auditing staff. In the cxcr-
cise of its responsibilities the Audit
Committee meets with management,
with the internal auditors, and with
the independent accountants.
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46
4 Examples of Published Management Reports
NCR Corporation
Report of Management
The Consolidated Financial Statements appearing in this Annual
Report have been prepared by management in conformity with gener-
ally accepted accounting principles and include, where required,
amounts based on the best estimates and judgments of management.
The integrity and objectivity of data in these financial statements are
the responsibility of management as is all other information included in
the Annual Report unless otherwise indicated. Financial information
elsewhere in this Annual Report is consistent with that in the financial
statements.
In fulfilling its responsibilities for integrity of data and safeguard-
ing assets, management employs a system of internal controls
including internal accounting controls which, considering the costs
involved and the benefits to be derived therefrom, are designed to pro-
vide reasonable assurance that NCR's assets are protected and that
transactions are appropriately authorized and recorded and summar-
ized properly. This system of control is supported by the selection of
qualified personnel, organizational assignments that provide appro-
priate delegation of authority and division of responsibilities, and the
dissemination of written policies and procedures. This is further rein-
forced by an extensive program of internal audits including follow-up
procedures that require responsive action by management.
The financial statements have been examined by Price Water-
house & Co., independent accountants. Their examination provides an
independent review of management's discharge of its responsibilities
insofar as they relate to the reported operating results and financial
condition of NCR. They obtain and maintain an understanding of NCR's
systems and procedures and perform such tests and other proce-
dures, including tests of the internal accounting controls, as they deem
necessary to enable them to express an opinion on the fairness of the
financial statements.
The Board of Directors monitors the internal control systems,
including the internal accounting controls, of NCR through its Audit
Committee. The Audit Committee is composed of directors who are not
officers or employees of NCR. The external auditors, internal auditors
and management have complete and free access to the Audit Commit-
tee, and the Committee periodically meets with each group to ensure
that each is properly discharging its responsibilities.
Donald L. McIntosh
Senior Vice President
Finance and Administration
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4 Examples of Published Management Reports
Occidental Petroleum Corporation
Management Responsibility for
Financial Statements
The management of Occidental Petroleum Corporation is
responsible for the integrity of the financial data reported by
Occidental and its subsidiaries. Fulfilling this responsibility
requires the preparation and presentation of financial
statements and other data in accordance with generally
accepted accounting principles which are consistently applied
in all material respects. Management uses internal accounting
controls, offers guidance through corporate-wide policies and
procedures and exercises its best judgement in order that such
statements reflect fairly the consolidated financial position,
results of operations and changes in financial position of
Occidental.
In order to gather and control financial data, Occidental has
established accounting and reporting systems supported by
internal controls. Internal control is maintained by: (1) the
selection and training of qualified personnel,(2) an appropriate
division of responsibility in all organizational arrangements,
(3) the establishment and communication of accounting and
business policies, and (4) an extensive program of internal
audits with prompt follow-up, when necessary, by appropriate
levels of management. In establishing systems of internal
control, management weighs the cost of such systems against
the benefits that it believes can be derived. Management
believes that its internal controls provide Occidental with
reasonable assurance that assets are safeguarded against loss
from unauthorized use or disposition and that the financial
records are reliable for preparing financial statements and
other data, and maintaining accountability for assets.
Arthur Andersen & Co., independent public accountants,
have been engaged to examine Occidental's financial
statements for the years ended December 31. 1979 and 1979.
Their report, which is included herein, is based on procedures
considered by them to be sufficient to provide reasonable
assurance that the financial statements are not materially
misleading and do not contain material errors.
The audit committee of Occidental's board of directors is
responsible for reviewing and monitoring the company's
financial reports and accounting practices to ascertain that
they are within acceptable limits of sound practice in such
matters. The membership of the committee consists of non-
employee directors. At periodic meetings, the audit committee
discusses audit and financial reporting matters with
representatives of financial management, the internal audit
George M. Cayce
Vice President and Controller
March 20, 1980
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4 Examples of Published Management Reports
TRW Inc.
Report of Management
TRW Shareholders
Management of TRW is responsible for the preparation of the accompanying
financial statements of the Company and its subsidiaries. The financial statements
have been prepared in conformity with generally accepted accounting
principles appropriate in the circumstances and consistently applied and, as
such, include the estimates and judgments of management The financial
statements have been examined by Ernst & Whinney, independent auditors,
whose report appears below.
The Company maintains a system of internal accounting control designed and
intended to provide reasonable assurance that assets are safeguarded and
transactions are executed and recorded in accordance with management's
authorization, The system is tested and evaluated regularly by the Company's
internal auditors as well as by the independent auditors in connection with
their annual audit.
The Directors of TRW have an audit committee currently comprised of three
Directors who are not members of management. The committee meets with
management, the internal auditors and the independent auditors in connection
with its review of matters relating to the Company's annual financial statements,
the Company's internal audit program; the Company's system of internal
accounting controls; and the services of the independent auditors The Committee
meets with the internal auditors as well as the independent auditors, without
management present, to discuss appropriate matters The Committee also
recommends to the Directors the designation of the independent auditors.
February 19, 1980 X % , ,,, i al
Ruben F Mettler Charles R Allen
Chairman of the Beard and Executive Vice President and
Chief Executive Officer Chief Financial officer
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4 Examples of Published Management Reports
Twentieth Century-Fox Film Corporation
TWENTIETH
CENTURY-FOX
FILM CORPORATION
The management of Twentieth Century-Fox Film Corporation is responsible for the integrity and
objectivity of the financial statements of the Company and its subsidiaries. The financial state-
ments on the following pages, including the notes, were prepared by the Company in conformity
with generally accepted accounting principles appropriate in the circumstances, and necessarily
include some amounts that are based on our best estimates and judgments. The financial informa-
tion in the remainder of this Annual Report is consistent with that in the financial statements.
The Company's practice has been to ensure the integrity of its financial reporting through the
use of generally accepted accounting principles and a comprehensive system of internal account-
ing controls. The system is designed to provide reasonable assurance as to the reliability of finan-
cial records and the protection of assets, and is supported by a staff of corporate auditors. The
system is further characterized by care in the selection, training and development of professional
financial managers, by organizational arrangements that provide for delegations of authority and
divisions of responsibility, and by the dissemination of accounting and business policies and pro-
cedures throughout the Company.
The financial statements have been examined by the Company's independent accountants in
accordance with generally accepted auditing standards. In connection therewith, the independent
accountants develop and maintain an understanding of the Company's accounting and financial
controls, and conduct such tests and related procedures as they deem necessary to render their
opinion as to the fairness of the financial statements.
The adequacy of the Company's internal financial controls and the accounting principles
employed in financial reporting are under the general surveillance of the Audit Committee of the
Board of Directors, consisting of three outside directors. The independent accountants and
internal auditors have free and direct access to the Audit Committee, and they meet with the
Committee periodically, with and without financial management present, to discuss accounting,
auditing, and financial reporting matters.
The Company has policy statements regarding, among other things, potentially conflicting out-
side business interests of employees, and proper conduct of domestic and international business
activities. We have developed and instituted additional internal controls and internal audit proce-
dures designed to prevent or detect violations of these policies. We believe that this provides rea-
sonable assurance that our operations are conducted in conformity with the law and with a high
standard of business conduct.
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4 Examples of Published Management Reports
Western Electric Company, Incorporated
The financial statements on the following pages, which
consolidate the accounts of Western Electric Company,
Incorporated and its principal subsidiaries, have been
prepared in conformity with generally accepted ac-
counting principles.
The integrity and objectivity of data in these financial
statements, including estimates and judgments relating
to matters not concluded by year end, are the responsi-
bility of management as is all other information in-
cluded in the Annual Report. To this end, management
maintains a highly developed system of internal ac-
counting controls and supports a program of internal
auditing to monitor compliance with the system. Man-
agement believes that this system provides reasonable
assurance at reasonable cost that the transactions of
the Company are executed in accordance with manage-
ment's authorizations and are recorded properly. This
system requires that the recorded assets he compared
with existing assets at reasonable intervals, and it pro-
vides reasonable assurance that access to assets is
permitted only in accordance with management's au-
thorizations. Management further seeks to assure the
integrity and objectivity of these financial statements
by the careful selection of its managers, by organization
arrangements that provide an appropriate division of
responsibility, and by communications programs aimed
at assuring that its policies, standards and managerial
authorities are understood.
These financial statements have been examined by
Arthur Young & Company, Certified Public Account-
ants. Their report, which appears on this page, expresses
an informed judgment as to whether management's
financial statements, considered in their entirety, pre-
sent fairly, in conformity with generally accepted ac-
counting principles, the Company's financial position
and results of its operations. In connection with their
examination of these financial statements, the auditors
have reported to management that their study and eval-
uation of the Company's system of internal accounting
control did not disclose any conditions that they be-
lieve to be material weaknesses. It is generally recog-
nized, however, that such study is based on selective
tests of accounting records and related data and there-
fore would not necessarily disclose all weaknesses
which might exist.
The Audit Committee of The Board of Directors,
which is composed of Directors (see page 32) who are
not employees, meets periodically with management,
the internal auditors and the independent auditors to
review the manner in which they are performing their
responsibilities and to discuss auditing, internal ac-
counting controls and financial reporting matters. The
independent auditors periodically meet alone with the
Audit Committee and have free access to the Audit
Committee at all times.
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51
4 Examples of Published Management Reports
Westinghouse Electric Corporation
Re rt of Management
The Corporation has prepared the
consolidated financial statements and
related financial information included in this
report Management has the primary
responsibility for the integrity of the financial
statements and other financial information
and for ascertaining that the data accurately
reflect the financial position and results of
operations of the Corporation The financial
statements were prepared in accordance
with generally accepted accounting
principles appropriate in the circumstances,
and necessarily include amounts that are
based on best estimates and judgments
with appropriate consideration to materiality
Financial Information included elsewhere in
this annual report is consistent with the
financial statements
The Corporation maintains a system of
internal accounting controls, supported by
documentation, to provide reasonable
assurance that assets are safeguarded and
that the books and records reflect the
authorized transactions of the Corporation
Limitations exist in any system of internal
accounting controls based upon the
recognition that the cost of the system
should not exceed the benefits derived
Westinghouse believes its system of
internal accounting controls, augmented by
its internal auditing function, appropriately
balances the cosbbenefit relationship
The independent accountants provide
an objective assessment of the degree to
which management meets its responsibility
for fairness of financial reporting They
regularly evaluate the system of internal
accounting controls and perform such tests
and other procedures as they deem
necessary to reach and express an opinion
on the fairness of the financial statements
The Board of Directors pursues its
responsibility for the Corporation's financial
statements through Its Audit Review
Committee which is comprised solely of
directors who are not officers or employes
of the Corporation The Audit Review
Committee meets regularly with the
independent accountants, management and
the internal auditors The independent
accountants have direct access to the Audit
Review Committee, with or without the
presence of management representatives,
to discuss the scope and results of their
audit work and their comments on the
adequacy of internal accounting controls
and the quality of financial reporting
We believe that the Corporation's
policies and procedures, including its
system of internal accounting controls,
provide reasonable assurance that the
financial statements are prepared in
accordance with the applicable securities
laws and with an appropriately high
standard of business conduct
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4 Examples of Published Management Reports
Xerox Corporation
Report of Management
The accompanying consolidated financial statements including the notes thereto of
Xerox Corporation and subsidiaries as of December 31, 1979 and 1978 and for the
years then ended have been prepared by management, which is responsible for their
integrity and objectivity. The statements have been prepared in conformity with
generally accepted accounting principles appropriate in the circumstances, and nec-
essarily include some amounts that are based on management's best judgments. The
financial information contained elsewhere in this Annual Report is consistent with
that in the financial statements.
Xerox maintains a system of internal accounting controls designed to provide
reasonable assurance that assets are safeguarded against loss or unauthorized use and
that the financial records are adequate and can be relied upon to produce financial
statements in accordance with generally accepted accounting principles. The concept
of reasonable assurance is based on the recognition that the cost of a system of internal
control must not exceed the related benefits. There are written internal accounting
and operating control policies and procedures that are communicated to the Com-
pany's worldwide operating units. Adherence to these policies and procedures is
constantly being evaluated by an extensive coordinated audit effort of our internal
audit staff and independent certified public accountants.
Xerox' accompanying consolidated financial statements have been examined
by Peat, Marwick, Mitchell & Co., independent certified public accountants, whose
examinations were made in accordance with generally accepted auditing standards
and included a review of the system of internal accounting controls to the extent
considered necessary to determine the audit procedures required to support their
opinion on the consolidated financial statements. The report of independent certified
public accountants appears on page 52.
The Audit Committee of the Board of Directors, composed solely of outside
directors, meets periodically with the Company's management, internal auditors and
independent certified public accountants to review matters relating to the quality of
financial reporting and internal accounting control and the nature, extent and results
of the audit effort. The independent certified public accountants have free access to
the Audit Committee.
In a business ethics policy that is communicated to employees annually, Xerox
has established its intent to maintain the highest standards of ethical conduct in all its
business activities. Ongoing review programs are carried out to ensure compliance
with this policy.
C. Peter McColough
Chairman and Chief Executive Officer Senior Vice President, Finance
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Mr. HYDE. Aside from the growing trend in the private sector,
internal controls are beginning to receive a lot of attention at the
State and local government level also. In fact, the New York Legis-
lature will consider a bill in the near future on internal controls in
government operations. The current draft of that bill requires man-
agement in the various State departments and agencies to analyze,
monitor, and annually report on the adequacy of their internal
control systems.
With the increased attention being given to internal controls in
private and State and local government sectors, I believe the pro-
posed Federal Managers' Accountability Act of 1981 becomes even
more significant as the key to reducing fraud, waste, and abuse in
the Federal Government.
As you may know, I sponsored a similar bill last session and
another this session called the Financial Integrity Act of 1981.
These bills are very similar; however, the Federal Managers' Ac-
countability Act of 1981 includes three different items I believe are
important since it gives the Congress direct oversight into areas it
presently does not have.
The first item, with which I concur, requires budget submissions
to the Congress by the President to include original amounts of
appropriations requested by each of the Offices of Inspectors Gen-
eral and all changes made subsequent to that original request until
final amounts submitted by the President.
The second item concerns the frequency of the report on internal
controls submitted by the head of each executive agency. Section
2(dXl) of the bill requires reports to be submitted by the agency
head for 2 years beginning at the end of 1982.
However, I believe continual monitoring and reporting on inter-
nal controls each succeeding year is essential to obtain the level of
assurance we seek that assets are safeguarded against waste and
abuse. I therefore recommend that the report requirement con-
tained in this bill be slightly modified to include annual reports
each succeeding year thereafter the date specified as the first
report date in this bill, as opposed to reports for only 2 years after
the passage of this legislation.
The third item requires the head of each agency to include with
appropriation requests a statement certifying that the request be
based on an accounting system that has been approved by the
Comptroller General.
The General Accounting Office (GAO) has raised a point concern-
ing this item. The GAO states that this item can be interpreted to
mean that appropriation requests might not be approved if an
agency's accounting system has not been approved by the Comp-
troller General. GAO reports to us annually that not all systems
have yet been approved though it continues to provide any assist-
ance agencies need.
Although I actively support the passage of the Federal Managers'
Accountability Act of 1981, I believe the GAO point is well taken
and would warrant consideration of a minor modification to that
part of the bill.
I concur with a GAO suggestion that a better approach might be
for the bill to require that when an appropriation is requested, the
head of an agency be required to report to the Congress on the
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54
status and progress made in having its accounting systems ap-
proved.
I have prepared suggested additions to section 4 of the bill to
incorporate this change appearing in the attachment to my state-
ment. This would give the Congress an opportunity to exercise its
oversight authority over individual agencies to see that their sys-
tems, including the internal controls contained in them, get ap-
proved by the Comptroller General.
Mr. BROOKS. Health and Human Services has a myriad of sys-
tems not yet approved. That could present a serious problem.
Mr. HYDE. It isn't asking too much of agency administrators to
know what their resources are and how they are being utilized. It
isn't asking too much to require those who administer Government
programs to be cost conscious, waste conscious, fraud conscious,
and to establish and monitor control systems that will give the
taxpayers an honest and effective return on their tax investment.
This vehicle, H.R. 1526, charts the course and provides the me-
chanics for accomplishing this. It stresses oversight of how well
public moneys are being spent, something we all talk about but see
very little of in practice.
In this congressional session, as I stated before, I have also
introduced similar legislation, the Financial Integrity Act of 1981,
H.R. 350. However, my primary concern is enhancing accountabil-
ity in the Federal Government by improving internal controls
through legislative mandate, as I have testified here today. I am
confident that if any bill passes it will be H.R. 1526, and so I would
appreciate it if the chairman would be so kind to consider me as a
cosponsor to the Federal Managers' Accountability Act of 1981.
We need answers to billions of dollars lost through waste, fraud,
and abuse. I think this is a reasonable and effective answer. Thank
you for listening to me.
[Additional material follows:]
Sec. 4. Section 215 of the Budget and Accounting Act, 1921 (31 U.S.C. 23), is
amended by inserting immediately after the first sentence thereof the following new
sentence: "The head of each department and establishment shall include with any
such requests for appropriations a statement (1) certifying that the funds requested
will be accounted for in an accounting system that has been approved by the
Comptroller General pursuant to section 112 of the Budget and Accounting Act of
1950, or (2) indicating the status and expected progress to be made, including
expected approval dates, in having the accounting system(s) of such department or
establishment approved by the Comptroller General and including the design of any
accounting system which is being developed or is to be developed (and any related
automatic data processing system development) which will account for the funds
which such appropriations are being requested."
Mr. BRooKS. We welcome your support. I am delighted that you
indicate a keen awareness of the problem. I hope that awareness
can be reflected throughout Congress, because passage of this bill
will take some doing. It is never easy to get anything like this
passed.
Many people also talk about savings; but when you try to imple-
ment controls, everybody is mad at you. We have been doing that
for 20 years, saving billions of dollars of Federal money. I never
saved a dime but what there was not somebody complaining bitter-
ly about it-Democrats, Republicans, or both.
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The members of this committee have steadfastly tried to protect
what is the public right, their right to good and efficient govern-
ment.
I have a couple questions for you. Fraudulent use of Government
funds can result in the loss of thousands, even millions, of Federal
dollars. How do you feel this bill will eliminate or reduce such
fraud?
Mr. HYDE. I think it highlights, underscores, turns the search-
light on these internal control systems. We have had requirements
that these be in place under the Budget and Accounting Proce-
dures Act of 1950. We passed Inspectors General legislation in
1978.
OMB has had a financial priorities program since 1979. Despite
that, the problems of fraud, waste and abuse go on and on.
In answering the question ,Congressman Horton I put earlier " Do
we need another law?" Is this just more paper work? I can only say
the laws we have have not been effective. We need a means to
enforce the laws which are on the books.
This legislation requires that these internal controls not be
shoved into the corner of the desk. They have to be evaluated and
we get reports. It makes our job of oversight, the most neglected
aspect of the entire congressional process, easier by facilitating
access to reports and reminding us of the constant need for con-
tinuing oversight.
Therefore, I think this is useful. It focuses attention on enforce-
ment of the requirement for effective internal controls.
Mr. BROOKS. Why do you feel this legislation is necessary inas-
much as it is an inherent function of management to maintain
controls over the resources entrusted to them?
Mr. HYDE. They have not been doing it. If this does not work, the
next step is civil penalties to agency heads; if that does not work,
criminal penalties.
However, when you deal with billions of dollars you should be
mindful of how they are being administered as to waste and fraud.
We all know horror stories. I can tell you some and you can tell
me some, and there are some in these reports. It covers neglect,
misplaced emphasis, and so on. I think this bill will focus the mind
of every agency and department head on the need to look at these
things and to report to us, the President, and the public. It is
disclosure of a very important sort.
Mr. BROOKS. Thank you.
Mr. Horton?
Mr. HORTON. First, Henry, I would like to congratulate you on
introducing your bill and also for taking your time. to be with us
this afternoon to testify. I want to indicate my support as you have
already indicated your support for this type of legislation. I think it
is important.
One of the questions I wanted to ask was this: This bill, as well
as yours, provides that the Comptroller General would have the
authority to establish a system of reporting on internal controls.
Why would you put that authority with GAO rather than OMB,
which in theory is the management arm of the executive branch?
Could it be just as effective with OMB?
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Mr. HYDE. Let me first say, Mr. Horton, that my interest in this
legislation generates from the interest of Mrs. Nancy Short of my
staff, who has made this a project of hers and made it my project. I
thank her for her interest in this very worthwhile piece of legisla-
tion.
I think the GAO should be more independent than OMB. OMB is
a very professional agency but it is politically appointed and has a
political function. The GAO should be and is independent and it
would be more clinical, it would seem to me, in approaching these
problems.
The answer really is OMB and the GAO have the resources, the
brains, and the energy to do this together. I am sure they can work
together in resolving these problems.
The GAO strikes me as the appropriate agency because it would
be a little more clinical.
Mr. HORTON. The only problem is that the GAO is an arm of the
legislative branch and not an arm of the administrative or execu-
tive branch. GAO does have this capability. Whether or not it
would be effective is another question.
Mr. HYDE. I would view it as an extension of our appropriations
function. We have appropriated the moneys. We need to see how
well they are being used for the purposes for which they were
appropriated.
Oversight is a congressional function. GAO best can help us in
exercising this oversight.
Meanwhile we are asking the agency heads to do the oversight
on their own agencies and then provide us with a look at it. There
is a role for both OMB and GAO here.
Mr. HORTON. I understand that OMB is working on a draft
circular which would in effect accomplish many of the objectives of
this bill. If they could come up with such a circular to cover the
same ground as the bill, would you still favor approval of legisla-
tion? If so, why?
Mr. HYDE. Yes. I think legislation has more impact than a circu-
lar or an Executive order or anything of a lesser standing. I think
only legislation has the force of law. Mandating of the disclosure to
the President, to the Congress, and to the public requires the
dignity and the status of law rather than any lesser mandate.
Mr. HORTON. It seems to me, too, this is an important matter. If
you have legislation, then it will not be changed unless they come
back to the legislature, the Congress, to do it.
If, on the other hand, they do it by circular, somebody can
change the circular next week or a year from now. You then have
nothing.
I would agree with you, therefore.
Mr. HYDE. I would like to be able to answer somebody when they
ask, "What are you doing about the billions of dollars lost in fraud,
waste and abuse?"
I can say, "We are told the executive agency issued a circular."
That is not an answer. It is our responsibility.
Mr. HORTON. Thank you.
Mr. BROOKS. Mr. Butler?
Mr. BUTLER. I, too, congratulate you on your legislation. It seems
to me it is a very important step.
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Your suggested amendment, which I think tightens it up, also
would be an improvement.
You took a hard line on GAO versus OMB. I judge if it was the
wisdom of this subcommittee that it was appropriate to shift this
function to the Office of Management and Budget your feelings
would not be hurt so that you would withdraw your support?
Mr. HYDE. I have great confidence in OMB, particularly under
Mr. Stockman, who is well-known for being the enemy of fraud,
waste, and abuse. No, I have no hangup on GAO versus OMB. I
think there is a role for both agencies to play in this.
Mr. BUTLER. The way this legislation is written it is the head of
each executive agency which the Director of OMB determines to be
covered. There is no agency that you can determine is not covered
by this, is there?
Mr. HYDE. Any agency dealing with public funds should account
for those funds. They should have an internal control system.
Someone has to look at that and say yes, it is adequate.
Mr. BUTLER. We had the Legal Services Administration before us
the other day at a Judiciary Committee hearing. They were sug-
gesting they were not under any kind of suggestions from OMB. It
is your intent that that agency and others who are semiautono-
mous should be covered?
Mr. HYDE. And those quasi-autonomous. Underscore that em-
phatically.
Mr. BUTLER. Yes. I think we cover both of those, at least halfway.
We have the other problem, it seems to me, that you and I on
the Judiciary Committee, as well as the chairman, frequently see
that an Attorney General has all of these areas of compliance and
problems. Would it not be more appropriate, or is there some way
we can say, for example, that the Immigration Service, within its
own Department, can evaluate itself as well as the department
head? There are many subdepartments and divisions which ought
to examine themselves and be required to certify. Will that ask too
much?
Mr. HYDE. My own feeling on the Immigration and Naturaliza-
tion Service is that it is almost a terminal case. It will require the
total attention of many skilled people to shape up that agency. I
would hope the provisions of this legislation would apply to that
agency as well.
Mr. BUTLER. No. Should not that agency develop its own internal
examination procedure rather than putting it on the Attorney
General who has to look after five or six divisions?
Mr. HYDE. No. I want someone looking over the Immigration and
Naturalization Service's shoulders, both shoulders, at all times.
The Justice Department seems to be appropriate.
Mr. BUTLER. Thank you.
Mr. BROOKS. Thank you again.
Mr. HYDE. Thank you, Mr. Chairman.
Mr. BROOKS. We appreciate your bringing in your study as well.
Our next witness is John Lordan, Chief of the Financial Manage-
ment Branch, Office of Management and Budget. He is a certified
public accountant, a graduate of Suffolk University, with advanced
degrees from Boston College and Harvard University.
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Mr. Lordan began his Government career with the General Ac-
counting Office. He is active in a number of professional associ-
ations, having served on the governing bodies of the American
Institute of Certified Public Accountants, the Association of Gov-
ernment Accountants, and the National Council on Governmental
Accounting.
Mr. Lordan has written numerous articles for professional jour-
nals, and has received a number of Government and professional
awards, the most recent of which was OMB's exceptional achieve-
ment award.
A native of Massachusetts, he lives in Columbia, Md., with his
wife and two children.
Mr. Lordan has been a source of inspiration to us for many
years. We are delighted to have you here.
STATEMENT OF JOHN J. LORDAN, CHIEF, FINANCIAL MANAGE-
' MENT BRANCH, OFFICE OF MANAGEMENT AND BUDGET
Mr. LORDAN. Thank you very much.
Mr. Chairman and members of the committee, I am pleased to
have an opportunity to meet with you today to discuss H.R. 1526,
the Federal Managers' Accountability Act of 1981. This bill has as
its primary objective the improvement of internal control systems
to prevent fraud, abuse, and waste in Government, an objective we
wholeheartedly support.
To date, much of our attention at OMB has been focused on four
major components of the President's program for economic recov-
ery-spending restraint, tax-rate reduction, regulatory reform, and
monetary stability.
We view efforts to improve the efficiency of Government as a
vital corollary to spending restraint. Simply stated, the Govern-
ment must do more with what it has, and the elimination of fraud,
abuse, and waste will make that possible.
Let me tell you about some of the things the administration is
doing that run parallel to the objectives of H.R. 1526.
First, as directed by the President, we are putting together a top
level interagency task force to attack waste and fraud. The task
force will be made up of the statutory Inspectors General, the
Justice Department, and other key audit and investigative officials.
The group will be chaired by OMB.
Second, the President has pledged to appoint as Inspectors Gen-
eral highly trained professionals who will spare no effort to elimi-
nate waste and fraud. OMB will provide support to these officials
in every way possible.
Third, we now have under consideration a new OMB circular,
"Internal Control Systems." The circular fills out the concepts of
internal control in more detail than they are described in H.R.
1526, and provides procedural steps for seeing to it that effective
systems of internal control are set in place.
The draft circular was developed by an interagency group, com-
prised of representatives of 22 major departments and agencies, as
well as representatives of the General Accounting Office. Here is
what the proposed circular would do:
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Each department and agency head would issue an internal con-
trol directive tailored to their particular program and organization.
OMB would review and approve these directives.
Administrative mechanisms would be set up in the agencies,
calling for reports on internal control breakdowns and disciplinary
action against responsible individuals.
Vulnerability assessments and risk analyses would be made of
all major programs and organizations.
Audits would be made of internal control systems and of agency
compliance with them.
The internal control responsibilities of each top manager would
be pinned down.
Perhaps most important of all, performance appraisals, on which
pay and bonuses are calculated, would include consideration of
internal control issues.
In time, additional guidelines would be added to the basic circu-
lar, giving detailed guidance on such areas as fund control, cash
management, debt collection, procurement, grant management,
automatic data processing, and payments systems.
While the requirements of the draft circular go well beyond
those in H.R. 1526, we believe they are entirely consistent with the
objectives of the bill. In fact, the draft circular could be said to
form a nucleus of the "system of reporting and guidelines" called
for by section 2(d)(3) of the bill.
This brings us to one feature of the bill that we express reserva-
tions about. Section 2(dX3) would require the Comptroller General
to establish a system of reporting and guidelines for the agencies
for making evaluations of their systems of internal control. Section
2(dX4) would require agencies to establish internal control systems
in accordance with standards prescribed by the Comptroller Gener-
al.
We believe both these functions-establishing guidelines and pre-
scribing standards-are executive branch responsibilities, and
ought not to be delegated to the Comptroller General.
Accordingly, we recommend that the duties prescribed in sec-
tions 2(d)(3) and 2(dX4) be assigned to the Director of OMB. This
would keep the responsibility for internal control focused where it
belongs, in the executive branch, and give Congress the opportuni-
ty to hold us fully accountable for the adequacy of internal control
systems.
We would, of course, work very closely with the Comptroller
General in developing guidelines and standards, just as we did in
? developing the draft circular referred to earlier.
There are two other features of the bill that cause us some
concern. One is section 3(k), which would require the President to
include in the supporting detail accompanying the budget a state-
ment of the original appropriation request of each Inspector Gener-
al, any changes made by the head of the agency, any further
changes made before submission of the budget to the Congress.
We believe this provision represents a serious breach in the
concept of executive budgeting, and could set an unfortunate prece-
dent in other areas of budget decisionmaking.
We believe the idea of a President's budget, which he alone
submits to the Congress, and which his administration justifies in
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detail, is an important tool in control over Government spending.
Routine exposure of the details of how Presidential budget deci-
sions are arrived at could have a chilling effect upon the process.
Of course, as you know, much of this detail is available from the
agencies on request of the Congress. Our concern about its routine
provision is the potential this holds for eroding the discipline of the
system.
Our next concern is one that we understand is shared by the
General Accounting Office. It involves section 4 of the bill, which
would require department and agency heads to certify that their
budget requests are based on accounting systems that have been
approved by the Comptroller General.
As you know from your work with the various agencies in trying
to move this legislation forward for some 20 years, about 40 per-
cent of these systems have not yet been approved, despite the
requirement for approval in the Budget and Accounting Act of
1950. This is a situation we intend to correct, but, in the meantime,
many department and agency heads would just not be able to make
the certification called for by section 4. We suggest, therefore, that
this section be deleted from the bill or that it be modified to
provide for a statement on the status of accounting system approv-
al, instead of a certification.
With these caveats, Mr. Chairman, let me repeat our strong
support for the objectives of the bill. We believe we can achieve
these same objectives administratively, and we are committed to
doing so. However, if the Congress believes that legislation on
internal control is appropriate, we hope our views on H.R. 1526
will be taken into account. Similarly, we would welcome any
thoughts from you or your staff on how our administrative efforts
on internal control could be improved.
Mr. Chairman, that completes my statement. I would be glad to
answer any questions you may have.
Mr. BROOKS. Thank you very much for an interesting and good
statement. I notice at page 4 your concern about the requirement
that the Comptroller General prescribe guidelines for use by the
Federal agencies in making evaluations of their systems of internal
control.
We have been trying to get the Comptroller General to get the
agencies' accounting systems approved over the years. He is slowly
getting that done, but some of the agencies drag their feet. They
dragged their feet under Republican administrations and dragged
their feet under Democratic administrations, and they are surely
dragging their feet now if you don't put a gun to their heads. This
is the nature of the situation. If you think otherwise you are
wrong.
I have been here 29 years and agencies are still not getting their
systems approved.
You mention the Inspectors General. We hope we get some ap-
pointed soon. We had a lot of them and they all left at the request
of the new administration. I remember that bunch. One came to
work in the Federal Government under Nixon; six came to work
under President Eisenhower. They came to work under various
Presidents and were selected on the basis of their capability. They
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eliminated some fraud and waste and they had competence to do
program evaluation.
These people were not picked off the street because they were
Carter Democrats. They were not. You cannot easily get people as
well qualified as those who were serving as Inspectors General in
the prior administration.
If political plums are made of these jobs, and the Reagan admin-
istration selects people because of their support for the President,
that will not do the job. It would be counterproductive. I don't
think that is what he wants to do.
I hope the staff recommending Inspectors General will select
people in accordance with their qualifications.
I talked to President Reagan about it. He said he would perhaps
reappoint many of those people who were serving as Inspectors
General in the last administration. I think most of them have been
interviewed. I think they have not yet decided how they will send
them down to Congress. If they have made appointments to any of
the Inspector General positions, I am not aware because I have
been out of town. However, the independence and credibility and
acceptance of Inspectors General was jeopardized to some extent
when the President fired all the Inspectors General. He had a right
to do that, but if the Inspectors General are performing their job
and have done nothing wrong and they are all run off-how would
you like to be the wrong next person taking the job? You can get a
little nervous. If an Inspector General is working on two programs
to eliminate fraud and suddenly he is no longer on the payroll,
that creates a pretty difficult situation for these people who will be
appointed to the job.
I would hope the administration will get Inspectors General ap-
pointed soon. This committee passed the legislation creating those
offices, and we are intimately familiar with it. During this Con-
gress we will take up and pass legislation to create an Inspector
General in the Treasury Department and the Defense Department,
where $33 billion in additional appropriations have been requested.
They will perhaps need tremendous Inspector General facilities in
the Defense Department to keep the bandits from stealing all of
that $33 billion.
They have been on a big high, and they have not even had a
drink, since they heard about the $33 billion.
President Carter was going to give them an additional $19 bil-
lion. President Reagan will give them $33 billion instead.
The appropriations committees will give them this money. The
Armed Services Committee will wonder whether that is enough.
That is the pattern and practice, and it has been that way for the
past 20 years.
As to the question whether Inspectors General get enough
money, sometimes it is a little difficult to get details about their
budget requests from the agencies. They squirm a little when you
ask them the amount the Inspector General requested for his staff
to do the job required in the X, Y, and Z agency.
They say, "You know, those requests came from the President.
They amounted to x dollars."
They are also reluctant to say that the Inspector General might
have asked for $10,000 and the agency might have approved it. But
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then the OMB might say, "All you can have is about $6,000." Then
a 10 percent cut across the board would drop it to $5,400.
Then the agency head might decide to pick up points at the
Cabinet meeting and cut it another $2,000.
He might say, "I had no trouble cutting my budget. We made
another 10 percent cut." He then eliminates Inspectors General a
little more. That makes it pretty tough because those are the
people who might save you many times the investment.
Just as I explained to Congress, if they want to cut out all the
money the Government Operations spent, it is all right. We saved
over $2,000,200,000 for the Government last year. If they don't
think that is a good return on the money-and obviously it is a
good return-but if they do not want to make that kind of return
for those who pay taxes, that is their choice. I like it and I think it
is worthwhile.
If Inspectors General do not have an adequate staff and they are
not protected among the agencies and the OMB, then you might
wind up with an Inspector General who has one secretary and two
clerks. "We have a tremendous Inspector General Department, one
of the best in the West. It has four people in it." They couldn't
catch scat. We want to avoid that possibility.
If you do not have an effective Inspector General Office operat-
ing in all of these agencies, we want you to catch hell for it. I want
all the tools necessary to haul you up on the carpet and work you
over. That is the reason we need this information.
People like Congressman Butler, and Congressman Horton are
dedicated to efficiency and effectiveness. They are not partisan in
this effort. However, they expect Inspectors General to be doing a
good job, financed adequately to save money and eliminate fraud.
That is the name of the game. That is the only way we can do it if
we are to provide the services that this country requires.
We cannot give this country the services required in various
fields if we waste 20 percent, 10 percent, 30 percent, 40 percent of
the available money. It cannot be done.
Mr. LORDAN. Yes, sir.
Mr. BROOKS. I don't think it will hurt you. I understand why you
would be a little reluctant for us to know, but generally you can
get that information.
Mr. LORDAN. Yes, sir.
Mr. BROOKS. Why not just forthrightly say that you would pro-
vide it?
Somebody in the Inspector General's Office, somebody who typed
the document, somebody who saw the document, somebody will tell
us the amount of the original request in the X, Y, Z agency, and
the OMB and the executive department cut it to the bone because
they were tired of it. The Inspector General was finding too many
things the agency didn't like.
They might even find-I cannot believe it-but they may even
find a Republican doing something wrong. It is not likely now
during these next few months because things are so rosy, but after
things get settled down they may, and I wouldn't want them just to
eliminate an Inspector General because he turned up one of those
dedicated souls doing something wrong.
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Mr. LORDAN. The concern expressed has to do with the potential
this might have for establishing a precedent for other areas where
Congress has special concern. Environmental issues, safety issues,
and others are examples.
Mr. BROOKS. I understand.
I think there are several ways to skin that cat. I have always
thought that if you ran OMB you would not have to worry about
anything. If Stockman will understand-and he seems to be getting
the hang of it, though we will see how he does-but they approve
the budgets. They can establish the level of efficiency required to
allow a budget to be submitted in the name of the President to the
U.S. Congress. Very often in the OMB they are too reluctant to
utilize that power.
I worked hard on McIntyre. He came along pretty well and was
getting the hang of it. However, it is tough.
You have to understand that in any government, when the head
of the OMB begins to make recommendations to the people run-
ning the agencies, they begin to say, "He is telling us how to run
our business?"; they do not appreciate that. They don't like OMB's
recommendations and respond to them officially, "We appreciate it.
Thank you. We are working on it. We have it under study. We are
making progress in this area." However, the bottom line is that
they are not doing anything they don't want to do. This happens
with the Democrats and it happens with Republicans.
If the President does not watch it very carefully, one set of
appointees will undercut another. This is a real difficulty. It means
that the OMB has to keep a very close eye on these budgeted items
and on every one of these agencies. OMB must see the agencies are
efficiently run. If not, you pull that chain on them.
Don't go to the papers. You don't have to go to the newspapers
and say what the agencies are doing. Just tell them, "You blew
this money on this deal. You have to get rid of those people. Clean
up that operation. Dump those regional managers who are incom-
petent." Incompetence is just as dangerous as corruption.
"I didn't mean to do it." Well, "I didn't mean to do it" is just as
dangerous if the man shoots you. Who cares why he shot you? He
just made a mistake. He didn't know the gun was loaded. He
misunderstood. He thought you were somebody else. That has no
bearing whatsoever if you are lying there bleeding to death.
That is what I think about the difference between incompetence
and corruption. You have to eliminate it.
Is there any reason why an agency head could not give a fair and
objective statement on the adequacy of the agency systems as
required by that section 2 on internal auditing?
Mr. LORDAN. We believe it would be quite possible for such a
statement to be submitted. Some of the agencies have expressed
concern about the expression of opinion on the adequacy of sys-
tems. That is a technical concern similar in some respects to the
one raised by the Comptroller General with regard to section 4
where it calls for certification of the adequacy of systems.
Except for that small distinction in language, I think it should be
quite possible for the agencies to submit a report on the adequacy
of their systems.
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Mr. BROOKS. I had a couple of questions as to the Comptroller
General being the man to design these guidelines. He has been
working on guidelines for some years. Forty percent of the agencies
have agreed with him.
Mr. LORDAN. Yes.
Mr. BROOKS. The only reason the others have not is because they
have been effectively dragging their feet. It is not impossible to
work under those guidelines. Now they come in and cry to you and
say, "We have trouble doing it."
They never fight you on the main issue. They are too smart for
that. They say, "Lord knows we want to do this. It is essential that
we get the best possible accounting procedures lined up. We are
dedicated to it and committed to it. We will do it. You can count on
it."
However, they never say when. "We are working on it." They
will say, "We have a hand-picked, blue-ribbon and gold-plated com-
mittee working on this now. It has been working on it for about 10
years. They don't tell you that, but they will work on it forever.
The only way you can get them to do it is to put the heat to them.
Tell them they have 30 days, 45 days. Tell them to get with it.
Send their top accountants down there and look at the plans with
the GAO and get a resolution of their accounting procedures.
I am not an accountant and I am not trying to dictate how they
do it. All I know is that they should reach accord. Forty percent of
the agencies have done it. OMB can have input into the GAO.
GAO has worked with OMB. Elmer Staats has tried to work with
OMB in improving accountability practices. OMB over the years
has always given him lip service, sometimes help, but often they
have been slow to require agencies to cooperate.
You can pass all the laws you want, but if the OMB lets the
agencies get away with noncompliance, the agencies still thumb
their noses at you. They are not unpleasant about it. That is just
the way it is.
Mr. LORDAN. The point is well taken about the role of the Office
of Management and Budget. I have served with the General Ac-
counting Office and worked closely with them at OMB. Of course, I
have worked with former Comptroller General Elmer Staats.
The precedent of the accounting systems approval process, where
the standards are set by the General Accounting Office, and agen-
cies submit to them for approval, has not been an entirely success-
ful process. We think perhaps a better analogy can be drawn in the
internal control area, to the process of approving funds control
regulations of the agencies, responsibility vested in the Director of
OMB by the Antideficiency Act.
We recently got the agencies to resubmit their systems for ap-
proval and approved the fund control systems of the 30 major
departments and agencies. We think that process worked well and
it can serve us well with regard to other areas.
Mr. BRooKs. When did you finish that?
Mr. LORDAN. It was completed in July of the past year.
Mr. BRooKs. You think the problem can be handled administra-
tively. Why do you think the agency will follow the OMB guide-
lines on internal control when in recent hearings of this subcom-
mittee the GAO testified that the agencies were not following
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guidelines OMB put out for the resolution on audit findings? That
is a fact. They have not done it.
Mr. LORDAN. The points raised by the GAO in that report are
currently under review. Certainly there has been, as is always the
case, some failure on the part of the agencies fully to comply with
the standards in Circular A-73. However, the GAO acknowledged
in its report that there has been substantial change in the proce-
dures of the agencies for tracking audit findings so the unresolved
amount can be determined.
We see the implementation problem as being primarily one of
phasing-in what is a considerable change in the practices of the
departments and agencies.
Congress, in passing legislation with regard to the resolution of
audit findings, Public Law 96-304, provided until the end of fiscal
1981 for the current backlog to be eliminated and provided a 6-
month period of resolution for findings thereafter.
I think that acknowledges that there is a time factor involved
and it does take some time to eliminate the huge backlogs which
existed when this committee highlighted that very serious problem
some time ago.
Mr. BROOKS. They sure work slowly, though. It is not just the
agencies. Some of that blame has to come down on OMB.
They have new personnel in charge at the agencies now. OMB
needs to follow through with the new personnel. You admit the
problems are there. All you have to do is call the top officials in
and explain this to them.
Mr. LORDAN. Yes, sir.
Mr. BROOKS. Mr. Lordan, I have several questions that I would
like to submit to you in writing for inclusion in the hearing record.
[The questions and submissions follow:]
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1. The Budget and Accounting Act gives the Comptroller
General the duty to approve agency accounting systems.
Wouldn't he also be the best person to develop
standards of internal accounting for the agencies and
to establish guidelines for evaluating their systems
for the agencies as required by this legislation?
Answer. Agency experience with regard to GAO accounting
standards have not been entirely satisfactory. As you know,
almost 40% of the agency systems have not yet been approved
by GAO, despite the approval requirements of the
Budget and Accounting Act amendments of 1950. This
40% includes some of the biggest systems in the
Government, most notably those of the Department of
Defense and the Department of Health and Human Services.
We believe a better model for internal control standards and
guidelines might be the process by which agency fund control
systems are developed and approved. Under the authority of
the Antideficiency Act, OMB issues fund control
standards in Circular A-34, "Instructions on Budget
Execution." Working within these standards, agencies
develop detailed systems of control, and submit the
systems to OMB for approval. The 30 largest departments
and agencies recently were asked to update and resubmit
their systems to OMB. All 30 systems were submitted and
approved within an 18-month period.
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OMB worked very closely with GAO throughout this process.
We believe, however, that it is more appropriate to have any
internal control standards developed within the executive
branch, rather than the GAO, a legislative branch agency.
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2. Do you see any reason why an agency's Inspector General
should not be responsible for investigating allegations
that employees provided false or misleading information
in connection with the preparation of the annual report
required by this legislation?
Answer. We believe the Inspectors General already have
authority to investigate allegations of employee misconduct
in the preparation of official agency reports. We see no
reason why that authority would not apply to reports pre-
pared in connection with H.R. 1526. Several agencies have
questioned the need to specify the Inspector General authority
in such detail in this legislation.
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3. Comptroller General Staats testified last week that the
provision for requiring the agency head to certify that
the system had been approved by the Comptroller General
is unduly restrictive. Are you in agreement with
General Staats on that point? Why, or why not?
Answer. We agree with former Comptroller General Staats.
The bill would call for a certification that an agency's
budget request was based on an approved accounting system.
As discussed in connection with question 1, many agency
systems have not yet been approved. It is not clear from
the language of the bill how the budgets of these agencies
would be handled. We agree with the former Comptroller
General that a better approach would be to call for a report
to the Congress on the status of accounting systems approval.
Such a report is already submitted to the Congress on an
annual basis by the GAO.
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4. The bill requires that the controls established by the
agencies shall provide reasonable assurances that (1)
all obligations and costs are in compliance with law;
(2) all funds and property are safeguarded against
waste or unauthorized use; and (3) all revenues and
expenditures are properly recorded and accounted for.
Do you find these reasonable standards that any agency
could comply with?
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Mr. BROOKS. Mr. Horton?
Mr. HORTON. I have a number of questions, Mr. Lordan. I would
like to submit them to you and perhaps you can submit your
responses for the record.
[The questions and submissions follow:]
1. I understand that OMB last year formed a task force on
internal controls. What specific problems did the task force
consider and what remedies did they recommend?
B. Does this legislation contradict any of their findings or
recommendations?
Answer. The Internal Control Task Force was formed to look into
potential weaknesses in agenny systems of internal control that
had been highlighted in a series of General Accounting Office
reports to the Congress, and in reports of the Inspectors
General. The Task Force recommended issuance of an OMB Circular
on internal control, and developed a draft circular, "Internal
Control Systems."
A. No formal task force position was taken on H.R. 1526.
However, a subcommittee of the task force reviewed
similar legislation introduced in the 96th Congress. The
subcommittee recommended against such legislation on the
basis that administrative action was more appropriate and
would involve less paperwork.
B. H.R. 1526 differs from the draft circular recommended by
the task force in some repects, but both are consistent
with the task force view that some form of central
guidance on internal control systems is desirable.
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2.
I understand that a proposed
circular on internal
controls
is in the works and that the comment period on it
has
recently expired. If H.R. 1526 becomes law, would
OMB
proceed with that circular and, if you do, how would it
differ from the thrust of this bill?
A.
Would this bill be duplicative of the OMB effort to
strengthen internal controls?
B.
What, in your view, would both the circular
legislation mean in terms of paperwork for
Would it mean more paperwork?
and
the
the
agencies?
Answer. If H.R. 1526 becomes law OMB would consider issuance of
a Circular to implement it. Such a Circular would, of course, be
consistent with the legislation. It would undoubtedly differ
from the presently proposed draft Circular in some respects, but
the basic thrust could remain the same.
A. H.R. 1526 and the draft Circular cover the same basic
subject, aqency internal control systems, and naturally
are somewhat duplicative.
B. The draft Circular was developed with a view toward
minimizing the paperwork burden it would impose on the
agencies. This was done by
-- requiring reports to agency heads on an exception
basis; i.e., only where major breakdowns in systems
occur
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H.R. 1526 attempts to hold down paperwork by calling on
the Director of OMB to identify the agencies to which
its requirements would apply. This would permit the
Director to exclude many smaller agencies where the value
of an annual report on internal control might not be
commensurate with its costs. It should be noted,
however, that the reporting requirements of H.R. 1526 are
more extensive than those set forth in the draft
Circular developed by the interagency task force. For
example, the bill would require
-- an annual report on the adequacy of all systems of
financial and administrative control
-- an "opinion" on the adequacy of all systems, a
requirement that could entail considerable analytical
work by the agencies
a separate "certification" that would be submitted as
part of an agency budget submission, dealing with
accounting systems approval.
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3.
How
and
many
many agencies are we talking about, bo
the bill? How would 0MB determine whi
agencies would be covered by this bil
th for the circular
ch agencies and how
l?
A.
B.
So that would mean how many new report
What would be the cost of that paoerwo
s?
rk?
C.
In your view, do the benefits of this
outweigh the costs involved?
kind of reporting
Answer. No decision has been made by the new Administration with
regard to the issuance of an 0MB Circular, nor with regard to its
coverage. The extent of coverage, under either H.R. 1526 or a
Circular, should be determined on the basis of the costs of
compliance vs. the potential benefits to be derived.
A. If all executive branch departments and establishments
were covered, this could involve several hundred reports
a year. If it were limited to the major agencies that
make up 90% of the budget and staff of the Federal
Government, it would he more like 30 agencies.
B. Estimates of costs of compliance are not now available.
It appears, however, that the costs of compliance would
be greater under H.R. 1526 than under the draft
Circular for the reasons outlined in the answer to
question 2.B.
C. This is a judgment that the Congress will have to make on
H.R. 1526; and the Administration, on the draft Circular.
Additional agency consultations on the subject are taking
place now.
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75
4. I understand your interest in protecting your turf in the
Executive Branch, but other than that concern, what other
substantive obiections do you have about placing in GAO the
authority to establish a system of reporting and guidelines
for the agencies?
A. What negative impact would that have on OMB?
B. Why do you feel that this particular provision would give
GAO any real sense of direction over the Executive
Branch?
C. If we reversed the language in that provision and gave
OMB the authority to establish the system in consultation
with GAO, you would still feel GAO looking over your
shoulder, wouldn't you?
Answer: The emphasis of H.R. 1526 is on establishing that
internal controls are a part of management responsibility. The
bill calls for a report from the head of a department or agency
as a mechanism for highlighting the importance of internal
controls in the overall management of Executive Branch
operations. It seems incongruous, therefore, to place the
responsibility for establishing internal control standards and
quidelines in the GAO, a Legislative Branch agency. We think
this responsibility would be more appropriately placed in the
Executive Branch.
A. Placing the responsibility for establishing internal
control standards and guidelines in the GAO would have no
negative impact on OMB. It would, however, unnecessarily
blur the lines of responsibility for Executive Branch
management.
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76
B. We are always concerned about measures which blur lines
of responsibility in Executive Branch management
including internal control over its operations.
C. We would have no objection to (',P.O oversight as the rAO
assists the Congress in its oversight role. We would
welcome their oversight and we would look forward to full
consultation with them, in the same spirit of cooperation
that has been shown to date in the development of the
draft circular on internal controls.
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77
5. I understand that OMB considers Section 3 a threat to your
budget discipline. Would you elaborate on that and tell us
why you believe that this section would establish a
potentially dangerous precedent?
A. If an agency head feels that he has substantive reason to
cut the IG budget request, would he still not be able to
make his case in the give and take of the normal budget
process?
Answer. Director Stockman, in response to a similar question
during his confirmation hearings, said
"As in the past, OMB supports the sharing of agency
budqet requests with the Congress after the President's
budget has been transmitted to Congress. Under existing
law and 0MB Circular No. A-10, after the President's
budget is transmitted to the Congress, the heads of
Executive Branch agencies may provide information
concerning their budget requests to the President when
the Congress asks for this information in connection with
its consideration of the President's budget. The
information may be obtained directly from an agency upon
the request of a Congressional committee with
jurisdiction. These procedures allow an agency to tailor
its response to the specific needs of the committee
making the request. We doubt that providing agency
budget information in the standard format you suggest
could be as useful, because different committees like to
receive information in differing formats. 0MB has also
made a practice of not interposing itself between the
agencies and their Congressional committees.
"Moreover, we do not believe that providing this
information routinely for all agencies will enhance
communication between the Legislative and Executive
Branches or control over the budget. Greater emphasis on
agency budget requests would shift discussions of the
President's budget from major budget issues to
explanations of differences between Presidential
recommendations and the more parochial recommendations of
the various departments and agencies. This can only
serve to cause confusion and divert attention from
viewing budget requests in the context of national
priorities, economic conditions, and overall budget
totals."
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78
6. How do the agencies feel about paragraph (5)(A) on page 3,
where the IG of an agency would be required to investigate
any allegation that an employee provided false or misleading
information in connection with internal report?
A. Could this language in any wav discourage full and
accurate participation in the reporting process?
B. Is there any reason to fear that it might have a chilling
effect on employees? If so, why?
(5)(A) of H.R. 1526 on the basis that Inspectors General already
have the authority to investigate allegations of misconduct under
the inspector General Act of 1978.
Mr. HoRTON. With regard to this section 3(k), the concern about
giving the information with regard to the original appropriation
request of the Inspector General when any change is made, and so
on, it does seem to me-and I understand your concern about
precedent-that this is a unique situation and one to be distin-
guished from the normal.
This is an instance in which Congress is concerned about its
oversight function. We have a need and a desire and it is very
necessary for us to perform our mission. We are concerned about
objectivity and the ability of the Inspector General to do his job.
I want to associate myself with the comments which the chair-
man made with regard to removal of all these Inspectors General. I
was with the chairman when we met with the President, and it so
happened it was on the very day that that order was issued.
We spoke to the President personally about it. Mr. Stockman was
there. They did give us the assurance which the chairman just
mentioned, that is, that some of those would be put back in. It was
unfortunate the way it was handled.
However, I am concerned not with this administration or the last
administration but with the fact we do not find these Inspectors
General in a situation where the Inspector General is able to
perform his mission; namely, to be a watchdog of that agency.
If we do not have that kind of information, it seems to me we
might defer the prejudice and our ability to be certain that Inspec-
tor General is able to call the shots the way he should be able to
call them.
Admittedly, the Inspector General is part of that agency, but it is
important for our oversight function to be certain that he is as
independent, objective and nonpartisan as possible and will not be
prejudiced one way or the other.
One of the quickest ways to cut the legs out from under the
Inspector General is to remove the amount of his budget request. It
is easy for the administration and OMB to explain the reason they
cut it back. We are reasonable. We are perfectly willing to get
reasonable explanations.
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However, if they ask for a certain amount and they have a good
reason for that, and then they arbitrarily and substantially cut
back, it will create some concern on our part with regard to their
objectivity.
We are dealing with a unique situation in this type of request
and I would hope OMB would not raise too much objection to that
particular part.
I can understand, also, your concern about the GAO. I have a
couple questions about that. Again, though, I think the chairman
covered it quite well in his remarks. There is no reason why GAO
and OMB cannot work together so that the standards are agreed
upon and accepted by the various agencies.
I have a question with regard to the proposed circular. I don't
know what status it is in at the present time, but if that circular
does go out, as you mentioned in your testimony, is there any
reason we should not go ahead with this legislation? Would it be
duplicative, in a sense supplementing the work of this legislation?
Mr. LORDAN. With regard to the status of the circular, it has
been published for comment in the Federal Register. The public
comment period has recently closed. We are in process of analyzing
those comments.
We plan to meet again with the internal control task force,
discuss the public comment with them, and make some revisions to
the draft circular before we go forward to the Director with recom-
mendations.
With regard to any conflict between the proposed legislation and
the draft circular, except for the issues addressed in my statement
we see no basic conflict. In fact, as I said in the statement, we see
the draft circular as a part of the standards and guidelines which
would be issued in the future for implementation of legislation of
this sort.
Our reason for raising the circular as an issue is that it might be
an alternative to proceeding legislatively in the event Congress
decides not to legislate.
Mr. HORTON. Thank you.
Mr. BROOKS. Mr. Butler?
Mr. BUTLER. Thank you, Mr. Chairman. I, too, appreciate the
testimony of the witness.
I am trying to identify who this applies to. It states that the
Director of the Office of Management and Budget shall determine
which executive agencies shall prepare a report.
What is that all about? Aren't the heads of all agencies affected
by this, or shouldn't they be?
Mr. LORDAN. Referring to H.R. 1526?
Mr. BUTLER. The vehicle before us, page 2, line 3.
Mr. LORDAN. I would not speak to the intent of the authors of the
bill. It seems to us that this gave us an opportunity to limit the
application to the major departments and agencies and avoid some
of the concerns that members of the committee have expressed
about potential paperwork impact of the legislation. There are
some very small agencies, for example, where perhaps routine
reports to the President and to the Congress would not be in order,
American Battle Monuments Commission, and a number of smaller
agencies.
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We would assume that provision meant, unless there is a legisla-
tive history to the contrary, that the Congress intended us to apply
it first to the major departments and agencies, or to agencies which
were having particular problems.
Mr. BUTLER. I thank you for the answer. However, under existing
law, as I read it, the head of each executive agency is to establish
and maintain systems of accounting and internal control designed
to provide a number of things.
Mr. LORDAN. Yes, sir.
Mr. BUTLER. The head of each executive agency is mentioned.
Mr. LORDAN. There is no question that applies to all.
Mr. BUTLER. We will be selective in this regard.
Mr. LORDAN. I think with regard to the annual reporting and the
rest of the requirements of this bill it would appear to be the
intent of the drafters to limit applicability perhaps to the major
departments and agencies.
Mr. BUTLER. But they all have to file annual reports, do they
not?
Mr. LORDAN. The annual report requirement is one of the new
legislation rather than the existing statute.
Mr. BUTLER. All right. I thought every agency put something in
writing once a year saying what a wonderful job they have done.
That is discretionary and the statutes don't require it?
Mr. LORDAN. Some statutes may. It is not an across-the-board
requirement.
Mr. BUTLER. The agency shall prepare a report stating an opin-
ion on the adequacy of the agency's system. What does it take to
discharge that obligation? Would it be sufficient to say, "I am the
head of the Department of Defense and we have an adequate
system of accounting and administration. Thank you"?
Mr. LORDAN. The exact form of the reporting is something which
would have to be worked out between the Office of Management
and Budget and the General Accounting Office whichever way the
legislation proceeds.
The work which would go behind such an opinion, though, it
would seem to me, would have to be quite extensive in a depart-
ment as large as the Department of Defense. This is the basis of
the concern expressed by some of the agencies to us, that legisla-
tion of this sort has the potential for imposing a paperwork burden
on them. They would have to do a lot of internal study before they
could reach a state of recommending to a Cabinet office certifica-
tion of the sort you describe.
Mr. BUTLER. I recognize that. I am wondering now whether it is
necessary to generate all that paperwork. Is there some way to get
that evaluation without requiring a report? In other words, dignify-
ing this thing with a statutory requirement is an awful burden. Do
you have an alternate plan?
Mr. LORDAN. I would not propose it as an alternate plan. I think
it is up to the Congress whether they wish to receive an annual
report of this type.
I can tell you what we have done with regard to the proposed
OMB circular. There our focus was to try to get reports first where
there were major breakdowns in the systems. This report is to the
Cabinet officer. And second, an annual report to OMB as part of
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the routine submission of financial improvements provided us each
year. In other words, this second report would be an additional
requirement to an existing annual report.
We did that on the advice of the internal control task force, an
interagency group, in order to minimize the paperwork burdens
that our own circular would impose on the agencies.
Mr. BUTLER. We really have a big deal, then, if this legislation
passes. We picked on the Department of Defense as an illustration.
However, that might be too big an illustration. Perhaps even Inte-
rior, or any other department, would have a problem. Would it be
more appropriate to phase it in on a selective basis within each
department? Would that be less disruptive?
Mr. LORDAN. Again, Mr. Butler, potential for doing that exists in
the introductory statement to the legislation which says the Direc-
tor of OMB would identify the agencies to which it applied. If we
applied it first to some of the bigger ones, we could phase it in and
see whether the process really works as well as anticipated.
Mr. BUTLER. You are really anticipating an awful lot of discre-
tion. It has not been apparent to me up to this point.
Mr. LORDAN. Again if the legislative history of this bill changes
that view, we would not try to read that into it. As it stands now, it
appears to give an element of discretion to the Director.
Mr. BUTLER. Let's take the Department of the Interior, would it
be your understanding that you could say to that Department,
"Let's work on the Park Service this year but not the rest of it"?
Or when you go for the department do you have to go for the whole
shebang?
Mr. LORDAN. Frankly, I had not given much thought to applica-
tion to individual agencies within the Department. It was strictly
in terms of identifying departments and agencies to which it ap-
plied, and I assumed that would apply across the board. However,
it may lend itself to that other interpretation.
Mr. BUTLER. I am anxious to put this legislation together but I do
not want to do anything that will go into overkill. That is the
reason for my questions.
How does Circular A-73 fit into this proposal? I do not see in this
legislation any suggestion that there is a requirement as to unrec-
onciled or unresolved audits. Perhaps I am not reading it correctly.
How does that fit into this legislation?
If this legislation passes, would it be your understanding that the
affected agencies would have to come up with an acceptable plan
for resolving all audits as A-73 requires?
? Mr. LORDAN. Audit followup would be an important element for
any agency for internal control. There are specific provisions in
that circular dealing with audit followup. It is the overall audit
policy circular from which we work. It requires that audit findings
? be resolved within 6 months and that there be a system in place
within each department and agency to make sure anything older
than that is properly resolved.
Some of the agencies have chosen to do that by establishing
audit resolution committees. Others have chosen instead to process
unresolved issues through the normal hierarchy, the chain of com-
mand up to the Cabinet or subcabinet level. In either case they
must have in place a system for the resolution of those issues.
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This bill would perhaps not address that issue specifically, but I
think it is safe to say that any comprehensive system of internal
control would have to address the question of resolving audit find-
ings.
Mr. BUTLER. Would it jeopardize the legislation to make that an
express provision of it?
Mr. LORDAN. Those systems are already required to be in place. I
would not think it would add any significant burden to the legisla-
tion.
Mr. BUTLER. I understood your response to say it is implicit in
the legislation but not expressed.
Mr. LORDAN. I think that is correct. It is expressed, however, in
OMB Circular A-73, so the requirement is already on the agency.
Mr. BUTLER. We had some criticisms of A-73 last week. I guess
you heard about those.
Mr. LORDAN. Yes.
Mr. BUTLER. Are you doing anything about that?
Mr. LORDAN. We are working with the agencies to resolve the
remaining issues. The GAO report did indicate progress has been
made. There is still a long way to go. It was a major problem when
it was first revealed by this committee.
The agencies have done some good work but they have a way to
go.
Mr. BUTLER. Mr. Staats had several suggestions about the specif-
ic language of A-73, one being that you identify the man responsi-
ble for resolving audits within an agency, so presumably you could
hang him if he did not comply. I assume that suggestion had
reached you at this point.
Mr. LORDAN. Yes.
Mr. BROOKS. Thank you, Mr. Butler.
You understand there is always a little slippage. OMB issues
circulars, GAO issues findings and reports, and the agency still
does what it pleases and nobody does anything about it in the final
analysis. That is so in many instances.
We will pass it one more time. If they will name the people
responsible, we will get those people for you, and we will call Mr.
Stockman and ask him what he has done about the unresolved
audit findings. We want to find out.
Mr. LORDAN. Yes, sir.
Mr. BROOKS. We will be very curious.
We have enjoyed having you.
Mr. LORDAN. Thank you, Mr. Chairman.
Mr. BROOKS. The next witness is Mr. John P. Abbadessa, accom-
panied by Mr. Gilbert Simonetti.
Mr. Abbadessa is executive vice president of the Association of
Government Accountants. During his career he served 15 years in
the General Accounting Office and 12 years with the Atomic
Energy Commission, where he was Assistant General Manager,
Comptroller. From 1975 to 1980, Mr. Abbadessa served as director
of the division of budget and finance of the International Atomic
Energy Commission. He has received numerous professional
awards.
Mr. Simonetti is chairman of the Association of Government
Accountants' Congressional Affairs Committee. He is partner-in-
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charge of Washington liaison for Price Waterhouse and Co. For-
merly Mr. Simonetti was vice president for Government relations
of the American Institute of Certified Public Accountants and ex-
ecutive editor of its publication, the Tax Adviser. He is a frequent
speaker and has numerous published articles to his credit.
We are delighted to have you here, gentlemen.
STATEMENT OF JOHN P. ABBADESSA, EXECUTIVE VICE PRESI-
DENT, ASSOCIATION OF GOVERNMENT ACCOUNTANTS, AC-
COMPANIED BY GILBERT SIMONETTI, CHAIRMAN, CONGRES-
SIONAL AFFAIRS COMMITTEE
Mr. ABBADESSA. Thank you, sir.
Mr. Chairman, I am John P. Abbadessa, executive vice president
of the Association of Government Accountants, an organization of
professional financial managers having more than 12,000 members,
dedicated to improving financial management at all levels of gov-
ernment. I am joined by Gilbert Simonetti, Jr., chairman of the
AGA's Congressional Affairs Committee and a partner in the ac-
counting firm of Price Waterhouse and Co.
We appreciate the opportunity to appear before your subcommit-
tee to present our views on H.R. 1526, the Federal Managers'
Accountability Act of 1981, which, among other things, would
amend the Accounting and Auditing Act of 1950 to require public
reporting on the adequacy of systems of internal accounting and
administrative controls by heads of executive agencies.
We fully endorse and strongly support this proposal. We believe
that issuance of such annual representations by top level Govern-
ment officials, and, more importantly, the substantive work that
would have to be done in order for those representations to be
made, will significantly improve the financial management of Gov-
ernment funds and will help restore confidence in our public insti-
tutions. Moreover, it would provide substance rather than theory to
the basic concept that the heads of departments and agencies must
take responsibility for their actions-in other words, they would be
accountable in some measurable degree to the public they serve.
Let me now elaborate briefly on our reasons for endorsing this
legislation.
The administration and the Congress are currently wrestling
with the difficult and painful process of cutting the Federal budget,
and certainly this is unavoidable if Government spending is to be
reduced. However, there is another aspect to Government finances
besides how much is spent and for what. That is, how well are the
Government's resources managed and accounted for?
Unfortunately, too often the answer to this question is, "not well
at all." The most visible and troubling result of this situaton is the
large number of reports from so many sources that billions of
dollars have been lost as a result of fraud, waste, and mismanage-
ment. The correction of this situation is at present one of the most
immediate and promising approaches to reducing the Federal Gov-
ernment's squandering of the country's limited resources.
We commend the Congress for its prompt action in addressing
this problem. Not the least of these efforts, Mr. Chairman, is the
consideration of this proposed legislation which has been intro-
duced by you, and which represents another of many examples
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over the years of your continuing efforts to improve the financial
management of Government funds in the best interest of the tax-
payer.
One indication of inattention to sound financial management in
Federal Government agencies is the fact that 30 years after the
Accounting and Auditing Act of 1950 required that the General
Accounting Office approve accounting systems in all Federal agen-
cies, only 64 percent of those systems have received such approval.
Among the accounting systems that have not received GAO ap-
proval are the largest and most important systems of the Depart-
ment of Defense and the Department of Health and Human Serv-
ices, which together account for more than half of the Federal
budget. Through follow-on reviews, the GAO has also found wide-
spread weaknesses in accounting systems that had been approved.
In some cases, agencies have either not implemented proposed
systems as approved or have allowed approved systems to deterio-
rate.
Why do situations like this continue? Here we share the view of
former Comptroller General Elmer Staats. He has stated that the
major reason internal control systems are in a state of disrepair is
that top management has devoted most of its concerns and empha-
sis to the delivery of funds and services, and that effective controls
over the tasks and functions which lead to the delivery of these
funds and services has had a low priority.
This attitude, which inevitably filters down through the organi-
zation, also has had a demoralizing effect on Government financial
managers. As a result, many of them are frustrated in their efforts
to carry out one of their principal functions-safeguarding public
assets.
Congress has been presented over the last few years with abun-
dant evidence of this attitudinal problem, and its costly results.
Further, this evidence has not, in any way, abated.
For example, in hearings before this subcommittee last month
the former Comptroller General presented results of a recent GAO
report whose title, "Disappointing Progress in Improving Systems
for Resolving Billions in Audit Findings," speaks for itself. Accord-
ing to that report, the Government is losing billions of dollars
because of failure by various agencies to act on audit recommenda-
tions. The report identified $14.3 billion in unresolved audit find-
ings representing potential recoveries, rebates, revenues, and sav-
ings for the Federal Government.
Just last week, Donald Scantlebury, a past national president of
AGA, who is Director of the Financial and General Management
Studies Division of GAO, conveyed similar information to the
House Budget Committee and, in addition, cited other enormous
losses due to failure to collect debts owed to the Federal Govern-
ment. Mr. Scantlebury attributed the problem primarily to the fact
that top management's attention to debt collection is inadequate.
Other witnesses at that hearing, Acting and Deputy Inspectors
General from several agencies, also referred repeatedly to problems
of preoccupation with delivery of services and disbursement of
funds, resulting in an inadequate emphasis on financial manage-
ment.
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It is disturbing that some Federal managers are not making
efforts to recover lost funds, even when such losses are specifically
identified. It is much more disturbing that there is a lack of atten-
tion to effective financial management which would help prevent
fraud, waste, and mismanagement from occurring in the first
place. We strongly believe that prevention has a much bigger
payoff than detection with corrective action.
An absolute requirement in order to achieve such preventive
financial management is the implementation of effective systems of
internal accounting and administrative control, which is a major
objective of this bill. Such system can properly safeguard Govern-
ment funds and property both by decreasing the potential for fraud
and error and by making detection of their occurrence easier.
Many Government officials have emphasized the need for such
controls. The former Comptroller General frequently remarked on
the importance of internal controls in Government, and he has
given examples of the types of fraud, sometimes amounting to
millions of dollars, which can occur in the absence of even the most
fundamental controls. In further support of his contention, Inspec-
tor General and GAO investigations have been turning up numer-
ous cases of fraud and abuse resulting from inadequate internal
controls.
Distressingly, as a result of its investigation of 11 Federal agen-
cies, GAO has concluded that internal control weaknesses pervade
the Federal Government. Moreover, the Office of Management and
Budget reported to Congress last year that "very few agencies have
comprehensive systems of internal control," and that `controls re-
quired by existing systems may not be properly observed."
Ever since the GSA fraud scandal broke in the summer of 1978,
we have had repeated revelations of fraud, waste, and mismanage-
ment in Federal Government programs, and repeated statements
on the ineffectiveness of internal controls and inattention to sound
financial management practices in Federal agencies. The recent
hearings in your subcommittee and the House Budget Committee
make the record conclusive.
Now it is time to stop compiling evidence and take action.
While some efforts have been made to improve control systems
in Government agencies, they can only be considered a piecemeal
approach to more effective action. Something much more funda-
mental is needed, and that is the promotion of a positive control
environment.
Mr. Chairman, we believe that your proposed legislation, by re-
quiring chief executives to report publicly, in writing, over their
own signatures, on the adequacy of internal control systems in
their respective departments and agencies, will go a long way
toward improving the financial management of Government funds.
The title of your bill, the Federal Managers' Accountability Act,
is self-explanatory, because the rationale for such public reporting
on internal controls is personal accountability-one of the most
valuable attributes a public official can have.
If this requirement is enacted, it is reasonable to expect that
agency heads will assume more formal responsibility for the qual-
ity of their organizations' internal control systems and will set a
newer, higher priority for overall good financial management
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which will filter from the top executive down through the organiza.
tion.
When agency managers and employees at all levels realize that
their chief executives are putting their own names on the line in
attesting to the integrity of basic systems which safeguard taxpay-
er dollars, they will want to insure that the work supporting such
attestations is thorough and accurate, that the work is independ-
ently tested and evaluated by inspections and audits, and that
identified weaknesses are promptly corrected.
We recognize and support the efforts that OMB has made in
attempting to promote sound financial management in the Federal
Government. We applaud OMB's financial priorities program, and
we are fully aware of the progress being made in drafting a circu-
lar on internal controls. By mandating public reporting on internal
controls at the highest agency levels, the proposed legislation will
strengthen what OMB is in the process of accomplishing.
Federal executives will require guidance in reporting on internal
controls, and in performing the reviews of internal control systems
necessary to support the assessments contained in the reports. To
that end, the proposed legislation directs GAO and OMB to develop
guidelines for performing control evaluations and to establish a
system for internal control reporting.
In anticipation of such a requirement, the AGA established in
1979 a voluntary task force on standards for Federal executive
reporting on internal controls to work with GAO and OMB in
developing the necessary guidelines. With this work now complet-
ed, we believe that the proposed Federal Managers' Accountability
Act can be implemented in a timely and orderly manner. The task
force was composed of a cross section of highly qualified profession-
als representing that joint financial management improvement
program, public accounting, and Government financial manage-
ment. The guidelines they developed are now available as a GAO
publication published in 1980. I respectfully request that a copy of
that document be included in the hearing record.
Mr. HORTON. Without objection, excerpts from this material will
be included in the record.
[The material follows:]
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The Accounting and Auditing Act of 1950 requires the heads of
the executive agencies to establish and maintain effective internal
accounting and administrative control system. The same Act requires
the General Accounting Office (GAO) to approve the agencies' accounting
system and GAO has regularly advised agencies that their system will
not be approved unless they have effective internal controls.
Interest in the need for strong internal control system is exempli-
fied by a recent bill, entitled the "Financial Integrity Act of 1980,"
which was proposed before the Oongress. The bill, if passed, would re-
quire ongoing evaluations and reports on internal control systems of each
executive agency. In an ongoing effort of support of effective internal
control system, the Association of Government Aooountants (AGA) estab-
lished a task force to help provide guidance and assistance to congres-
sional oammittees and Federal agencies in developing standards and proce-
dures for executive agencies to evaluate and report on their internal
control system .
This document entitled "Executive Reporting on Internal Oontrols in
Government" was recently completed by the AGA task group. It provides a
general discussion on the definition and objectives of internal aocxu ting
and administrative controls as well as suggesting reporting requirements
that could be adopted whether or not the proposed legislation is passed.
We in GAO believe this is an excellent document for bringing out further
awareness for the need of strong internal controls, and we are certainly
encouraged by the fine contribution of the task force of the Association
of Government Accountants. We support the objectives of this document as
well as the concepts and principles provided in it. This document is
valuable for informational purposes as well as a vehicle to encourage in-
volvement in strengthening internal controls in Government.
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I
INTERNAL CONTROLS--A BASIC UNDERSTANDING
The Scope of the Control Review Contemplated by the Legislation
The Financial Integrity Act of 1980 specifies that the head
of each executive agency designated by the Office of Management
and Budget will be required to submit annually, to the President,
a report on the adequacy of their agency's system of internal
accounting and administrative controls. The Act 'requires a
report on those controls which are designed to provide reasonable
assurance that the following control objectives are achieved:
(1) All obligations and costs were in compliance with
applicable law;
(2) All funds, property and other assets were safeguarded
against waste, loss, unauthorized use or misappropria-
tion; and
(3) All revenues and expenditures applicable to agency
operations were properly recorded and accounted for to
permit the preparation of accounts and reliable finan-
cial and statistical reports and to maintain accounta-
bility over the assets.
Probably the most difficult task in conveying an understand-
ing of what is meant by the broad term Internal Controls is to
agree upon a definition which is clearly understood by persons
who have little or no background in the field of administration
and financial management. The first question usually raised is;
How do internal controls relate to accounting systems? Accord-
ingly, one must first address the complementary relationship
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between accounting systems and controls before attempting a more
detailed understanding of factors affecting the quality of
internal control systems.
Accounting systems, in a broad sense, include four principal
components: (1) the system hardware, namely general ledgers and
their inherent account structures, whether they be in the form of
manually posted or machine processed records, (2) the assigned
duties and responsibilities for maintenance of those records or
the organizational structure adopted, (3) the specific procedures
to be performed by persons in the execution of their role in the
accounting process, the procedural controls, and (4) the informa-
tion system or form of periodic reports which summarize incurred
financial activity.
It is a fundamental premise of a sound accounting system
that the organization of personnel and the specification of pro-
cedures to be performed should be constructed in such a fashion
as to preclude any one individual from authorizing, approving
and executing.financial transactions. This is achieved through
appropriate "segregation of duties" which results in the assign-
ment of key control procedures to different persons or different
organizational elements.
Internal Accounting Control has been defined by the American
Institute of Certified Public Accountants as ". . . the plan of
organization and the procedures and records that are concerned
with safeguarding of assets and the reliability of financial
records . . . ."
In addition to accounting related internal controls, every
organization will implement a wide spectrum of additional con-
trols usually referred to as Internal Administrative Controls.
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Administrative Controls are designed to provide a structure to
carry out other organizational objectives such as planning,
productivity, programmatic quality, economy, efficiency, and
effectiveness. In practice administrative controls and internal
accounting controls have often been referred to by a number of
alternative titles and terms. The significance of the title used
is obviously of less importance than understanding the use and
role of each such controls within the organization.
In its Standards for Audit of Governmental Organizations,
Programs, Activities and Functions, the General Accounting office
included both accounting and administrative controls in its defi-
nition of internal control in Government. Internal Control is
defined as:
"The plan of organization and all the coordinate methods
and measures adopted to safeguard assets, check the
accuracy and reliability of accounting data, (accounting
controls), promote operational efficiency, and encourage
adherence to prescribed managerial policies (administra-
tive controls)."
In performing a review of controls within a Governmental
organization, it might be considered desirable to review each
type (accounting and administrative) separately. However, in
practice this is rarely, if ever, practical since managerial
decisions in the administrative control area can often have a
direct influence on the quality and adequacy of accounting con-
trols. In a simple, but nonetheless effective example, the
establishment within a unit of Government of administrative
controls to foster and encourage a high level of supervision
and review of employee performance can be expected to have a
significant influence on the quality of employees' execution of
accounting controls.
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Accordingly, while the presence or absence of specific
accounting controls can usually be readily determined, a review
of the adequacy.of the overall accounting control system will
usually necessitate a review of administrative controls to the
extent that they (1) establish an appropriate accounting control
environment, (2) influence the nature of internal accounting
control procedures required, or (3) help to satisfy internal
accounting control objectives.
Administrative controls which can influence the control envi-
ronment generally relate to those such as indicated in the
example: (1) have an effect upon employees awareness of their
responsibilities, (2) create a positive organizational attitude,
(3) act as an incentive to employees to follow procedures, and
(4) provide reasonable assurance that the failure to perform
assigned procedures appropriately will result in disciplinary
action.
Some administrative control procedures can also have a sig-
nificant influence on the type of internal accounting controls
required within the system. For example, an administrative
decision which permits borrowers under loan programs to make
payments at regional or district offices will necessitate a dif-
ferent series of accounting controls than those accompanying a
system which permits loan repayments to be processed only through
one centralized processing center.
Also, as pointed out, the implementation of certain adminis-
trative controls can strengthen or mitigate the need for account-
ing controls. The head of a department or agency may institute
administrative procedures which delegate to program managers the
responsibility to closely monitor and accept responsibility for
financial, as well as programmatic activity. It is likely that
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in the performance of their responsibilities program managers
will, through their review and inquiry into the appropriateness
of reported financial results, act as a monitor of the accounting
system. In these circumstances program managers serve in the
dual capacity of carrying out both a programmatic (administra-
tive) and accounting control function.
In summary the term, internal Controls, is broad and includes
both accounting and administrative controls. Controls in either
the administrative or accounting area are implemented through the
segregation of key control duties and responsibilities among
employees and the establishment of specific operating procedures
which specify the manner in which their functions will be con-
ducted. Accounting controls deal principally with safeguarding
assets and the accuracy and reliability of accounting trans-
actions and reporting. Administrative controls are typically
designed to encourage adherence to prescribed managerial policies
and promote operational efficiency.
While the control evaluation procedure discussed herein is
not designed to evaluate administrative controls to assure effi-
ciency and effectiveness, undoubtedly insights will be gained
into these areas through this process. Further, it must be
remembered that the adequacy of accounting controls can often be
significantly influenced, positively or negatively, by adminis-
trative controls adopted by the organization.
As agreed by a wide spectrum of authors on the subject of
control evaluation . . . an understanding of the distinction
between accounting and administrative controls is useful for
purposes of obtaining a fundamental knowledge of their interre-
lationship. However, the importance of the distinction becomes
less significant if the attention of a control evaluation focuses
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more appropriately upon the objectives which the organization is
trying to achieve through the implementation of controls. While
it might be contended by some that the objectives specified in
the Act are more closely related to traditional accounting con-
trols, that observation should not be viewed with significance.
Rather, it should be the intention of department heads to assess
the adequacy of both accounting and administrative control sys-
tems which are designed to achieve the previously listed broad
objectives of the Act.
While the use of predetermined detailed checklists which
identify customary or traditional control techniques can be of
value, they should be utilized as a tool and not relied upon as
the sole procedure for conducting control evaluations.
The Relationship Between Objectives and Controls
There is substantial agreement among professionals that an
evaluation of a control system must begin with an identification
of the organization's control objectives. It is assumed that
management will convert broad control objectives (such as those
in the Act) which relate to the organization as a whole, into
specific control objectives for all affected organizational units
and types of transactions. In most cases there will be a readily
identifiable relationship between specified control objectives
and the financial or operational risks against which protection
is sought.
Some difference of opinion exists as to whether evaluations
should be performed on a transactional or organizational (func-
tional) basis; nevertheless, under either approach specification
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of meaningful objectives is critical to the successful perform-
ance of a control evaluation. As an example, while the main-
tenance of adequate internal accounting controls is an appropri-
ate overall objective for an executive department, effective
determination of whether that overall objective is being achieved
will necessitate the identification and review of numerous sup-
porting objectives. Such a supporting payroll objective would be
that--all employee overtime is approved prior to being paid. It
would be expected that many supporting objectives of this nature
would be expressed through policy statements or regulations.
As a further example, dissecting a small portion of one con-
trol objective specified in the legislation would identify the
overall organizational objective that:
"all . property . . . (is) safeguarded against
unauthorized use . . ."
In most agencies the achievement of that overall objective
will frequently necessitate the identification of a significant
number of supporting objectives relating to the often wide vari-
ety of property which is entrusted to the care of the agency
and a specification of what, in each case, constitutes unauthor-
ized use. It is expected that in many cases the necessity to
identify control objectives will encourage management to address
and establish positions on a number of issues which may not have
been previously specified in either Federal regulations or pre-
vious agency policies. Many times opportunities for fraud, waste
and abuse are created simply because inadequate attention is
focused on defining control system objectives and organizational
policy.
Once the objectives of a control system are identified, an
effective evaluation to determine whether they are being achieved
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can commence. The subsequent evaluation will focus upon whether
or not objectives are being achieved, with little concern as to
whether the controls relied upon are identified as either
accounting or administrative controls.
To assist departments and agencies in the development of
control objectives applicable to their own organizations,
Chapter Two contains a discussion and description of the princi-
pal objectives usually related to frequently encountered func-
tional areas in Government organizations.
Most systems involve the use of Automatic Data Processing
equipment and systems. The reliability of an ADP system is
dependent on the adequacy and the emphasis placed on controls
during the development, installation, maintenance and use of
the computer equipment and software. System specification and
design control should be designed to ensure the development
of effective and adequately controlled systems. Additionally,
auditability of systems should be addressed throughout all
aspects of their development.
The unique attributes of each Government organization,
program and administrative function do not lend themselves to
delineating a single evaluation method. Likewise experience is
lacking in conducting overall organizational control assessments
within public as well as in the private sector. Considering
these factors a model Action Plan to conduct internal control
evaluations has been developed and is described in Chapter III
of this guide. The plan is developed in six major steps from a
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description of the head of the department's initial role, to the
final independent review and opinion by management on the effec-
tiveness of the department's or agency's control system.
The Action Plan described utilizes a Project Team approach.
The intent of the plan is to systematically evaluate existing
systems from those estimated to have the largest risk potential
to those with the smallest risk or vulnerability. Since the con-
trol environment is subject to change, (i.e., personnel com-
petency, integrity and sufficiency, along with program scope and
objectives) higher risk areas will require reexam.nation on a
more frequent basis.
Expected Results
In assessing whether the organization's control objectives
are reasonably achieved the evaluators of the system will become
principally involved in a review to determine whether
(1)
pro-
cedures adopted are appropriate in the circumstances,
(2)
key
duties and responsibilities are properly segregated,
and
(3) pol-
icies and procedures are satisfactorily documented, communicated
and executed.
Many contend that one of the most important aspects of any
control system is how effectively individuals perform their
functions. Consequently, in the performance of a control eval-
uation, the reviewers should be expected to arrive at a deter-
mination as to whether persons performing key functions appear
to be executing their responsibility properly. They will also
consider whether responsibilities are assigned to an appropriate
level within the organizational structure. Evaluating whether
key functions are properly assigned within the organization to
individuals capable by training and experience to execute them
effectively, is of no less importance to the outcome of the
evaluation than is judging the appropriateness of the procedures
themselves. .
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Mr. ABBADESSA. We also endorse the provisions of the proposed
legislation regarding strengthening the role of the Inspectors Gen-
eral. We believe it appropriate that the Inspectors General receive
and investigate any allegations that an employee of the agency
provided false or misleading information in connection with the
evaluation of or reporting on internal accounting and administra-
tive controls. It is also essential that disciplinary or corrective
action be taken by the head of the agency where the results of the
investigation disclose that such is warranted.
I would now like to comment briefly on two additional provisions
of H.R. 1526.
First, we are not competent to comment on any legal or jurisdic-
tional objections which have been raised about the provision in
section 3 which concerns reporting on budget requests by Offices of
Inspectors General. However, we believe that it is essential and
cost effective for Inspectors General to have the resources needed
for them to do their jobs adequately, and we recognize that Con-
gress has a responsibility to help insure that this happens.
Section 4 requires agency heads to include with appropriation
requests a statement certifying that the request has been based on
an accounting system that has been approved by the Comptroller
General. We understand that the GAO has raised concerns that a
certification requirement might not be workable, considering the
number of systems which have not been approved. We concur with
-their suggestion that inclusion with the appropriation request of a
status and progress report on accounting system approval would be
more practical. This would help Congress exercise its responsibility
for oversight of approval of agency accounting systems.
Mr. Chairman, this concludes my prepared statement. I shall be
pleased to answer any questions you or members of the subcommit-
tee may have.
Mr. HORTON. Thank you, Mr. Abbadessa.
Have you anything to add, Mr. Simonetti?
Mr. SIMONETri. I do not. Thank you, sir.
Mr. HORTON. The chairman had to leave for just a moment. He
has several questions. If you do not mind, I would like to submit
those questions to you, with the exception of one which I will ask
you now, and then perhaps you can supply written answers for the
record. Can you do that?
Mr. ABBADESSA. Yes, sir.
Mr. HORTON. I also have questions I will submit to you on the
same basis.
[The questions and submission follow:]
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Answers by John P. Abbadessa
Association of Government Accountants
to Questions from Congressmen Brooks and Horton
Hearings on H. R. 1526
The Office of Management and Budget has testified that the establishment
of standards and guidelines should be the responsibility of the Executive
Branch rather than the General Accounting Office in the Legislative Branch.
Which office would you suggest have responsibility?
The Association does not wish to take a position as to which Agency should
have responsibility, but we strongly believe and want to emphasize that it
is enormously important for the work to be done without further delay. We
believe it would be most unfortunate if a Jurisdictional argument results
in a further lack of progress. The plain facts are that GAO and OMB both
have responsibilities in this matter, both have competency; and the full
support and vigorous efforts of both are essential to get the job done.
OMB in its testimony indicated that the objectives of the legislation can
be accomplished administratively. Have you seen the draft circular and if
so, what is your opinion on this matter?
Answer
We believe that the present situation is completely unacceptable and that
both administrative efforts and the legislation introduced by the chairman
should be rigorously pursued. We have seen the draft circular; and by
letter dated February 11, 1981, we submitted our comments to OMB. Basically
our comments consisted of suggested additions to the draft circular which
would bring it more in conformity with the provisions of the legislation
being discussed today.
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How much of a positive influence would this legislation have on those
accounting systems not yet approved by GAO? Would it strengthen them just
by having these internal controls in place? Why and how?
There is no question that the provisions of the legislation, providing the
agencies establish and maintain the systems of internal accounting and ad-
ministrative controls as prescribed in the legislation, would have a posi-
tive influence. I must emphasize again, however, the provisions of the
legislation that require public reporting on the adequacy of systems of
internal accounting and administrative controls by the heads of executive
agencies is the best insurance policy the taxpayers could have to assure
that the necessary work gets done.
Some questions have been raised at the staff level about the use of the
term "opinion" in Section 2(D)(1). In accounting and auditing terms, how
formal and imposing is the word "opinion"?
a. Would we lose any impact if we struck the phrase "stating an
opinion" and simply required a report on the adequacy of the
agency's control system?
In accounting and auditing terms, the word "opinion" is quite formal, well
understood, and important. We believe the intent of the legislation would
be clearer, and the assumption of accountability by the heads of agencies
would be stronger if the word "opinion" is retained. However, while
striking the phrase "stating an opinion" would dilute the effectiveness
of the provision, it certainly would not destroy its effectiveness. If
such a compromise is desirable or necessary to retain the concept of pub-
lic accountability by the heads of agencies, we would recommend that the
Committee not insist on a formal opinion.
Has your organization studied the application of this concept in any of
the various state governments? I understand thatNew York, for example,
is considering a similar legislative remedy.
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Mr. Chairman, I am not aware that we have studied this concept in any of
the various state governments. We think the concept is certainly workable
at the state level; and if our views were requested, we would strongly
endorse its application also at the state level. While there are certain
basic differences between state governments and the Federal establishment,
these differences do not extend to the area of sound management in the
expenditure of public moneys. It is our view that the concepts set forth
in the proposed legislation would be equally effective and desirable at the
state level.
Do you favor this bill over the distribution of a new 0MB circular on
internal controls? Why?
I would favor both the enactment of this legislation and the distribution
of a new 0MB circular on internal controls. I think the problem is so vast
and so pervasive that the full weight of the President and the Congress is
warranted.
Mr. HORTON. The one question which would be important to have
you answer at this time is the following:
The Accounting and Auditing Act of 1950, that is 31 years ago,
required Federal agencies to maintain effective internal control
systems. This requirement has existed for 31 years. Yet fraud,
waste, and mismanagement continue to exist.
Why do you think agency management has not fully complied
with this requirement of the act of 1950?
Mr. ABBADESSA. My initial reaction is to ask agency manage-
ment, sir.
Mr. HORTON. As I understand it, you were the Comptroller at the
Atomic Energy Commission. The AEC had the first complete ac-
counting system approved by GAO.
Mr. ABBADESSA. I think the real answer is priorities. I think the
track record is clear, and it is the heart of today's problem. Pro-
gram managers are interested in delivering the product, which is
their primary mission, and they do not and have not given a high
enough priority to the establishment of strong accounting systems
and systems of internal control.
I appreciate the chairman's reference to the AEC being the first
agency to receive a GAO approval of its accounting system. It is an
example that ties in to priorities. I was with GAO and I made the
review of the AEC. We resolved it down to about five issues.
I then became the Comptroller of the AEC and made the changes
that were necessary. A major point here is that the Atomic Energy
Commission has a Comptroller who is responsible for both budget
and accounting.
Many agencies in this Government have separate budget and
accounting functions. Budget will attract top management atten-
tion on a priority basis. Accounting will not. I think this is the
heart of the problem.
Mr. HORTON. In essence what you are saying is that it is a
priority matter and perhaps the priority time has arrived with the
crisis, and perhaps this legislation can spur on the achievement of
that goal set out in that act of 1950.
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Mr. ABBADESSA. I believe that is correct, sir. I think the public
pressure is such today, the publicity is such, and the perception of
the problem is such, that the situation is now a national scandal.
I have come back from living in Europe for 6 years. Ever since
Lockheed and the GSA matter, they have headlined such stories in
European papers. It was not that comfortable being in this business
and being an American.
It seems almost unbelievable that the situation continues when
you have so much evidence, so much agreement that something
has to be done, and so much agreement as to what should be done.
The competence is certainly there. Hopefully, with this kind of
legislation, the public pressure, the strength now coming from
executive leadership to clean this up, and the Inspectors General
legislation, we will get corrective action.
I think this legislation is critical, sir.
Mr. SiMoNErri. Let me add a comment if I may. In echoing what
Mr. Abbadessa said about priorities, that is certainly true in the
executive branch. However, as I was listening to the witness from
OMB, I think it also should be stated, in fairness to the good work
that OMB has attempted, that they too, have a problem of prior-
ities.
The management side of the OMB house is undernourished not
because there is no interest, not because there is lack of under-
standing of the need, but rather a lack of high priority. The man-
agement side of OMB is thin, not in quality, not in dedication, but
in resources. Hence, you have the same problems emerging right
through Government, through each of the executive agencies, and
the responsible central financial management agency of the execu-
tive branch.
There must be a reordering of priorities at OMB. I applaud Mr.
Stockman's attention to the budget. There should now be increased
attention to the issue of sound financial management so that we
can say that the management of our Government is going to re-
ceive as much attention as the budgeting side of OMB's house. I
think the two go hand in hand.
Mr. HORTON. Well said, Mr. Simonetti.
Mr. Butler?
Mr. BUTLER. I am not an accountant. I would like some enlight-
enment as to exactly what happens when an agency undertakes to
assign the priority that you suggest here today. How long a process
is this? What does that do to those things which are presumably
downgraded? How does it work after you decide what you are going
to do in an agency? How do they go about it and is it reasonable to
expect immediate response?
Mr. ABBADESSA. A lot of this depends on how large and complex
the activities of the agency are, and even more importantly, the
status of their existing system. If it is a basically good system and
you need only refinements, it is a relatively quick job.
If you have a bad system and you have a large organization, this
is not a task that will be done quickly. You have to develop your
system, be sure you have your manuals, and be sure that the
systems are integrated. The accounting system has to be integrated
with the budget system. You have to be sure of fiscal integity for
protection of assets and you have to be sure of controls over cash
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management. It is very difficult, therefore, to put a fixed time
frame on it. It depends on the magnitude of the problem.
However, it is not difficult if you have a reasonably good system.
At the Atomic Energy Commission we had a reasonably good
system; there were just some relatively minor aspects of the GAO
standards that we did not meet. We made the changes very quick-
ly. However, we had a strong system to start with and a strong
desire to improve our system to get the GAO approval.
Mr. BUTLER. You have to analyze the existing system and then
determine where you are trying to go and then work up a game
plan to get it from here to there. I think that is what you have
stated.
Mr. ABBADESSA. Yes.
Mr. BUTLER. How disruptive is it for an agency to remake its
accounting system in this fashion? Of course, we all know it is
desirable to get there. However, how swiftly can we expect an
agency to move once they resolve they are going to do this?
Mr. ABBADESSA. I am not trying to avoid the question--
Mr. BUTLER. I am not asking you to give me a timetable.
Mr. ABBADESSA. I will tell you one thing, for certain, and I think
this is the real value of this legislation-if the top man wants
strong systems of internal controls and makes it clear that he
wants such systems, it will get done enormously faster than it
would otherwise get done because it otherwise most likely would
not get done.
Mr. SIMONETTi. As I view the legislation, some will say it is just
another report. I think it should go beyond that.
What we are really trying to do is cause a reordering of the
priorities by top management in the agencies. It is not intended to
be a quick fix. I think Mr. Abbadessa has been justly cautious in
suggesting to you it is not something that can be turned around in
1 or 2 years, but it could be depending upon the agency's top man.
If he says, "I want this run like a business. I want this run as
though I had a bottom line to worry about," then you will get
faster action.
Therefore, what we are hoping is that the report, which is the
end result of activity that should be taking place within the
agency, will moved the chief executive to move his agency along
faster in adopting sound financial management techniques.
Mr. ABBADESSA. One other thing. I feel Mr. Butler that you have
some concern that the committee might be starting a paper bliz-
zard with this requirement. I honestly think quite the contrary is
true.
Two things are important. First, you have to realize this Govern-
ment has a pretty fair paper blizzard going now in detecting fraud
and waste and what they do with it after they discover the prob-
lems, including all of the hearings, justifications, and excuses.
If you move forward, there certainly is a price. However, you
also obtain two big advantages. First you redirect the effort you are
now making into developing systems, instead of explaining to cer-
tain people what went wrong. Second, and far more important, the
potential savings, not only in dollars but the real savings in accom-
plishing effectively your program objectives on a reasonable time
frame, would more than offset any additional cost in my judgment.
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I would be hard pressed to identify any report that I have known
of in 30 years of Government service that would be more cost
effective than the report required by this legislation.
Mr. BUTLER. I am sorry the chairman did not hear that com-
ment.
I would appreciate your looking at the legislation. If you have
any suggestions which might cull out unnecessary paper require-
ments, we would like to have the benefit of your judgment in that
regard.
Mr. ABBADESSA. Yes, sir.
Mr. BUTLER. Thank you.
Mr. HORTON. Thank you very much, Mr. Abbadessa, and thank
you, Mr. Simonetti.
The next witness will be Mr. John K. Watsen. Mr. Watsen is
director of auditing of the Federal National Mortgage Association,
here in Washington, D.C., a position he has held since April 1974.
Prior to that time, he was associated for 12 years with Price
Waterhouse and Co.
Mr. Watsen is testifying as a representative of the International
Institute of Internal Auditors. He is a member of that organiza-
tion's Professional Standards and Responsibilities Committee and
serves as president of its Washington, D.C., chapter.
We are happy to have you with us and we look forward to your
testimony.
STATEMENT OF JOHN K. WATSEN ON BEHALF OF THE
INSTITUTE OF INTERNAL AUDITORS
Mr. WATSEN. Thank you, Mr. Chairman.
My name is John Watsen. I am president of the Washington
chapter of the Institute of Internal Auditors and director of audit-
ing of the Federal National Mortgage Association.
Today, I am appearing before you as the authorized spokesman
for the Institute of Internal Auditors, Inc., an international organi-
zation consisting of more than 23,000 members, most of whom are
located in the United States and Canada. We are pleased to count
among our members several hundred who are employees of the
Federal Government in the various agency audit groups.
The institute has long been concerned with the adequacy of
systems of internal accounting and administrative control and with
the process of evaluating the effectiveness of internal control sys-
tems, both in Government and in the private sector. You might say
it is the No. 1 occupational activity of our members. We are,
therefore, very pleased to have been invited to testify before this
committee on the subject of the Federal Managers' Accountability
Act of 1981.
We wholeheartedly endorse the concept of annual reporting on
internal controls by Federal agency executives for the following
reasons:
One, numerous audit reports issued by the General Accounting
Office and statements made by Comptroller General Elmer B.
Staats have cited serious deficiencies in Federal agency internal
control systems. Similarly, the American press has frequently re-
ported these deficiencies and numerous actual instances of major
abuse or mismanagement of Government programs. Thus, there
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would appear to be both a real need to strengthen agency control
systems and an equally important need to demonstrate to the
public that the Government is acting responsibly to curtail waste
of the American taxpayer's resources.
Two, in view of the aforementioned real and perceived problems,
it appears necessary to reaffirm the Federal agency executive's
responsibility and accountability for maintaining effective internal
accounting and administrative controls.
Three, by requiring that formal annual reports on internal con-
trols be submitted to the President and made available to Congress,
the relative importance of maintaining effective internal control
systems, in relation to other aspects of agency operations, is greatly
and properly increased. Thus, this aspect of the agency executive's
responsibility will receive greater attention.
Four, finally and perhaps most importantly, the required disclo-
sure of any inadequacy or material weakness in internal controls
will improve Federal executive and congressional awareness of the
existence of any major problems in the systems, and the means of
solving those problems. This requirement will also facilitate the
tracking of future improvements in the internal control systems.
We would also like to express our support for provisions in the
proposed legislation which require investigation of any allegation
that false or misleading information was provided in connection
with the evaluation of internal control systems or in connection
with the preparation of the annual report on internal controls.
Such provisions serve to underscore the seriousness of internal
control evaluations and reports, and improve the reliability of such
evaluations and reports.
We also agree with the provisions in the proposed legislation
which require budgetary disclosure of the amount of appropriations
requested by the Office of the Inspector General of the Federal
department, together with the changes made in such requests by
the head of the department and any further changes made prior to
submission of the budget to Congress. We believe these procedures
will improve the ability of Congress to monitor the adequacy of
funding available for evaluations of internal controls by the Offices
of Inspector General and serve to further underscore the impor-
tance of this vital function.
Finally, although not directly related to any specific provisions of
the proposed legislation, we thought it might be useful to this
committee for us to state some of the major conclusions relating to
internal control systems which we have developed by working with
them in the private sector.
We have found that the most important determinant of the
effectiveness of an internal control system is top management atti-
tude concerning the importance of controls. When top management
actively participates in establishing oganizational controls and pro-
cedures and insists upon prompt correction of any deficiencies dis-
closed by their internal auditors or others, the control conscious-
ness of the entire organization is enhanced and the system of
internal control functions more effectively.
Also, in well-managed organizations it is common to establish a
senior executive position with specific responsibility for financial
management and control. The typical title for this position is vice
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president, finance, and the position is usually filled by someone
having a strong background in accounting and management. The
key to success is to designate an appropriately qualified senior
executive whose primary responsibility is financial management
and control.
We believe the Financial Managers' Accountability Act of 1981
will promote improved agency executive attitudes toward the im-
portance of maintaining effective internal control systems, and,
thereby, foster increased attention toward identification and correc-
tion of any deficiencies in such systems. Accordingly, we strongly
support the introduction and passage of this legislation.
For further information concerning the Institute of Internal
Auditors' views on management reporting on internal controls, I
refer you to chapter 4 of a recent publication by the Foundation for
Auditability, Research and Education, Inc., entitled "A Focus on
the Role of the Internal Auditor."
Mr. Chairman, that completes my prepared statement. I will be
pleased to respond to any questions that you or the other members
of the committee may have.
I would like to have this document inserted in the record, Mr.
Chairman.
Mr. HORTON. Without objection.
[The material follows:]
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The Internal Auditor
"A FOCUS ON THE
ROLE OF THE INTERNAL
AUDITOR
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A FOCUS ON THE
ROLE OF THE INTERNAL
AUDITOR:
The Foreign Corrupt Practices Act,
Management Representations on
Control, & the Internal Auditor
an assessment of roles, relationships, and
directions to better utilize the internal
auditor in support of the organization
Foundation for Auditability Research and Education, Inc.
Altamonte Springs, Florida
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108
Copyright ? 1979 by Foundation for Auditability Research and Education, Inc., 249
Maitland Avenue, Altamonte Springs, Florida 32701. All rights reserved. Printed in
the United States of America. No part of this publication may be reproduced, stored
in a retrieval system, or transmitted in any form by any means - electronic,
mechanical, photocopying, recording, or otherwise - without prior written
permission of the publisher.
ISBN 0-89413-079-x
Library of Congress Catalog Card No. 79-55763
79135N-79
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109
ACKNOWLEDGMENTS
The major part of this book was prepared and written
by William E. Thompson of Birmingham, Alabama, the
senior vice president and director of internal auditing
for the Alabama Bancorporation, Alabama's largest
bank holding company.
A Certified Internal Auditor (CIA) and a Chartered
Bank Auditor (CBA), Thompson has served The
Institute of Internal Auditors, Inc., in a number of
capacities, including: chapter president; member of a
chapter board of governors; seminar leader; conference
speaker; vice president of the southern region; member
of the international budget and finance committee;
chairman of the international research committee;
international treasurer, and member of the executive
committee.
Members of the Professional Practices Committee of
The Institute of Internal Auditors, Inc., and the trustees
of the Foundation for Auditability Research &
Education (FARE) served as the review committee for
this publication.
Trustees of FARE
1978-1979
John D. Bradt
Frank F. George
Stanley C. Gross
David V. Dunbar
James R. Kelly
William E. Thompson
D. Eugene Shaeffer
William E. Perry
Members of the
Professional Practices Committee
1978-1979
Frank F. George
William E. Swanson
Stanley C. Gross
Victor Z. Brink
Robert L. Richmond
W. James Harmeyer (Ex-Officio)
Charles L. Brown (Ex-Officio)
Edward R. Cheramy (Special Advisor)
Leonard H. Greess (Special Advisor)
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INTRODUCTION
The passage of the Foreign Corrupt Practices Act of
1977 and proposed SEC requirements for management
reporting have heightened management's awareness of
the quality of the internal accounting control system
and the means of evaluating its effectiveness.
This book is designed to help management and the
internal auditor evaluate the internal accounting control
system to comply with the law and reporting rules. It
also may be used as a briefing for executive
management and audit committee members.
It broadly discusses the management reporting issues
related to the Foreign Corrupt Practices Act and
assesses the roles and relationships of the parts of the
organization which are involved in meeting these
requirements. The directions to be taken in meeting
these requirements and the roles the internal auditor
plays in the evaluation process are also discussed.
Implications of the law and the regulatory
requirements are presented. Particular attention is
given to the "environment" of internal accounting
control. A broad description of the techniques the
internal auditor and others use in evaluating the internal
accounting control system is also provided.
The term "internal auditor" used throughout this
book is based on the assumption that the operations of
the internal auditor are in compliance with the
Standards for the Professional Practice of Internal
Auditing as adopted by The Institute of Internal
Auditors, Inc. (IIA). Appendix A includes a brief
description of IIA and its professional standards.
The author recognizes that the prime duty of the
internal auditor is to support the organization and its
management in assuring a sound and effective control
system. While performing this duty, the internal auditor
can have a critical involvement in the evaluation of the
internal accounting control system to aid the
organization in assuring compliance with the law and to
support management's representations on the internal
accounting control system.
FARE
The Foundation for Auditability Research and
Education (FARE) is a public foundation (501)(c)(3)
established by members of The Institute of Internal
Auditors, Inc., to promote research and education in
internal auditing.
As a public foundation, FARE conducts public
discussions, forums, and conferences to inform the
public about the value and scope of internal auditing. It
can also award scholarships, grants, and certificates to
organizations or individuals undertaking educational or
research projects in internal auditing, which will increase
the public's knowledge of the profession.
FARE is funded solely by voluntary grants, gifts, and
bequests. Corporations, foundations, and individuals
interested in extending internal auditing research and
educational activities are the principal sources of FARE's
financial support. Government grants for specific
projects represent another source of funding.
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CONTENTS
CHAPTER 1 PROPOSED SEC RULES .....................................................
Implications of the proposed rules of the SEC requiring
management statements on internal accounting controls
CHAPTER 2
CHAPTER 3
CHAPTER 4
CHAPTER 5
CHAPTER 6
ENVIRONMENT ............................................................. 5
Environmental issues which impact the system of
internal accounting control and the internal auditor
INTERNAL AUDITOR ........................................................ 7
The specific system of internal accounting control
and the relationship of the internal auditor
MANAGEMENT REPORTING ................................................ . 11
Approaches which may be used to support the
management statement
METHODOLOGY ............................................................ 15
Broad descriptions of methodology used in evaluation
THE FUTURE ................................................................ 17
Future literature and research into methodologies
of evaluation and control guidelines
APPENDIX A A brief description and history of The Institute of
Internal Auditors, Inc . .......................................................... 21
APPENDIX B The Foreign Corrupt Practices Act, Accounting
Standards Section (102) ........................................................ 23
ASR 242 of the Securities and Exchange Commission
(SEC Release #34-14478) ........................................................ 24
Proposed rules of the Securities and Exchange Commission
entitled, Statement of Management on Internal Accounting
Control (SEC Release #34-15772) ................................................ 27
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1
PROPOSED SEC RULES
Implications of the proposed rules of the SEC
requiring management statements on
internal accounting controls
Capsule: The Foreign Corrupt Practices Act requires the maintenance of an
internal accounting control system that meets the broad objectives of the Act.
Proposed rules of the Securities and Exchange Commission will require
management representation on the internal accounting control system.
Accomplishment of these requirements necessitates the evaluation, documen
tation, correction, and continued monitoring of the internal accounting control
system. Guidance is needed to assist in the accomplishment of these
responsibilities.
In December of 1977, the Foreign Corrupt Practices
Act of 1977 was signed into law. The Accounting
Standards Section of that law, as announced by
Accounting Standards Release (ASR) 242 of the
Securities and Exchange Commission (SEC), requires
certain standards of internal accounting control for
registered issuers of securities, (See Appendix B for a
copy of the relevant sections of the Act and ASR 242.)
The standards set forth in the Act are taken from long
existing auditing literature,' and are desired objectives
of all types of enterprises and organizations. However,
the enactment of this law is the first time that these
objectives have been required with judicial penalty for
noncompliance.
In May of 1979, the SEC proposed rules which
require that managements of registered issuers report
on their internal accounting control systems by specific
statements in the company's annual report and Form 10
K. (See Appendix B for a copy of SEC Release 3415772
proposing rules for reporting by management on
internal accounting control.) To meet the requirements
of the law and SEC rules, managements of registered
companies will need to accomplish a (an):
I. evaluation of the system of internal accoun-
ting control
American Institute of Certified Public Accountants, Inc, Codifica
tion of Statements on Auditing Standards (Chicago: Commerce
Clearing House, Inc, 1976), Section 320.28.
z In the test of this book, the term "monitoring" means (a) the
ongoing evaluation of the strengths, weaknesses, and adequacy of the
internal accounting control system, an "audit" function and (b) the
reaction to and correction of specific exception conditions, errors, or
regularities disclosed by the system, a "management" function. This
is discussed further in Chapter 3.
2. documentation of the evaluation
3, correction of any disclosed weaknesses
4. continued monitoring of the system of
internal accounting control to assure ongoing
compliance
Managements, directors, public accountants, after
neys, and internal auditors are concerned that, not only
most the system of internal accounting control be
adequate to protect the organization, but also
management most be able to support its representation
of compliance in public reports. A number of
professional firms and groups are attempting to explain
to clients and potential clients what is involved in
determining and documenting compliance. Virtually all
of these efforts are based on known and proven
techniques of evaluation and documentation. However,
the added pressures of public representation have
resulted in sophistication of these techniques and
improved skill in their use.
The most recent product of this effort is the
development of specific criteria by which an
organization measures its success in meeting pre-
scribed control objectives. These criteria have generally
evolved over time through the interchange of ideas
among individuals charged with the responsibility of
establishing, implementing, or evaluating controls, and
through the work of organizations formed to educate
and provide research for the practitioner with control
responsibilities. There is a continuing need to establish
guidelines on the actual evaluation process. These
guidelines form the necessary link between control
criteria and the organization's success in accomplishing
the control objectives.
In addition to understanding and approving the
evaluation techniques and the criteria used in the
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evaluation, management is confronted with determining
who should perform the initial evaluation of the system
and how to provide for the monitoring or ongoing
evaluation that will assure that needed controls
continue.
The evaluation and monitoring of the control system
require individuals or groups that have unique
knowledge and skills. The skills required include:
1. analysis methodology and techniques
2. documentation methodology and techniques
3. skill and experience in evaluating controls
4. offering constructive recommendations for
improvement of weaknesses
The evaluation and monitoring of the control system
require that individuals have knowledge of the:
1. control principles
2. operating and control system of the organi-
zation being evaluated
3. organization's control environment
4. control requirements or criteria which should
be applied to an evaluation of the control
system in each particular organization
5. means and methods by which control
improvements can be effected
In its proposed rules for statements of management
on internal accounting control, the SEC recognized that
central agencies would not find it practical "to prepare a
comprehensive list of internal accounting control
procedures . . . which would be appropriate for all
organizations."3 By issuing such a statement, the SEC
gives managements the opportunity to explore the
internal accounting control system within the confines
of their own company to determine the most effective
and efficient control procedures to assure a properly
functioning system of internal accounting control. The
proposed rules do, however, give some very direct
guidance on the conceptual elements that should be
included in the appraisal.
Just as the Commission avoided establishing an all
inclusive list of control procedures, it also avoided the
trap of indicating that there was only one correct way to
perform the evaluation. The Commission said "that
specific methods of approaching and implementing
evaluations of systems of internal accounting control
will vary from company to company. Accordingly, the
proposed rules do not specify the method of or
procedures to be performed in an evaluation of infernal
accounting control."4 This portion of the rules went on
to highlight certain areas that should be encompassed
in the evaluation process, including the following:
"First, evaluation of the overall control environ.
ment; second, translation of the broad objectives
' Securities and Exchange Commission, Statement of Management
on Internal Accounting Control (Washington, D.C: Securities and
Exchange Commission, April 30, 1979) Release #3415772, p. 29.
of internal accounting control into specific control
objectives applicable to the particular business,
organizational and other characteristics of the
individual company; third, consideration Cf the
specific control procedures and individual envi-
ronmental factors which should contribute to
achievement of the specific control objectives;
fourth, monitoring of the control procedures and
consideration of whether they are functioning as
intended; and finally, consideration of the benefits
(consisting of reduction in the risk of failing to
achieve the objective) and costs of additional or
alternative controls."s
While this advice from the Commission appears
extremely prescriptive in making an evaluation, a great
deal of latitude exists within each of the five elements
just mentioned. The first element of environment will be
discussed in the next chapter.
The second element about the translation of "broad"
internal accounting control objectives (the specific
provisions of the Foreign Corrupt Practices Act) into
"specific" control objectives applicable to the particular
business or company is of special interest. There is a
definite need for organizations or groups which have
explicit control knowledge of specific industries to
consider this element of evaluation. Industry groups
could serve member organizations by assembling
groups of auditors and/or comptrollers to analyze and
outline the types of specific control objectives which are
generally recognized within their industry. In its report,
the AICPA Special Advisory Committee on Internal
Accounting Control (advisory commttee) included an
appendixs of specific illustrative objectives for a
hypothetical manufacturing company.
The advisory committee indicated that this was not
an all-inclusive list for every industry and that certain
objectives and attendant control procedures were for
illustrative purposes. Any business or industry group
needing a codification of their industry's objectives can
find guidance from the advisory committee report.
Element three as defined by the Commission calls
for careful consideration. At this stage, the organization
translates the specific objectives of control into
procedures to assure their accomplishment. While
specific objectives of control might be common to
companies within a particular industry, the detail
procedures used and the environmental factors
affecting the determination of those procedures are
derived from characteristics of the individual organiza-
tion. A certain control procedure which may work for
one company in its environment may not be an effective
' Special Advisory Committee on Internal Accounting Control,
Report of the Special Advisory Committee on Internal Accounting
Control New York: American Institute of Certified Public
Accountants, Inc., 1979), Appendix.
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alternative procedure for another company in another
environment.
Moreover, the composition of functional units within
an organization may dictate the use of different
procedures because of the nature or characteristics of
the organizational unit. Consider for example, two
subsidiaries, engaged in similar operations but of
different size, or staffing and employing different
operating systems. Each separate fact and condition
indicates a need for careful consideration of different
control procedures to accomplish the specific
objectives of control. Management and the evaluation
personnel should give careful consideration to the
selection of the individual control procedures.
Effectiveness and cost//benefits judgments should also
be considered and documented.
The process (shown in element four and element five
from the SEC) for determining which control
procedures to use and whether their cost exceeds their
benefit, must be performed by each company within the
confines of their organization and operations. The
methodology of evaluation and documentation of
decision is a very important consideration. The control
system should be displayed so that it can be followed by
any other person of equal competence.
Decisions weighing cost-to-benefits are more easily
made and records kept if proper evaluation techniques
are used. The SEC stressed the need for appropriate
documentation in each element of the evaluation
process (1-5 above).
When evaluations and documentation are complete,
management is able to make representations in its
annual report and Form 10 K. The SEC has proposed
two specific phases in its proposed rules for making this
representation. After December 15, 1979, and prior to
December 16, 1980, management is required to include:
1. Management's opinion as to whether, as of the
date of such audited balance sheet, the
systems of internal accounting control of the
registrant and its subsidiaries provide reason-
able assurances that specified objectives of
internal accounting control were achieved;
and
2. A description of any material weaknesses in
internal accounting control communicated by
the independent accounts of the registrant or
its subsidiaries which have not been
corrected and a statement of the reasons why
they have not been corrected."' [Emphasis
supplied.]
This first phase of reporting places the sole burden on
management for determination and representation or
opinion on the internal accounting control system, as of
the date of the audited balance sheet. Although
independent accountants who have uncovered material
' Securities and Exchange Commission, Statement of Management,
p. 27
weaknesses will have some direct input into the
representation, the prime responsibility will belong to
management.
As structured in the proposed rules, the second tier is
for periods ending after December 16, 1980. The second
phase calls for representation to be made for periods for
which audited statements of income are required. Man-
agement's statement on internal accounting controls
would include their opinion as to whether the system of
internal accounting control provided reasonable
assurances that specific control objectives were
achieved. In addition, however, management's state
ment on internal accounting control must be examined
and reported on by an independent accountant for such
periods While the proposed rules do not specifically
describe the methodology to be used by the independent
accountant, the SEC did request comment on two
proposed alternatives. The first requires an exami-
nation that would sufficiently enable the public
accountant to express an opinion as to whether
management's representations were reasonable. The
Commission's report states, "In effect this would
require the independent public accountant to reach
independent conclusions as to whether the systems of
internal accounting control provided reasonable
assurances (cost-benefit judgments not limited to
material amounts) of achievement of the broad
objectives of internal accounting control."t
The second alternative does not require such an
extensive examination by an independent public
accountant. The independent accountant would review
the statement made by management and require the
filing of a report "if an affirmative statement is made."'
Though the difference seems subtle, an independent
examination providing independent conclusions, as
required in proposal number one, undoubtedly calls for
more extensive work by the independent accountant
than proposal number two. The Commission points out
that professional standards for conducting an examina-
tion under either proposal do not exist and would have
to be prepared.
It seems reasonable to believe that under proposal
number two, the independent accountant would be
concerned with an examination of the soundness and
methodology used in evaluation, the documentation of
the findings of that evaluation, and the actions taken by
management as a result of the findings. The review by
the independent accountant would be aimed at the
evaluation process rather than at the control system
itself. Consequently, this case would heighten the need
for an organized, structured, and defendable evaluation
process. In addition, the proposed instructions for the
preparation of Form 10 K state that the independent
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accountant should be able to express specific,
independent opinion on material items.1?
For many years internal auditors have been
concerned with evaluation of the control system: the
control system's adequacy, efficiency, and effective-
ness. In so doing, the internal auditor has also become
accustomed to being examined by his fellow
professional, the independent public accountant. The
experience and expertise of the internal auditor can be
advantageous for both the organization and the
independent public accountant. The benefit will pass
through them to all of the persons and agencies who are
beneficiaries of the renewed and heightened interest in
internal accounting control.
While the proposed rules may be amended or
modified before their final adoption, it is safe to assume
that any planning to meet the proposed rules would be
adequate to meet the final rules. The rules, once
adopted, will no doubt be subject to later revision,
modification, and amendment. Hence, the means and
methods to assure compliance with these rules should
be soundly based on an understanding of the underlying
reasons for the rules. With that understanding, future
revisions will not produce traumatic changes in the
original plan.
A copy of the proposed rules will be found in
Appendix B. Reading the entire text will provide better
insight into the Commission's thinking and aims at the
time these rules were proposed.
Summary: The FCPA and proposed public reporting rules of the SEC have created
a need for management to develop a supporting framework on which to base
statements representing the quality and soundness of its system of internal
accounting control. The framework will consist of the evaluation, documentation,
and monitoring of the system. The presentation statements will be in one format
fiscal year ends 12-15-79 through 12-15-80, and in an expanded form after 12-16-80,
due to the addition of CPA association with the statement and expansion of the
statements to cover the entire reporting periods. The internal auditor has
developed considerable knowledge and skills which can provide management with
the necessary assurance that it is fulfilling its responsibilities under the Act and
provide a sound basis for public reporting on the adequacy of control systems.
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2
ENVIRONMENT
Environmental issues which impact the
system of internal accounting control
and the internal auditor
Capsule:: The control environment is key to the success or failure of the entire
internal control system. The nature of the environment and the impact of the
environment on the internal auditing function are discussed in this chapter.
One of the concepts receiving increased emphasis in
the study of internal accounting control is the "control
environment" concept. To define the environment
within which the internal control system operates, it
may be beneficial to draw an analogy to the biological
environment within which the human organism exists.
The biological environment is made up of a number of
elements necessary for the existence of life. Air, water,
shelter, food, and heat are essential for the organism's
continued existence. In combination with other
desirable, yet not necessary elements, they comprise
the environment. Their simple existence, however, is
not the only important measure when examining the
environment. The quality of the elements and of the
combination of the elements determines the "quality of
life." Likewise, the environment within the internal
accounting control system is also comprised of a
number of elements. These elements are important not
only in their existence, but also in the quality of that
existence.
In describing the first element of evaluation (the
evaluation of the overall control environment), the SEC
described the environment as follows:
"The Commission recognizes that such evalua-
tions will require a careful exercise of manage-
ment's judgment, generally involving consider-
ation of matters such as the organizational
structure, including the role of the board of
directors; communication of corporate proce-
dures, policies and related codes of conduct;
communication of authority and responsibility;
competence and integrity of personnel; accounta-
bility for performance and for compliance with
policies and procedures; and the objectivity and
effectiveness of the internal audit function. The
role of the board of directors in overseeing the
establishment and maintenance of a strong
control environment, and in overseeing the
procedures for evaluating a system of internal
accounting control, is particularly important.""
"It is unlikely that management can have
reasonable assurance that the broad objectives of
internal accounting control are being met unless
the company has an environment that establishes
an appropriate level of control consciousness."'"
The control environment and the level of control
consciousness within the organization provide an
umbrella structure under which the entire internal
control system including internal accounting control
exists. The organization can expect no higher level of
compliance with the codified control system than the
level practiced by management. Therefore, the
evaluation of the organization's control environment is
the first logical step in the evaluation.
To facilitate the overall evaluation of the environ-
ment, a documentation should be made of all the steps
taken by the organization. Once recorded, the
organization can determine the sufficiency of the
measures already established and implemented. Any
weakness that is found and any action that is taken to
correct the weakness should also be carefully
documented.
For the internal auditor, the control environment is a
strong and underlying issue impacting on the objectivity
and effectiveness of an internal audit function. The
commitment of management and the board of
directors, or its audit committee, to an adequate control
system obviously has great impact on an internal audit
department. In addition, the organization's recognition
12 Special Advisory Committee on Internal Accounting Control,
Report, p 12.
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that without appropriate controls financial success may
be short lived or even ineffective, is a key element in
establishing proper control consciousness. The extent
that the organization incorporates rewards for meeting
control objectives as well as operating objectives can be
instrumental in strengthening the audit department's
effectiveness.
An atmosphere which recognizes the elements of the
control environment which facilitate the most effective
operation of an internal audit department will assure
that the internal audit department is equipped to aid
management in its representation on the internal
accounting control system. A high-caliber professional
internal audit department, operating in an appropriate
atmosphere, can supply a major portion of the
evaluation information which management needs for its
representation. In monitoring compliance with control
procedures, the SEC recognized that "an objective,
effective internal audit function can play an important
role in monitoring compliance." 13
Internal auditors should employ the methodology or
methodologies which are most appropriate for
performing the evaluation and monitoring of the control
system. Chapter five offers methodologies for making
control evaluations.
In order to provide proper support to management in
documenting and evaluating the internal control
system, management should require that internal
auditors are skilled in evaluation methodology. Internal
auditors should strive to deliver services which match
management's expectations.
n Securities and Exchange Commission, Statement of Management,
p. 32.
Summary: The control environment consists of discernable, assessable parts, which
should be documented and appraised. The existence of the environment and the
quality of its parts is important to the functioning of the internal accounting control
system. In addition, the environment involves, includes and heavily impacts the
internal auditor. In a proper environment, the internal auditor can and should aid
management in the process of evaluation of the system as a natural by-product of
the role currently being fulfilled by the internal auditor.
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3
INTERNAL AUDITOR
The specific system of internal accounting control
and the relationship of the internal auditor
Capsule: This section discusses some of the specifics of an internal accounting
control system and the development of those specific provisions. The relationship
of the internal auditor as an appraiser and evaluator of that system is discussed.
One of the great dangers now is attempting to closely
define the exact scope of the system of internal
accounting control. The scope of the internal
accounting control system will vary markedly from one
industry to another. For example, the pervasiveness of
the accounting system in a banking organization is
much greater than the accounting system of a
manufacturing concern. While the importance of the
accounting system and the need for competent
personnel to deal with it are no greater, the percentage of
the personnel which are in direct contact with the
accounting system is far greater in a banking concern
than in a manufacturing concern.
Although the exact scope of internal accounting
control is not defined, a number of characteristics
which apply to internal accounting control systems can
be identified. One of the recognized texts about the
characteristics of an internal control system is the Ninth
Edition of Montgomery's Auditing. 14 This text discusses
the definition, objectives, characteristics, conditions,
and basic types of controls expected in the system. In
addition, a number of public accounting firms have
recently published works on expected control system
attributes. It has become increasingly important that
financial managers and auditors reemphasize their
efforts to know and contribute to the improvement of
current literature on the control system.
The internal auditor should be a primary expert on
control technique and methodology within the
organization. The role of the internal auditor is to
appraise the control system throughout the organi-
zation as a function. The auditor and other personnel
with control responsibilities should thoroughly under-
stand the control systems within the organization.
These individuals should be aware that the control
system is interactive with and complementing the
operating system. The control system should assure
that the operating system is functioning properly.
,< Philip L Detliese et al., Montgomery's Auditing, 9th ed. (New York:
The Ronald Press Company, 1975).
In chapter one it was noted that the term
"monitoring" can be divided into two specific activities.
These can be defined, for convenience, as a
"management" process and an "audit" process. In this
context, the management process refers to that portion
of management which has the direct supervisory
responsibility over the operations of the control system
and its basic design. It is management's function to
design an internal accounting control system which
provides reasonable assurance. Management will then
implement the system and administer it on a day to-day
basis. Management also has a responsibility to maintain
the system and assure by periodic inspections that the
system is functioning as designed. As conditions change
within the organization, management is responsible for
correcting the system to operate with the new
conditions. Management also must inform individuals
engaged in the system's operations of the proper
procedures and any necessary changes. Management
has to also react to exceptions or anomalies which arise
in the system's operations. It is a function of the system
to discover errors and irregularities by surfacing
exceptions and anomalies in the system's operations.
In system monitoring, the audit function is the
periodic evaluation of the system to assure that it is
achieving the objectives of internal accounting control.
Although internal auditing is a part of the management
function, it will be identified here as separate from the
management function. An audit tests the system;
checks it for operation in accordance with
management's plan; and evaluates the system's
effectiveness and efficiency. An audit should also
review the system, appraise its adequacy, and
recommend any needed improvements to
management. Audits also advise management on the
means and methods for effecting improvements. In
general, the audit function is a periodic appraisal and
evaluation of the system which generates
recommendations for the system's improvement. The
relationships of these two functions are illustrated in
Figure 1.
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FIGURE I
DEFINITION OF MONITORING
Relation of Management and Audit Functions
Management responsibi-
libes on a continuous basis
? Establish requirements
? Design the system
? Implement the system
? Administer the system
? Maintain the system
? Instruct employees on the system
? Correct weaknesses in the system
? Amend the system in changing conditions
? Supervise activity in the system
? React to system output and excep-
tions
INTERNAL AUDIT RESPONSIBILITIES
ON A PERIODIC BASIS .
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The concept of "reasonable assurance" recognizes
that it is not in the interest of the organization, or its
shareholders, for the cost of internal control to exceed
the benefits which may be derived therefrom. Such
benefits, and in many cases such costs, are not likely
to be precisely quantifiable. Therefore, many decisions
on reasonable assurance will necessarily depend, in
part, on estimates and judgments by management.
Consideration of the benefits of internal accounting
control will generally involve some estimation of the
possible effect and likelihood of future conditions and
events. In addition, the benefits considered may often
include not only "quantitative" benefits, such as
reduction in exposure to the theft of assets, but also
"qualitative" benefits, such as the company's
reputation and its management. The concept of
reasonable assurance, as cited by the SEC in its
proposed rules, has long been recognized within the
areas of control and auditing expertise. It has,
however, gained renewed emphasis with the passage
of the Foreign Corrupt Practices Act which specifically
embodies the reasonable assurance concept. The
renewed interest in the concepts and practicalities of
the control system calls for those responsible for either
the control system or its evaluation to sharpen their
skills. Senior management and the board of directors
and its audit committee should expect continued and
up-to-date insight into the concepts and practice of
control from such individuals within their organization.
A definition of the scope of internal accounting
control is not provided here because a precise definition
of internal accounting control has considerable
dependence on the type of business to which the
definition is applied. Probably one of the cardinal issues
in determining compliance with the Foreign Corrupt
Practices Act over the next few years will be a more
precise definition of the scope of internal accounting
controls within specific industries. Managements will
undoubtedly find that such definitions will best be
determined and codified by industry groups who have
unique knowledge and insight into the operations of
companies in their specific type of business.
Summary: The specific boundaries for internal accounting control are not well
defined. They must be interpreted within individual organizations. The
responsibility for establishment and maintenance of an adequate system of
internal accounting control rests with management. Such a system must be
sufficient to provide reasonable assurance that the specific objectives of internal
accounting control are achieved, while ensuring that the costs of control do not
exceed the benefits to be derived. The internal auditor can play an important
separate role in monitoring the system (evaluating, appraising, and reporting) to
aid management in fulfillment of its responsibilities.
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4
MANAGEMENT REPORTING
Approaches which may be used to support
the management statement
Capsule: A number of different approaches have been suggested for
accomplishing the evaluation, documentation and monitoring of the control
system. This chapter will explore some of the facets of structuring a group to
undertake this effort.
The process of evaluating, documenting, and
monitoring the internal accounting system provides the
proper support for management's representations on
the system. From company to company, the approach
will vary somewhat depending on the number of
individuals employed in this process and the
qualifications of the individuals within the organization.
Certainly, five groups of people should be strongly
considered because of their individual areas of skill and
expertise. They are:
1. financial management (controller, etc.)
2. operating management
3. legal counsel
4. internal auditors
5. public accountants
Each organization must determine the number and
mix of these individuals. A principle concern must be
the ability of individual team members to contribute to
the process. It is doubtful that any one of these groups
will be given total and complete responsibility for this
process; although the nature of certain organizations
may demand that the process is assigned to only one
such group.
Internal auditors have unique expertise that can be
used in a number of capacities in the process. They
may be coequal partners within a composite group,
advisors to a group of individuals or those having the
primary responsibility with other groups acting as
advisors.
The internal auditing profession has developed
standards, certification programs, research facilities,
education courses, conferences, and seminars to
assure that the members of the profession are experts
in their field. Through the activities of The Institute of
Internal Auditors, Inc., internal auditors receive
effective support to help them provide the best
possible service for management and the directorate of
their particular employing organization. Through such
professional development, and in the changing
requirements of employers, internal auditors have
become the resident experts in internal controls within
the organizations. Internal auditors are uniquely
qualified to evaluate and monitor control systems
because this has been their primary interest through
their careers. While the purpose of their evaluation
may be shifting from solely responding to
management's internal organizational concerns to
include a support of management's public
responsibilities, the methodology, documentation, and
analysis required will remain basically the same.
Because internal auditors work within one
corporation or organizational structure, they are very
familiar with the operating and control systems of that
enterprise. Therefore, they are able to advise on many
of the cost/benefits decisions made in an evaluation
monitoring process. While internal auditors are
certainly not the only ones within the organization that
know about the control system and operating
environment, they are unique because their full-time
dedication is the appraisal of control systems. Their
knowledge and experience include not only the
specifics of the internal accounting control system as
set forth in the Foreign Corrupt Practices Act, but also
the company's total internal control system. Thus,
they are able to meet any demands arising from
extended definitions of the Foreign Corrupt Practices
Act's language.
Economy is another advantage that internal auditors
offer compared to outside sources. Internal auditors
are thoroughly versed in every facet of the company's
operation and this almost certainly assures a more
efficient and effective process. Internal auditors employ
methodology and techniques at least as advanced as
those used by outside sources. Thus management
confidently relies on internal auditors to see that
savings are not achieved at the sacrifice of quality.
Once the initial evaluation is made, it is imperative
that the system of internal accounting control be
continually monitored and evaluated on an ongoing
basis. Certainly, in this capacity, the internal auditor is
the company's most qualified resource.
In the proposed SEC rules, the requirements for
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122
Figure 2
THEORETICAL SCHEMATIC FOR COMPLIANCE PROJECT
INTERNAL FINANCIAL OPERATING LEGAL INDEPENDENT
MANAGEMENT COUNSEL ACCOUNTANTS
FAMILIARIZE WITH
REQUIREMENTS
DEVELOP ACTION
PLAN
ASSEMBLE ACTION
TEAM & CHARTER
THE TEAM
EVALUATE THE
CONTROL
ENVIRONMENT
CODIFY SPECIFIC
OBJECTIVES
RECOMMENDATIONS
DETERMINE
PROCEDURES NEEDED
TO ACHIEVE
SPECIFIC OBJECTIVES
DETERMINE THAT
PROCEDURES ARE
IN PLACE
CONTINUE
TO MONITOR
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management reporting of the ongoing system
evaluation make the internal audit function a naturally
identified resource. In fact, the function is recognized
within the proposed SEC rules. The ability of the audit
function to evaluate, document, and provide
management with immediate feedback on the status of
controls, is the most economical means of performing
an effective ongoing evaluation. Therefore, the internal
audit function is an important part of the evaluation
process in its initial stages and may be an even more
instrumental part of the ongoing evaluation process in
the future.
Management should expect its internal audit
department to have a natural command of the
evaluation methodologies that are most beneficial to
the organization. Management should also expect the
internal audit department to be aware of the means of
proper documentation to support the required
representations and be experienced in consulting with
members of the legal, financial control, and public
accounting disciplines in order to provide a resource
for their efforts.
There is no "perfect" means or method of
constructing a compliance project. A theoretical
schematic of the compliance project is shown in Figure
2. It should be noted that the broken path line at the
bottom of the figure indicates that the monitoring will
continue into the future. The project itself is to be a
never-ending evaluation to assure the proper
maintenance of a sound internal accounting control
system.
Some argue that the more available the documenta-
tion, the more ammunition is given to anyone who
questions the decisions made. It has been convincingly
proved by auditors, however, that the documentation
of the decision-making process makes it far easier to
display the thought process and support the logic of
decisions. Not only should the system be documented,
but also the considerations leading to the system's
individual parts. With this documentation available, the
organization can show that its control procedures
were carefully considered. Cost/benefits judgments
which are made should be documented for an easier
recall later. The impact of environmental factors on the
chosen procedures should be recorded also.
Summary: There are varied compositions of resources which can be employed to
accomplish the evaluation. The internal auditor can interface with a number of
different structures, and in so doing, the internal auditor can be a very cost-
productive resource.
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5
METHODOLOGY
Broad descriptions of methodology
used in evaluation
Capsule: Various techniques for control evaluation are briefly described. They
include Cycle, Flowcharting, Matrix Analysis, Checklist, and EDP Concerns.
Definition
The purpose of this section is to review various
recognized methodologies the internal auditor uses
when performing the evaluation. The descriptions are
cursory and rudimentary representations for these
systems and provide a basis for interaction between
the parties involved.
Techniques
Cycle Approach: This technique for the analysis of a
control system has been introduced with varying
modifications by several public accounting firms and
by the Special Advisory Committee on Internal
Accounting Controls of the AICPA. This approach is
based on the review of transactions as they pass
through the accounting system.
Transactions are grouped together into definable
groups called "cycles" for the purpose of analysis. As
an example, the revenue cycle begins with the
acceptance of a customer and continues to include
credit, shipping, sales, sales deductions, receivables,
cash receipts, allowance for doubtful accounts, sales
warranties, and so forth. Other cycles include
expenditures, production or conversion, financing, and
external financial reporting. The transactions and their
handling are measured against prescribed guidelines. In
many cases, this system's publications also include
flowcharting and risk identification in the total evaluation
process.
Flowcharting: Flowcharting has long been
recognized in the internal audit profession as a
productive means of evaluating administrative,
operational, and accounting controls. It involves the
graphic representation of operations through
recognized symbolic recording.
Very often, the flowchart will incorporate parallel
narrative descriptions of the system. Flowcharting
enjoys the advantage of being adaptable to cyclical,
organizational, or functional perspectives.
Flowcharting has also been very commonly used in
data processing programming circles.
Matrix Analysis: The matrix analysis technique
reviews the internal control system as a network of
interactive controls in relationship to an organization's
existing risks. It recognizes the concept of employing
controls to minimize risk and the cross relationship of
individual control procedures to supply backup
controls with minimum redundancy.
It supports investigation of cost/benefits. This
technique uses a matrix to measure all controls in a
functional, cyclical, or organizational unit against the
risks in that unit to establish the relationship and
effectiveness of the individual procedures and the
network of procedures. It is also designed to be
responsive to the dynamics of changing organizations
because of the ease of updating and amending.
EDP: Because of the unique nature of electronic
data processing, the techniques of audit and control
analysis require specialized tools and especially skilled
auditors. Therefore, in this description EDP audit and
control evaluation will be treated as a separate subject.
Some of the techniques described above will be used
with specialized techniques in control and evaluation
examinations of electronic data processing facilities.
The pervasiveness of computers in all kinds of
organizations brings a special concern to the control
evaluation process. The computer once viewed as a
high-powered adding machine, is now an integral part
of the operations and control systems. The evaluation
of controls in computer operation, programming, and
administration concerns not only the control
procedures in the direct operations of the data
processing department, but also the environment
which is created throughout the organization because
of the use of computers. Systems Auditability and
Control (SAC), one of the foremost research reports
on computer control and related auditing techniques,
was recently published by IIA. This three-volume
publication, developed under the sponsorship of IBM,
is the backbone of the evaluation guide.
Checklist: Internal control checklist is a review and
analysis technique that is particularly useful in a highly
structured situation where control procedures are
highly manualized and the exact procedures are used
at several locations. This is particuarly true for retail
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locations that are highly standardized as to their would have documented standard procedures for each
complete operations. For example, a corporation with location. In these cases an internal control checklist
a large number of franchised locations that basically could be a valuable tool for verifying that the location
had the same size, volume, and number of employees is in compliance with such procedures.
Summary: Corporations have several recognized techniques, which may be
employed singularly or in concert, to initially evaluate the internal accounting
control system, to document the system and its evaluation, and to employ in the
ongoing monitoring of the system. Management should be generally familiar with
the methodologies available and should discuss with the review committee
(described in Chapter 4) the rationale for the use of any method or combination
of methods for conducting their evaluation. The professional internal auditor
should supply management and the review committee with an ongoing monitoring
program designed to evaluate and document the system in accordance with the
agreed methodology. This will provide management and the board of directors
with an assurance that the internal accounting control system is appropriately
documented and effectively monitored.
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6
THE FUTURE
Future literature and research into
methodologies of evaluation and control guidelines
Capsule: A discussion of specific future needs to support the evaluation process
and management representations.
Just before December, 1977, it became apparent that
the Foreign Corrupt Practices Act with its current
provisions would be passed into law. Since that time
heightened efforts have been made to identify and
codify the mechanical processes or methodologies used
in the evaluation and documentation process. Most
notably, the advisory committee and the larger public
accounting firms have expended considerable re-
sources in money and manpower to provide manage-
ment, internal auditors, and the public accounting firms'
staffs, with improved methodology for evaluating
control systems. While some variation does exist among
these groups. a basic thread tends to run through their
work. They appear to be aimed at an approach which
may be too casually accepted as a "laundry list." The
firms which have developed these systems, and the
person or company astutely studying their work, will
recognize that the analytical process is far deeper and
more significant than a simple "laundry list" of all of the
control procedures which should be ideally employed.
In the previous chapter, several analytical approach-
es were described which direct even the most casual
observer into the analytical process. It is not only
desirable, but necessary, to continue study and
development in order to devise and refine even more
improved systems of control evaluation. A system of
control evaluation which facilitates the cost/benefits
decisions in this process is greatly needed.
The Institute of Internal Auditors, Inc., is developing
and publishing texts on at least two analysis
methodologies: flowcharting and matrix analysis. In
addition, texts on documentation and the reporting of
evaluation results are also being published by The
Institute. While all of these texts are generally aimed at
the internal auditor, they should be helpful to any
organization.
An industry codification of the specific objectives of
the internal accounting control system is critically
needed for facilitating the evaluation of the control
system. Industry's development of such specific
objectives would serve as guidance for individual
companies and as an authoritative body of knowledge
for such industries.
While individual companies are at some variance
over the specific control procedures employed in
companies within an industry, the objectives of the
control system should not vary markedly. Any two
companies in the same industry should be able to cite
the same control objectives while still having latitude to
differ broadly on the control procedures that meet their
own organizational and operating philosophy. Several
groups now existing within industry or trade
associations competently deal with the formation of
their industry's specific objectives. The Institute is
trying to identify professionally competent groups and
encourage them to undertake this task. The Institute
cannot accept responsibility, however, for the
commitment of such associations.
11A believes that such industry groups and
associations can provide their members with a
meaningful service by undertaking these efforts. Any
group desiring to participate in such an effort should
contact the president of The Institute of Internal
Auditors, Inc., in Altamonte Springs, Florida. Corpo-
rations with memberships in such trade and industry
associations should involve their colleagues in such an
undertaking in order to serve their industry and
individual companies within it.
Summary: Through a broadened understanding of the Foreign Corrupt Practices
Act and the related reporting requirements, individual organizations will hopefully
find the means and incentives to make this a productive process. This book has
tried to stimulate the reader's thinking about the organized undertaking of
evaluation documentation and the monitoring of the internal accounting control
system. When property reviewed and used, the internal accounting control system
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can be an exceedingly beneficial part of any organization's total structure. It is
hoped that internal auditors will help make the organization aware of the law's
requirements and regulations and will help prepare and f"tate compliance with
them.
The Institute of Internal Auditors, Inc., continues to provide members of its
profession with the tools to assist in this effort.
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APPENDICES
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APPENDIX A
A Brief Description and History of
The Institute of Internal Auditors, Inc.
How often has it been said: They didn't know what
they were getting themselves into."
Such a statement will never be made about the
handful of dedicated men who in 1941 founded The
Institute of Internal Auditors, Inc.
Nearly three months before the actual incor-
poration, this handful of men met and drafted a letter
to prospective charter members. The letter welcomed
those interested in promoting internal auditing and
stated the following objectives for The Institute:
? Furtherance of the generally acknowledged
professional status of the internal auditor;
? Development of the member's individual
status through the personal and technical
aspects of The Institute's activities;
? Education of other corporate officers and
businessmen in general to an understanding
of the true scope and potentialities of
internal auditing;
? Study of the problems of internal auditing
and provision of the needed professional
literature in this field; .
? Cooperation with The American Institute of
Accountants, The Controllers Institute, and
other recognized professional groups in
contiguous or closely related fields.
In general, that same letter stated the need for an
association to advance the professional status of
internal auditors and to further the public under-
standing of internal auditing.
No doubt they knew what they were doing, those
founding fathers. For a belief in those broad and
comprehensive objectives and purposes by many other
internal auditors down through the years has helped
The Institute grow from that dedicated handful - 24
charter members gathered in New York City - to
more than 20,000 members in 85 countries. Today it's
still growing, not simply in numbers but also in
productivity, resources, and prestige.
One reason why IA membership has more than
doubled in the past five years is that those founding
fathers saw the growth of the internal auditing function
as a response to new management needs resulting
from the increasing size and complexity of corporate
and governmental organizations. That belief is as valid
today as it was 38 years ago.
In the early years, growth was slow but steady By
1947 IA membership had increased to 1,322 and 20
chapters in the United States and Canada had been
established.
By 1962 the membership had grown to more than
5,000, and the number of chapters had more than
tripled to 73.
Nine years later, in 1971, membership totals stood at
more than 8,000 in 97 chapters. The headquarters staff
numbered 13. In 1966 a director of technical services,
heading research, educational and publication activi-
ties, was appointed. In 1968 the Cadmus Educational
Foundation (CEF) under a director of education was
formed.
While IIA headquarters remained in New York, the
CEF office was located in Winter Park, Florida. Th
e
formation of the educational foundation was a major
development in IIA history.
By 1971, the Cadmus Educational Foundation,
administering a new internal auditing educational
program, was sponsoring 24 seminars that attracted
more than 500 registrants.
In 1977, Institute membership had grown to more
than 14,000 with 125 chapters. The IIA staff now
numbered more than 40. Such dynamic growth, both
in numbers of members and in staff activities,
ultimately led to the acquisition of the site of The
Institute's present headquarters - two three-story
office buildings on more than five acres of land in
Altamonte Springs, just northeast of Orlando.
Growth in membership and staff has been only one
aspect in the evolution of The Institute. In order to
keep pace with the increasing demands of the
profession, IIA's seminar program, which only eight
years ago attracted 500 registrants to 24 seminars,
emerged to the point where it now services more than
? 2,000 auditors through specialized seminars.
IA's conference program has also kept pace with
overall Institute growth and needs. Annual conferences
began in 1942 with the first four held in New York. In
1947 the site shifted to Detroit and the conference
drew a record 560 people. Today's international confer-
ences, the educational and social highlights of the IA
year, draw easily four times that many people.
Specialized conferences, to help practitioners keep
abreast of their constantly changing environment, are
also a major ingredient of IIA's continuing education
program. Last year nearly 2,000 people participated in
IA educational conferences.
Research, like education, has always held top
priority within The Institute. Provisions for doing
research in the field of internal auditing were made as
early as 1942. Perhaps the first major research project
involved the development of the Statement of
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Responsibilities for Internal Auditors. The statement
covers the nature of internal auditing, objectives and
related activities, scope of authority and responsibility,
and independence. Approved by IIA's Board of
Directors in 1947, the statement has been revised
twice and provided the foundation upon which the
present Standards for the Professional Practice of
Internal Auditing were built.
While the research carried on by The Institute
covers a wide range of subjects, one landmark project
deserves special note. Funded by a $500,000-grant from
the IBM Corporation and working with the Stanford
Research Institute and a 47-member advisory group,
IIA embarked in 1975 on a two-year project to explore
the role of the internal auditor in data processing. In
1977 The Institute published the findings in a three-
volume Systems Auditability and Control (SAC)
report. The widely-acclaimed SAC reports - for
executive management, auditors, and EDP practi-
tioners - provide practical solutions to current
problems associated with computer audit and control.
Certainly the SAC project was a major break-
through for The Institute in the EDP auditing area, but
it was only the beginning. IIA fully realizes the need to
understand the EDP aspect and to carry out internal
auditing in the evolving EDP environment. Such an
understanding has prompted The Institute to take a
leadership role in providing the technology for internal
auditing in EDP.
Among top IIA priorities is the continuing establish-
ment of internal auditing courses in college and
university curricula. With the development and
publication of more adequate text and teaching
materials, The Institute is making more progress in this
area.
In fact, The Institute has long been concerned about
publications, not only for use in colleges, but also for
the practicing internal auditor. IIA's publication catalog
now lists the foremost sources of information or.
modern internal audit theory, training, and practice
available. These include textbooks, research reports,
handbooks, and references written by leading internal
auditors with an emphasis on the practical application
of internal audit knowledge.
Another facet of professional development in which
The Institute has assumed a leadership role is its
certification program. Early planning for the certifi-
cation program began in the mid-1960s and important
landmarks along the way included the adoption of a
Code of Ethics in 1968 and the identification of a
Common Body of Knowledge, on which to base the
examination for certification.
In 1973 The Institute made its debut in governmental
and public affairs, when it committed to assist to
improve management practice in public administration
and nonprofit institutions through auditing. The area of
governmental and public affairs is obviously one of
emerging importance.
The Institute's increasing emphasis on research and
education led to the establishment in 1976 of the
Foundation for Auditability, Research, and Education
(FARE).
FARE is a separate, legal entity. It is a fully
approved, tax-exempt corporation permitted to re-
ceive grants and contributions for promoting and
furthering education in internal auditing. FARE has
already put such contributions to good use by
cosponsoring, along with The Institute, a pair of
conferences dealing with the Foreign Corrupt Prac-
tices Act.
Much has been accomplished in 38 years, thanks to
thousands of IIA members working on a voluntary
basis for the advancement of their profession and The
Institute. And, thanks also to the founding fathers'
farseeing goals, much will be accomplished in the
future.
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131'
APPENDIX B
Accounting Standards
Assets, Sec. 102. Section 13(b) of the Securities Exchange Act of 1934
transactions and (15 U.S.C. 78q(b)) is amended by inserting "(1)" after "(b)" and by adding
dispositions. at the end thereof the following;
15 U.S.C. 78m.
15 U.S.C. 78/ "(2) Every issuer which has a class of securities registered pursuant
Post p.1500. to section 12 of this title and every issuer which is required to file
reports pursuant to section 15(d) of this title shall -
Records, "(A) make and keep books, records, and accounts which in reasonable
maintenance. detail, accurately and fairly reflect the transactions and dispositions of the
assets of the issuer; and
Internal accounting controls, "(B) devise and maintain a system of internal accounting controls
establishment. sufficient to provide reasonable assurances that -
"(i) transactions are executed in accordance with management's general
or specific authorization;
"(ii) transactions are recorded as necessary (I) to permit preparation
of financial statements in conformity with generally accepted accounting
principles or any other criteria applicable to such statements, and (II) to
maintain accountability for assets;
"(iii) access to assets is permitted only in accordance with management's
general or specific authorization; and
"(iv) the recorded accountability for assets is compared with the existing
assets at reasonable intervals and appropriate action is taken with respect
to any differences."
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Securities and Exchange Commission
[Release No. 34-14478; ASR 242]
NOTIFICATION OF ENACTMENT OF FOREIGN CORRUPT
PRACTICES ACT OF 1977
Agency: Securities and Exchange Commission.
Action: Notification of enactment of Foreign Corrupt
Practices Act of 1977.
Summary: The Commission wishes to call to the
attention of issuers, accountants, attorneys and other
interested persons the enactment of the Foreign
Corrupt Practices Act of 1977. The Act, which is
described in detail below, requires issuers subject to
the registration and reporting provisions of the
Securities Exchange Act of 1934, as amended, among
other things to comply with certain accounting
standards. It also makes unlawful the use of any means
of instrumentality of interstate commerce by any such
issuer, or by any domestic concern not subject to the
Securities Exchange Act, in furtherance of any offer,
payment, promise to pay or authorization of the
payment of any money, or offer, gift, promise to give or
authorization of the giving of anything of value, to
foreign officials and certain other persons for certain
corrupt practices.
For further information contact: Frederick B.
Wade, Office of the General Counsel (202/755-1229),
Barbara L. Leventhal, Division of Corporation Finance
(202/755-1750), or Edward R. Cheramy, Office of Chief
Accountant (202/376-8020), Securities and Exchange
Commission, 500 North Capitol Street, Washington,
D.C. 20549.
Supplementary information: The Securities and
Exchange Commission wishes to call to the attention
of issuers, attorneys, accountants and other interested
persons, the recent enactment of the Foreign Corrupt
Practices Act of 1977 (the "Act"). i The Act, which was
signed by the President on December 19, 1977, and
became effective on that date, amends Section 13(b) of
the Securities Exchange Act of 1934 [15 U.S.C.
The Act is contained in Title I of Public Law No. 95213 (Dec 19,
1977)_ Title II of the legislation, the Domestic and Foreign Investment
Improved Disclosure Act of 1977, amends Section 13 of the Securities
Exchange Act of 1934 (15 U.SC 78m) to require expanded
disclosure by persons who acquire or possess beneficial ownership of
more than 5 percent of a class of securities which is registered
pursuant to Section 12 of the Exchange Act, or any equity security of
rance company, which would have been required to be so
registered except for the exemption contained in Section 12(g)(2)(G)
any equity security issued by a closed end investment company
registered under the Investment Company Act of 1940. Rulemaking to
implement Section l3(g) as part of a uniform integrated approach to
disclosure under Sections 13(d),(f( and (g) is under consideration and
will be the subject of a separate release.
78m(b)] to require every issuer which has a class of
securities registered pursuant to Section 12 of the
Securities Exchange Act, and every issuer which is
required to file reports pursuant to Section 15(d) of the
Securities Exchange Act, to comply with certain
accounting standards. The Act also makes it unlawful
for such issuers, or any domestic concern not subject
to the Securities Exchange Act, to engage in certain
corrupt practices with respect to foreign officials.
Because the Act became effective upon signing, it is
important that issuers subject to the new requirements
review their accounting procedures, systems of
internal accounting controls and business practices in
order that they may take any actions necessary to
comply with the requirements contained in the Act.
A. ACCOUNTING STANDARDS
Section 13(b) of the Securities Exchange Act is
amended by renumbering existing subsection (b) as
paragraph (b)(1) of Section 13, and by adding two new
paragraphs to that subsection. New paragraph 13)b)(2)
applies to issuers which have a class of securities
registered pursuant to Section 12 of the Securities
Exchange Act, and issuers required to file reports
pursuant to Section 15(d) of the Securities Exchange
Act (hereinafter referred to collectively as "reporting
companies"). It requires reporting companies to make
and keep books, records and accounts which, in
reasonable detail, accurately and fairly reflect the
transactions and dispositions of the assets of the
issuer. The maintenance of accurate books and
records by publicly-held companies is a necessary
concomitant of the existing requirement for full, fair
and accurate periodic reports. Inaccurate books, off-
the-book accounts, and related practices are pro
scribed by the Act.
Reporting companies are also required to devise and
maintain a system of internal accounting controls
sufficient to provide reasonable assurances that:
(i) Transactions are executed in accordance
with management's specific authorization;
)u) Transactions are recorded as necessary: (a)
to permit preparation of financial statements
in conformity with generally accepted ac-
counting principles or other applicable
criteria; and (b) to maintain accountability for
its assets;
(iii) Access to assets is permitted only in
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accordance with management authorization,
and
(iv) The recorded accountability for assets is
compared with existing assets at reasonable
intervals and appropriate action is taken with
respect to any differences.
New paragraph 13(b)(3) of the Securities Exchange
Act provides that, with respect to "matters concerning
the national security of the United States, no duty or
liability under paragraph (2) * * * shall be imposed
upon any person acting in cooperation with the head
of any Federal department or agency responsible for
such matters if such act in cooperation with such head
of a department or agency was done upon the specific,
written directive of the head of such department or
agency pursuant to Presidential authority to issue such
directives." Each such directive shall expire one year
after it is issued unless it is renewed in writting.
B. FOREIGN CORRUPT PRACTICES BY
ISSUERS
Pursuant to the Act, a new Section 30A has been
added to the Securities Exchange Act, which makes it
unlawful for any reporting company, or any officer,
director, employee, or agent of the company, or any
shareholder acting on behalf of such a company, to
make use of the mails or any means or instrumen-
talities of interstate commerce, corruptly, in further-
ance of an offer, payment, promise to pay, or
authorization of the payment of any money, or offer,
gift, promise to give or authorization of the giving of
anything of value, to three classes of persons:
1. An official of a foreign government or
instrumentality of a foreign government;
2. A foreign political party-or-official thereof, or
any candidate for a foreign political office; or
3. Any other person where the reporting
company knows, or has reason to know, that
all or a portion of such money or thing of
value will be offered, given or promised,
directly or indirectly to any foreign official,
foreign political party or official thereof, or
any candidate for a foreign political office.
New Section 30A applies to payments made for the
purpose of influencing an act or decision of a foreign
official, foreign political party or candidate for foreign
political office (including a decision not to act), or
inducing such a person or party to use his or its
influence to affect any government act or decision, in
order to assist an issuer in obtaining, retaining or
directing business to any person. A "foreign official" is
defined to mean any officer or employee of a foreign
government or any department, agency or instru-
mentality thereof, or any person acting in an official
capacity for or on behalf of such government. The
term does not include employees whose duties are
essentially ministerial or clerical.
C. THE COMMISSIONS ENFORCEMENT
RESPONSIBILITIES
The legislative history of the Act reflects that the
Commission's enforcement responsibilities extend to
conducting investigations, bringing civil injunctive
actions, commencing administrative proceedings if
appropriate, including public or private disciplinary
proceedings pursuant to Rule 2(e) of the Commission's
Rules of Practice,2 and referring cases to the Justice
Department for criminal prosecution where warranted,
just as the Commission currently does with respect to
its existing responsibilities under the federal securities
laws.3 In addition, as is true with respect to violations
of other provisions of the Securities Exchange Act,
controlling persons of an issuer may be liable for
violations of the new requirements,4 and a negligence
standard will govern civil injunctive actions brought to
enforce the Act.5 The legislative history of the Act also
contemplates that private rights of action properly
could be implied under the Act on behalf of persons
who suffer injury as a result of prohibited corporate
bribery.?
In the case of an individual, the penalties for each
criminal violation of the corrupt practices provisions of
new Section 30A are a fine of up to $10,000 or
imprisonment for up to 5 years, or both; in the case of
a corporation, the penalties for violation of the Section
include a fine of up to $1,000,000. In this regard, the
Act provides that any fines imposed upon individuals
may not be paid directly or indirectly by an issuer.
D. FOREIGN CORRUPT PRACTICES BY
DOMESTIC CONCERNS
The Act also subjects any domestic business
concern, other than one subject to the reporting
requirements of the Securities Exchange Act, and any
officer, director or agent of such a domestic business
concern or any natural person in control of such a
domestic concern to the same prohibitions and
penalties that are applicable to reporting companies.
The provisions applicable to domestic concerns will be
administered and enforced by the Justice Department
rather than the Commission.
E. IMPACT ON DISCLOSURE POLICIES
While the Act imposes new requirements on
reporting companies with respect to the maintenance of
internal accounting controls, and outlaws certain
foreign corrupt practices, it does not alter the existing
obligation of such companies to adequately disclose
s 17 CFR 201.2(e).
s S. Rep. No. 95114, 95th Cong., 1st Sess. (1977) at 12; H R. Rep.
No. 95-640, 95th Cong., 1st Sess. (1977) at to.
See Section 20 of the Securities Exchange Act, 15 US C. 78t,
H.R. Rep. No. 95640, 95th Cong., 1st Sess. (1977) at 10.
Id
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material questionable and illegal corporate payments
and practices. In addition to providing all information
called for by the specific disclosure requirements of the
various registration and reporting forms promulgated
pursuant to the Securities Act of 1933 and the
Securities Exchange Act of 1934, registrants have a
continuing obligation to disclose all material information
and all information necessary to prevent other
disclosures made from being misleading with respect to
such transactions.? Although the legality or illegality of a
particular transaction is one of the factors that must be
assessed in determining its materiality, other factors
must also be considered. A transaction which is not
unlawful under the Act may still be material to investors
and therefore required to be disclosed under the federal
securities laws. For guidance in determining whether or
not a specific fact is material, attention is directed to the
discussion of materiality contained in Securities and
Exchange Commission, Report on Questionable and
Illegal Corporate Payments and Practices, which was
submitted to the Senate Committee on Banking,
Housing and Urban Development on May 12, 1976, at
16-32 ("Report").
F. EFFECT ON OUTSTANDING RULE
PROPOSALS
On January 19, 1977, the Commission published for
comment a series of rulemaking proposals designed to
promote the reliability and completeness of financial
information, prevent concealment of questionable or
illegal corporate payments and practices, and provide
information to investors concerning management
? See e.g., 17 CFR 230.405(1); 17 CFR 230.408; 17 CFR 240.126-20;
17 CFR 240.106.2; 17 CFR 240.14a-9.
involvement in such transactions.s The proposals were
substantially similar to a legislative proposal submitted
by the Commission to the Senate Committee on
Banking, Housing and Urban Affairs on May 12, 1976,
parts of which were ultimately incorporated in the Act9
The Commission is considering the numerous
comments it has received on these proposals and will
determine whether to adopt, modify or withdraw those
rule making proposals.i0 In view of the extensive
comments which already have been received no further
comments on these proposals are being solicited. An
appropriate announcement respecting the Commis-
sion's determination with respect to these rules
proposals will be published in the near future.
x Securities Exchange Act Release No. 13185 (Jan 19, 1977) 11 SEC
Docket 1514 (1977).
? The proposals were contained in the Commission's Report, supra,
at 63, which is, accordingly, a part of the legislative history of the Act
The Commission's proposals were originally introduced by Senator
Proxmire, Chairman of the Senate Committee on Banking, Housing
and Urban Al lrs, as 5.3418. Following hearings, the committee
referred a bill to the senate floor - S 3664 - which embodied the
Commission's recommendations as well as certain other proposals
S.3664 was passed by the Senate unanimously on September 15,
1976. The House of Representatives, however, was unable to
complete work on the legislation before adjournment sine die on
October 2, 1976.
The substance of the Commission's proposals was again included
in 5.305, which was passed by the Senate on May 2, 1977, but two of
the proposals were deleted in the joint conference committee
appointed to reconcile the differences in the Senate and House
versions of the bill, prior to enactment of the legislation
1? The accounting provisions in the new law, which are described
above, are similar to proposed Rules 13b-1 and 13b-2. The rulemaking
proposals not incorporated in the legislation include proposed Rule
13b3, which would prohibit the falsification of corporate books or
records; proposed Rule 136 .4, which would prohibit the making of false
or misleading statements to an accountant; and proposed Item 6(d) of
Schedule 14A relating to disclosure of management involvement in
questionable or illegal payments or practices.
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Securities and Exchange Commission
(17 CFR Parts 211, 229, 240, 249)
(Release No. 34-15772, File No. S7-779)
STATEMENT OF MANAGEMENT ON INTERNAL
ACCOUNTING CONTROL
Summary: Since the enactment of the Foreign Corrupt
Practices Act of 1977, interest in the effectiveness of
internal accounting controls has been enhanced. To
provide information about the effectiveness of systems
of internal accounting control, the Commission is
proposing for comment rules which would require
inclusion of a statement of management on internal
accounting control in annual reports on Form 10-K filed
with the Commission under the Securities Exchange
Act of 1934, and in annual reports to security holders
furnished pursuant to the proxy rules. The Commission
also is proposing that such statement be examined and
reported on by an independent public accountant.
Dates: Comments should be received by the
Commission on or before July 31, 1979.
Address: Comments should be submitted in triplicate
to George A. Fitzsimmons, Secretary, Securities and
Exchange Commission, 500 North Capitol Street,
Washington, D.C. 20549. Comment letters should refer
to File No. S7-779. All comments received will be
available for public inspection and copying in the
Commission's Public Reference Room, 1100 L Street,
N. W., Washington, D. C. 20549.
For further information contact: James J. Doyle,
(202-472-3782), Office of the Chief Accountant,
Securities and Exchange Commission, 500 North
Capitol Street, Washington, D.C. 20549.
Supplementary information: The Securities and
Exchange Commission is proposing for public comment
amendments to Form 10-K (17 CFR 249.310);
Regulation 14A (17 CFR 240.14a-1 et seq.); and
Regulation S-K (17 CFR 229.20). The proposed
amendments, if adopted, would require inclusion of a
statement of management on internal accounting
control in Forms 10-K and in annual reports to security
holders furnished pursuant to Rule 14a-3 117 CFR
240.14a-3]. To standardize the disclosure requirements,
the information to be included in the statement of
management on internal accounting control would be
specified in proposed new Item 7 of Regulation S-K.
The amendments are proposed to be adopted in two
stages. As of dates after December 15, 1979 and prior to
December 16, 1980 for which audited balance sheets
are required, the statement of management on internal
accounting control would be required to include the
following:
1. Management's opinion as to whether, as of
the date of such audited balance sheet, the
systems of internal accounting control of the
registrant and its subsidiaries provided
reasonable assurances that specified
objectives of internal accounting control were
achieved; and
2. A description of any material weaknesses in
internal accounting control communicated by
the independent accountants of the registrant
or its subsidiaries which have not been
corrected, and a statement of the reasons
why they have not been corrected.
For periods ending after December 15, 1980 for
which audited statements of income are required, the
statement of management on internal accounting
control would be required to include management's
opinion as to whether, for such periods, the systems of
internal accounting control of the registrant and its
subsidiaries provided reasonable assurances that the
specified objectives of internal accounting control were
achieved. In addition, the statement of management on
internal accounting control would be required to be
examined and reported on by an independent public
accountant for such periods.
Thus, initially the management opinion which would
be required would extend only to conditions existing as
of the balance sheet date, and the statement of
management would not be required to be examined and
reported on by an independent accountant. There
would be a specific disclosure requirement relating to
any material weaknesses in internal accounting control
communicated by the independent accountants which
have not been corrected.
After the initial stage, the management opinion which
would be required would extend to conditions
which existed during the periods for which audited
statements of income are required, and the statement
of management would be required to be examined and
reported on by an independent public accountant.
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1. BACKGROUND AND BASIS FOR
PROPOSED RULES
In December 1977, Congress enacted the Foreign
Corrupt Practices Act of 1977 ("FCPA").' Among other
things, the FCPA requires that issuers subject to the
registration and reporting provisions of the Securities
Exchange Act of 1934, as amended, devise and maintain
a system of internal accounting control sufficient to
provide reasonable assurances that
(i) transactions are executed in accordance with
management's general or specific authorization;
(ii) transactions are recorded as necessary (a) to
permit preparation of financial statements in
conformity with generally accepted accounting
principles or any other criteria applicable to such
statements, and (b) to maintain accountability for
assets;
(iii) access to assets is permitted only in
accordance with management's general or specific
authorization; and
(iv) the recorded accountability for assets is
compared with the existing assets at reasonable
intervals and appropriate action is taken with
respect to any differences3
While the FCPA, which was effective upon
enactment,3 contains a specific statutory requirement
that certain issuers devise and maintain an effective
system of internal accounting control, the
establishment and maintenance of such a system have
always been important responsibilities of management.
An effective system of internal accounting control has
always been necessary to produce reliable financial
statements and other financial information generated
from the accounting system, as well as to assure that
assets and transactions of the business are adequately
controlled.
The Commission believes that information regarding
the effectiveness of an issuer's system of internal
accounting control may be necessary to enable
investors to better evaluate management's performance
of its stewardship responsibilities and the reliability of
interim financial statements and other unaudited
financial information generated from the accounting
system, and that, therefore, the proposed rules may be
a These internal accounting control provisions of the FCPA are
codified in Sectlon13fb11211B1 of the Securities Exchange Act of
1934, 15 US.C. 78m(b)(2)IBI
The Comission discussed the enactment of the FCPA in
Accounting Smeries Release No. 242 (Securities Exchange Act Release
No 14478, February 16, 1978. 43 FR 7752), in which it stated:
Because the Act became effective upon signing, it is
important that issuers subject to the new requirements review
their accounting procedures, systems of internal accounting
controls and business practices in order that they may take
any actions necessary to comply with the requirements
con, in the Act
The Commission also discussed the provisions of the FCPA in
Securities Exchange Act Release No. 34-15570 (44 FR 10964),
February 15, 1979.
necessary to the interests of investors and other users
of financial information."
In proposing to require a statement of management
on internal accounting control, the Commission is not
setting forth detailed, prescriptive rules for control
procedures and techniques which will ensure
compliance with the internal accounting control
provisions of the FCPA. The Commission believes that
the control procedures and techniques which will
provide for compliance with those provisions must be
determined in the context of the circumstances of each
issuer, and it is the responsibility of management to
make those determinations.
As noted above, the Commission is proposing that,
for periods ending after December 15, 1980 for which
audited statements of income are required, the
statement of management on internal accounting
control be examined and reported on by an
independent public accountant. Because of the
independent public accountant's expertise with respect
to internal accounting control and the fact that internal
accounting control is integral to preparation of financial
statements, the Commission believes that an
examination by an independent public accountant of a
statement of management on internal accounting
control would result in increased reliability of such a
statement. It should be emphasized, however, that the
independent accountant's responsibility will be more
limited than that of management. The responsibility for
complying with the substantive internal accounting
control provisions of the FCPA, as well as with the
disclosure requirements of these proposed rules, rests
with the issuer and its management.
The Commission notes that increasing attention
recently has been focused on the need for a
"management report" directed to management
responsibilities for financial reporting. The principal
initiative in this regard was taken by the Cohen
Commission, which recommended, among other
things, that companies include with the financial
statements a report that acknowledges management's
responsibilities with respect to the financial information
reported.' The Financial Executives Institute ("FEI")
responded to the Cohen Commission's recommenda-
tion by endorsing the furnishing of a management
report and, in June 1978, issued suggested guidelines
for preparation of a management report. Those
guidelines generally follow the recommendations of the
? The Commission on Auditor's Responsibilities ("Cohen Commis
on") concluded that users of financial information are interested in
whether controls are adequate to reduce the risk of loss of assets
through unauthorized use misappropriation and to produce
reliable financial information, and that users may need to be informed,
as part of adequate disclosure, about the condition of controls. See the
Commission on Auditor's Responsibilities "Report, Conclusions, and
Recommendations" (1978) (hereinafter cited as "Cohen Commission
Report"), p. 55. See also MV Brown, "Auditors and Intemal
Controls: An Analyst's View," CPA Journal 47 (September, 1977),
pp. 2731.
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Cohen Commission. In addition, the American Institute
of Certified Public Accountants ("AICPA") formed the
Reports by Management Special Advisory Committee,
consisting of financial executives, attorneys, a financial
analyst, and other users of financial information, to
consider the Cohen Commission's recommendations
pertaining to management reports and to develop
guidance on matters that should be included in a
management report. In December 1978, the Reports by
Management Special Advisory Committee issued, for
public comment, a report of its tentative conclusions
and recommendations.6
The Cohen Commission's report, the FEI guidelines,
and the AICPA Special Advisory Committee's tentative
report each contain the suggestion that a management
report include an assessment of the company's system
of internal accounting control.? This aspect of a
management report has received significantly more
attention than any other, in large part as a result of the
enactment of the FCPA.
It should be noted that the management statement
which the Commission is proposing today does not
involve matters other than internal accounting control
that might be included in a management report. The
Commission intends to follow closely the further
initiatives of the private sector and will consider the
need to propose additional rules relating to such other
matters. In the meantime, the Commission encourages
issuers to provide meaningful disclosure regarding
management responsibilities. At this time, however, the
Commission is proposing to require only the more
limited management statement discussed and set forth
below.
11. DISCUSSION OF PROPOSED RULES
A. Management Opinion
Proposed Item 7(a) of Regulation S-K would require a
statement of management's opinion as to whether, as of
any date after December 15, 1979 and prior to
December 16, 1980 for which an audited balance sheet
is required, and for periods ending after December 15,
1980 for which audited statements of income are
required, the systems of internal accounting control of
the registrant and its subsidiaries provided reasonable
assurances that:
1. Transactions were executed in accordance
with management's general or specific
authorization;
6 Tentative Conclusions and Recommendations of the Reports by
Management Special Advisory Committee, AICPA, December 8,
1978.
r The example of a management representation regarding
assessment of the company's system of urtemal accounting control
contained in the tentative report of the Reports by Management
Special Advisory Committee is limited to "errors or irregularities that
could be material to the financial statements" Id. at p. 5.). As
discussed herein, neither the internal accounting control provisions of
the FCPA nor the representations which would be required in the
proposed statement of management on internal accounting control
are so limited. See also Securities Exchange Act Release No. 15570,
supra., n. 3.
2. Transactions were recorded as necessary (a)
to permit preparation of financial statements
in conformity with generally accepted
accounting principles (or other applicable
criteria), and (b) to maintain accountability for
assets;
3. Access to assets was permitted only in
accordance with management's general or
specific authorization; and
4. The recorded accountability for assets was
compared with the existing assets at
reasonable intervals and appropriate action
was taken with respect to any differences.
1. Objectives of Internal Accounting Control
Proposed Item 7(a) is based upon the broad
objectives of internal accounting control stated in the
FCPA. In this regard, the Commission recognizes that
systems of internal accounting control must be
designed to fit individual circumstances. Numerous
factors, such as the types of products or services
provided, types of customers, degree of centralization,
and methods of data processing, will affect the choice of
control procedures that may be necessary or
appropriate to achieve the broad control objectives.
Consequently, it is not practicable to prepare a
comprehensive list of internal accounting control
procedures, nor is it possible to prepare a list of certain
internal accounting control procedures which would be
appropriate for all organizations.
2. . Internal Accounting Controls
The Commission believes that it is important to
emphasize that the scope of internal accounting control
cannot be defined in terms of types of control
procedures or in terms of organizational or functional
departments. Any factors within an organization which
affect the achievement of the objectives of internal
accounting control must be considered in evaluating the
effectiveness of a system of internal accounting control,
and may often include factors which also are concerned
with what the authoritative auditing literature defines as
"administrative control."e
In this connection, the AICPA's Special Advisory
Committee on Internal Accounting Control emphasized
the importance to the effectiveness of systems of
internal accounting control of factors in addition to
specific internal accounting control procedures:
The internal accounting control environment
established by management has a significant
impact on the selection and effectiveness of a
company's accounting control procedures and
techniques.
The control environment is shaped by several
8 See Statement on Auditing Standards No. 1, AJCPA, Section
320.27, for the definition of administrative control. That statement also
recognizes, at Section 32029, that administrative controls and
accounting controls are not mutually exclusive.
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factors. Some are clearly visible, like a formal
corporate conduct policy statement or an internal
audit function. Some are intangible, like the
competence and integrity of personnel. Some, like
organizational structure and the way in which
management communicates, enforces, and
reinforces policy, vary so widely among
companies that they can be contrasted more
easily than they can be compared.
Although it is difficult to measure the
significance of each factor, it is generally possible
to make an overall evaluation. The committee
believes that an overall evaluation of a company's
internal accounting control environment is a
necessary prelude to the evaluation of control
procedures and techniques.
A poor control environment would make some
accounting controls inoperative for all intents and
purposes because, for example, individuals would
hestitate to challenge a management override of a
specific control procedure. On the other hand, a
strong control environment, for example, one with
tight budgetary controls and an effective internal
audit function, can have an important bearing on
the selection and effectiveness of specific
accounting control procedures and techniques'
The Commission concurs with the foregoing
statements of the Special Advisory Committee
regarding the importance of the control environment to
the effectiveness of a system of internal accounting
control. The Commission also agrees that, in addition
to the overall importance of an environment which
provides a high level of control consciousness,
individual environmental factors, such as strong
budgetary controls and an effective objective internal
audit function, can contribute directly to achievement
of internal accounting control objectives and must be
considered in evaluating whether reasonable assurance
of achievement of such objectives is provided.
3. Reasonable Assurance
Like the specified objectives of internal accounting
control, the phrase "reasonable assurance" is contained
in the FCPA. The concept of reasonable, as opposed to
absolute, assurance is incorporated in the proposed
rules in recognition that it is not in the interest of
shareholders for the cost of internal accounting control
to exceed the benefits thereof. Such benefits, and in
many cases such costs, are not likely to be precisely
quantifiable. Therefore, many decisions on reasonable
Tentative Report of the Special Advisory Committee on Internal
Accounting Control, AICPA, September 15, 1978 (hereinafter cited as
"Tentative Report"), p. 9. See generally pp. 9-12 for a discussion of the
control environment. The Special Advisory Committee was formed to
develop criteria for evaluating internal accounting controls. The
Tentative Report was issued to solicit comments horn interested
parties and, thus, is not the final work product of the Special Advisory
Committee. The Special Advisory Committee plans to issue a final
report in the near future.
assurance will necessarily depend in part on estimates
and judgments by management which are reasonable
under the circumstances.
Consideration of the benefits of internal accounting
controls generally will involve some degree of
estimation of the possible effects and the likelihood of
occurrence of various future conditions and events. In
addition, the benefits to be considered often may
include not only quantitative benefits, such as redution
in exposure to theft of assets, but also qualitative
benefits, such as the reputation of the company and its
management. For example, the benefits to be
considered in connection with evaluating controls
intended to prevent bribes and other illegal payments
cannot be measured solely by the amounts of such
payments which might be prevented. Rather, as the
Commission repeatedly has emphasized,10 the
relationship between such illegal payments, and other
questionable activities - whether or not the amounts
are significant - and the reputation of the company
and integrity of its management is a significant benefit to
be considered. The Commission recognizes that
placing a value on such qualitative factors will almost
invariably involve judgments by management.
Many managements may decide that it is desirable to
discuss in the statement on internal accounting control
the concept of reasonable assurance and the extent to
which decisions on reasonable assurance depend on
management estimates and judgments. Some may
believe that such a discussion is essential for informed
use of the statement.'] Comments are requested on
whether such a discussion should be required in all
statements of management on internal accounting
control.
The Commission recognizes that there are limitations
upon the effectiveness of any system of internal
accounting control.iv However, limitations upon the
effectiveness of a system of internal accounting control
do not limit the responsibility of registrants to maintain
a system of internal accounting control which provides
reasonable assurances that the objectives of internal
accounting control are achieved. Indeed, the fact that
errors may arise as a result of human frailties, that
systems of internal accounting control may be
circumvented as a result of collusion or overridden by
10 See generally Report of the Securities and Exchange Commission
on Questionable and Illegal Payments and Practices Submitted to the
Committee on Banking, Housing and Urban Affairs, United States
Senate (May 12, 1976). Also se e.g., S.E.C. o. Sharon Steel
Corporation, Civil No. 771631 (D.C.D.C., September 20, 1977) and
S.E.C. v. Ormond Industries, Inc., Civil No. 77-0790 (D.C. D.C., May
9, 1977).
11 The Cohen Commission's example of a management report
includes such a discussion. See Cohen Commission Report, p. 79.
12 Limitations of internal accounting control are discussed in
Statement on Auditing Standards No. 1, AICPA, Section 320.4.
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management,13 and that changes in conditions may
require changes in control procedures, mandates
ongoing review and monitoring of any internal
accounting control system if such reasonable assurance
is to be provided.
4. Evaluation of Internal Accounting Controls
a. Conceptual Elements
The Commission believes that specific methods of
approaching and implementing evaluations of systems
of internal accounting control will vary from company to
company. Accordingly, the proposed rules do not
specify the method of or procedures to be performed in
an evaluation of internal accounting control.
However, the Commission believes that evaluations
by managements of systems of internal accounting
control should encompass certain conceptual
elements.14 Determination of whether a system of
internal accounting control provides reasonable
assurances that the broad objectives of internal
accounting control are achieved generally will involve
the following:
? First, evaluation of the overall control
environment;
? Second, translation of the broad objectives of
internal accounting control into specific
control objectives applicable to the particular
business, organizational and other
characteristics of the individual company ;
? Third, consideration of the specific control
procedures and individual environmental
factors which should contribute to
achievement of the specific control objectives;
? Fourth, monitoring of control procedures and
consideration of whether they are functioning
as intended; and
oo In this regard, in February 1979 the Commission adopted
Regulation 13B 2, which expressly prohibits the falsification of
corporate books, records, or accounts and prohibits the officers and
directors of an issuer from making false, misleading or incomplete
statements to any accountant in connection with any audit or
examination of the issuer's financial statements or the preparation of
required reports. See Securities Exchange Act Release No. 15570,
supra., n. 3.
u The Commission believes that the conceptual elements discussed
herein also are reflected in the Tentative Report of the AICPA's
Special Advisory Committee on Internal Accounting Control (see
Note 11, supra). The Commission believes that the work of the
Special Advisory Committee should be very useful to managements
by providing a framework which win be helpful to all companies in
establishing an approach, or appraising the effectiveness of an
existing approach, to evaluate whether the broad objectives of
internal accounting control are achieved. However, the Special
Advisory Committee's Tentative Report does not represent a manual
that can be followed by companies in evaluating their accounting
control systems. This was recognized by the Special Advisory
Committee (at p. 8 of the Tentative Report):
ITlhe approach to an evaluation suggested in this report is
not the only way an evaluation can be performed, and the
criteria included . not and cannot be detailed rules.
However, the committee believes that the recommendations in
this report should help management in its continuing
evaluation and monitoring of internal accounting control.
? Finally, consideration of the benefits
(consisting of reductions in the risk of failing
to achieve the objectives) and costs of
additional or alternative controls.
The first element of such a determination is
evaluation of the overall control environment. The
Commission recognizes that such evaluations will
require a careful exercise of management's judgment,
generally involving consideration of matters such as the
organizational structure, including the role of the board
of directors; communication of corporate procedures,
policies and related codes of conduct; communication
of authority and responsibility; competence and
integrity of personnel; accountability for performance
and for compliance with policies and procedures; and
the objectivity and effectiveness of the internal audit
function. The role of the board of directors in
overseeing the establishment and maintenance of a
strong control environment, and in overseeing the
procedures for evaluating a system of internal
accounting control, is particularly important. The
Commission has often stressed the importance of audit
committees to enable boards of directors to better fulfill
their oversight responsibilities with respect to an issuer's
accounting, financial reporting and control obligations. 15
A strong control environment will not, in itself,
provide a basis for reasonable assurance that the broad
objectives of internal accounting control are achieved.
However, the Commission agrees with the AICPA's
Special Advisory Committee on Internal Accounting
Control that
fill is unlikely that management can have
reasonable assurance that the broad objectives of
internal accounting control are being met unless
the company has an environment that establishes
an appropriate level of control consciousness. is
For that reason, an evaluation of the overall control
environment is a necessary first step in evaluating a
system of internal accounting control.
The second and third conceptual elements of an
evaluation of a system of internal accounting control
might be characterized as review of the system. The
effectiveness of the design of control procedures in
place cannot be evaluated without first relating the
broad objectives of internal accounting control to the
particular circumstances of a company. The AICPA's
Special Advisory Committee on Internal Accounting
is See Securities Exchange Act Release No. 14970 (43 FR 31945),
July 18, 1978, in which the Commission proposed rules requiring
issuers to state whether they have an audit committee and whether it
performs "customary functions" of such committees, and which
includes a discussion of previous Commission actions regarding audit
committees. The Commission adopted the proposal in Securities
Exchange Act Release No. 15394 (43 FR 58522), December 6, 1978,
after amending it to require disclosure of the functions which the audit
committee actually performs.
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Control found a transaction cycle approach a
convenient way to develop illustrative specific control
objectives and examples of specific control procedures
and techniques.17 Some companies might use a
transaction cycle approach in reviewing the system;
others might organize a review of the system by
functional area within the organization or use some
other approach or combination of approaches.
Regardless of the way in which the review of the system
is organized, what is important is that the specific
control objectives appropriate for the company, and the
specific control procedures and individual
environmental factors which should contribute to
achievement of those specific objectives, are identified
and considered.
The fourth conceptual element of an evaluation of a
system of internal accounting control might be
characterized as monitoring compliance with control
procedures. Management must have reasonable
assurance not only that the system of internal
accounting control is appropriately designed, but also
that it is functioning as designed. In addition, knowledge
that adherence to company policies and procedures will
be monitored is an important element of an overall
control environment. Monitoring compliance with
control procedures may take place through observation
and supervision and through testing of controls in
effect. An objective, effective internal audit function can
play an important role in monitoring compliance.
The final conceptual element of an evaluation of a
system of internal accounting control might be
characterized as determination of reasonable
assurance. As discussed previously, determining
whether reasonable assurance of achievement of
control objectives is provided often will depend in part
on estimates and judgments by managements,
b. Documentation
Appropriate documentation is important to each
aspect of an evaluation of internal accounting control.
The overall control environment often will be enhanced
by written policies and procedures, formalized
reporting responsibilities within the organization, and
written descriptions of authority and responsibility.
Very few, if any, registrants could perform an effective
review of their systems of internal accounting control
without documenting their specific control objectives
and the control procedures in place which should
contribute to achieving those objectives.
Documentation of tests of controls in effect is necessary
to determine that the tests were appropriately planned
and performed and that the results of the tests were
appropriately considered. Because of the judgmental
aspects of cost-benefit analyses, a record of the bases
for management's conclusions with respect to
reasonable assurance considerations may be
particularly important.
c. Performance of Evaluation Procedures
Because of the interaction of numerous factors both
within and outside the organization which affects the
choice of control procedures necessary to obtain
reasonable assurances that the broad objectives of
internal accounting control have been achieved, control
systems are necessarily dynamic. As a result of this
dynamic nature and the possibilities that controls may
be circumvented or overridden and that compliance with
control procedures may deteriorate, evaluation of any
system of internal accounting control requires ongoing
review of the system and monitoring compliance with
control procedures.
It should be emphasized that the management
opinion which would be required by proposed Item 7(a)
for periods ending after December 15, 1980 would
encompass reasonable assurances of achievement of
the broad objectives of internal accounting control
during the periods for which audited statements of
income are required. The Commission believes that
effective, ongoing evaluations of systems of internal
accounting control often may result in identification of
the need for and implementation of improvements in a
system. To the extent that such improvements are
necessitated by changing circumstances (including both
circumstances which affect the benefits of controls by
changing the risks of failing to achieve the broad
objectives of internal accounting control and
circumstances which change the costs of controls) and
are made on a timely basis, the Commission believes
that they do not indicate that the system did not provide
reasonable assurances of achievement of the objectives
of internal accounting control. In this connection, the
Commission encourages the process of interaction
between registrants and their independent accountants
whereby independent accountants suggest ways in
which management might improve its internal
accounting controls.
On the other hand, weaknesses which have existed
but have not been identified on a timely basis as a result
of inadequate procedures for review and monitoring of
the system of internal accounting control would indicate
that the system did not provide reasonable assurances
of achievement of the objectives of internal accounting
control throughout the period and, therefore, would
preclude an unqualified management opinion under
proposed Item 7(a) for periods ending after December
15, 1980. Of course, any weaknesses which have been
identified but not appropriately corrected also would
preclude such an unqualified opinion.
The Commission recognizes that some registrants
may conclude that maintenance of review and
monitoring procedures which will be sufficient to obtain
reasonable assurances that the objectives of internal
accounting control are achieved does not require
performance of all such procedures at all locations in
each reporting period. Because of the dynamic nature
of internal accounting control and the resultant
continuing nature of the evaluation process, the extent
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and timing of the review and monitoring of a system of
internal accounting control are among the cost-benefit
judgments involved in the concept of reasonable
assurance. In its determinations regarding the need to
take enforcement action with respect to the internal
accounting control provisions of the FCPA, among
other things the Commission will consider the nature of
weaknesses in a system of internal accounting control
and efforts to identify and correct such weaknesses.
B. "Material Weaknesses" in Internal
Accounting Control
Proposed Item 7(b) of Regulation S-K would require
that statements of management on internal accounting
control as of dates after December 15, 1979 and prior to
December 16, 1980 include a description of any
"material weaknesses" in internal accounting control
which have been communicated by the independent
accountants of the registrant or its subsidiaries which
have not been corrected and a statement of the reasons
why they have not been corrected.
Present auditing standards with respect to internal
accounting control are directed to, and were developed
in the context of, examinations of financial statements.
Under generally accepted auditing standards, the
auditor's purpose in reviewing and evaluating internal
accounting control is not to determine whether the
broad objectives of internal accounting control have
been achieved, but rather to form a basis for
determining the scope of the examination of the
financial statements. Under present auditing
star dards,18 the responsibility of an independent public
accountant for reporting on the results of the review
and evaluation of internal accounting control performed
in connection with an examination of financial
statements is limited to reporting to management and
the board of directors or audit committee "material
weaknesses" which came to the accountant's
attention.19
The examination by an independent public
accountant of the statement of management on internal
accounting control which would be required by
proposed Item 7(c) of Regulation S-K would be required
initially for periods ending after December 15, 1980. The
Commission believes it is appropriate in the first, more
limited, stage of the proposed rules, wherein an
examination by an independent public accountant
would not be required by the proposed rules, to require
disclosure by management relating to any uncorrected
" A "nwterid weakness" s dined in Statement on Auditing
Standards No. 1, AICPA, Section 320.68, as
la) condition in which the au6tw believes the prescribed
procedures or the degree of compliance with them does not
provide reasonable assurance that errors or irregularities in
annunta that would be material in the financial statement,
being audited would be prevented or detected within a timely
period by employees in the nornai course of performing that
assigned tunctim.
141
"material weaknesses" communicated by independent
accountants as a result of their present responsibilities
with respect to examinations of financial statements,
including disclosure of the reasons why such "material
weaknesses" were not corrected.
It should be noted that the independent accountant
will have certain responsibilities, including revision of his
report on the financial statements to include an
explanatory paragraph, in the event management does
not appropriately disclose uncorrected "material
weaknesses" under proposed Item 7(b)1?
C. Examination by Independent Public
Accountant
Proposed Item 7(c) of Regulation S-K would require
that, for periods ending after December 15, 1980, the
statement of management on internal accounting
control be examined and reported on by an
independent public accountant.
Independent public accountants have long been
involved with internal accounting control. The auditing
professions's second standard of field work states:
There is to be a proper study and evaluation of the
existing internal control as a basis for reliance
thereon and for the determination of the resultant
extent of the tests to which auditing procedures
are to be restricted.21
In addition, the objectives of internal accounting
control set forth in the FCPA, which are the same
as those in proposed Item 7(a) of Regulation S-K,
were taken directly from Section 320.28 of
Statement on Auditing Standards No. 1. Because
of the independent public accountant's expertise
with respect to internal accounting control and the
fact that internal accounting control is integral to
preparation of financial statements, the
Commission believes that an examination by an
independent public accountant of a statement of
management on internal accounting control would
result in increased reliability of such a
management statement.
1. Objectives of Examination
Proposed Item 7(c) specifies that the examination be
sufficient to enable the independent public accountant
to express an opinion as to (1) whether the
representations of management in response to
proposed Item 7(a) are consistent with the results of
management's evaluation of the systems of internal
accounting control, and (2) whether such management
representations are, in addition, reasonable with
respect to transactions and assets in amounts which
w Statement on Auditing Standards No. 8, AICPA, set, forth the
independent accountant's reapauibikies when the accountants
aware of any naterial orcorristencinn or material nustatementa of
fact in documents containing audited financial statements.
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would be material when measured in relation to the
registrant's financial statements. The proposed
examination by an independent public accountant of
the statement of management on internal accounting
control would, therefore, require expansion of the
independent public accountant's present
responsibilities with respect to internal accounting
control.
To reach an opinion, as would be required by
proposed Item 7)c)(1), as to whether the management
representations were consistent with the results of
management's evaluation of the systems of internal
accounting control, the independent public accountant
would have to review management's procedures for
reviewing, monitoring and evaluating the systems of
internal accounting control and the results thereof. The
purposes of this review would be to determine whether
the management representations recognized any
conditions which indicated that reasonable assurances
of achievement of the objectives of internal accounting
control were not provided, and to determine that
management's procedures for reviewing, monitoring
and evaluating the systems of internal accounting
control were not insufficient as a basis for its
representations. Although the independent accountant
would not necessarily be required to perform
independent tests to reach the opinion which would be
required under proposed Item 7(c))1), that opinion
would, of course, also have to reflect any other
knowledge which the accountant may have as a result
of an examination of the financial statements, as a result
of the more extensive examination procedures which
would be required under proposed Item 7(c)(2), or
through other means.
The independent public accountant's responsibilities
under proposed Item 7(c)(2) would be more extensive.
To reach the reasonableness opinion which would be
required under proposed Item 7(c)(2) the independent
accountant would, in effect, have to reach independent
conclusions as to whether the systems of internal
accounting control provided reasonable assurances
that transactions were recorded as necessary to permit
preparation of annual and interim financial statements
in conformity with generally accepted accounting
principles; that transactions in amounts which would be
material when measured in relation to the registrant's
financial statements were appropriately authorized; and
that assets in amounts which would be material when
measured in relation to the registrant's financial
statements were appropriately safeguarded, and there
was appropriate accountability for such assets.
The independent public accountant would, therefore,
have to independently evaluate and test the underlying
bases for management's conclusions as to the
effectiveness of the design and functioning of the
systems of internal accounting control and as to cost-
benefit considerations, to the extent that those
conclusions relate to reasonable assurances of
achievement of the objectives of internal accounting
control with respect to transactions and assets in
amounts which would be material when measured in
relation to the registrant's financial statements.
It should be emphasized that the materiality limitation
contained in proposed Item 7(c)(2) would apply only to
the objectives and scope of the independent public
accountant's examination. The proposed materiality
limitation reflects a cost-benefit judgment by the
Commission with respect to the appropriate extent of
the independent accountant's examination for purposes
of the proposed rule. In contrast, the management
representations which would be required by proposed
Item 7(a) would not be, and the internal accounting
control provisions of the FCPA are not, so limited.
Rather each extends to reasonable assurances that the
broad objectives of internal accounting control were
achieved, without regard to materiality of amounts.
2. Examination and Reporting Standards
The Commission recognizes that examinations by
independent public accountants of statements of
management on internal accounting control will require
development of appropriate professional standards with
respect to such matters as examination procedures;
procedures for consideration of other knowledge,
gained from the accountant's examination of the financial
statements or other means, which may be inconsistent
with management's representations; and procedures
when the accountant believes that management does
not have a sufficient basis for its representations. The
Commission notes that a task force of the AICPA's
Auditing Standards Board is currently considering the
general issue of reporting to the public on internal
accounting control. The Commission believes that it is
appropriate to continue its past policy of permitting the
accounting profession to determine the standards and
procedures underlying accountants' reports as long as
this policy is consistent with the interests of investors,
the federal securities laws, and the Commission's rules
and regulations thereunder.
Since the standards applicable to reporting should be
integrated with those applicable to the conduct of the
examination, the Commission also believes that it is
appropriate to allow the accounting profession to take
the lead in determining the standards applicable to the
specific form and content of an accountant's report on
an examination of a statement of management on
internal accounting control.
Accordingly, the Commission urges the AICPA's
Auditing Standards Board to continue its study of
reporting on internal accounting control in the light of
the Commission's proposed requirement for an
examination by an independent public accountant of a
statement of management on internal accounting
control, and to be prepared to adopt, on a timely basis,
an authoritative pronouncement which sets forth the
standards and procedures to be followed in connection
with such an examination, and the form and content of
a report thereon. The Commission intends to follow this
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work closely. If it appears that sufficient progress is not
being made toward development of appropriate
standards and procedures, the Commission will
undertake to develop such standards and procedures.
III. OTHER ISSUES
A. Costs of Proposed Rules
The Commission is aware that in most cases an
expansion of the independent accountant's work with
respect to internal accounting control would be
necessitated by this proposal. While such an expansion
of work would probably result in additional costs to
registrants,22 the Commission believes that such costs
likely would be in large part of an initial rather than a
continuing nature. In addition, the Commission believes
that in many instances the additional work of the
independent accountant with respect to internal
accounting control would result in reductions in costs of
the examination of the financial statements, as
independent accountants would be able to place more
reliance on internal accounting control 23 The
Commission believes that the additional costs of the
proposed requirement that the statement of
management on internal accounting control be
examined by an independent public accountant would
be outweighed by the increased reliability of the
statement of management which would result from
such examination.
The Commission believes that the benefits of new
requirements to present and prospective investors
should outweigh any additional costs involved. Since
the benefits of the proposed examination by an
independent public accountant of the statement of
management on internal accounting control are not
subject to quantification, and the measurement of costs
includes many variables which are highly uncertain, the
weighing of costs and benefits of such an examination
will inevitably require the Commission's judgment. The
Commission specifically requests comments on the
costs and benefits of the proposed requirement for
examination by an independent public accountant,
including possible alternatives to the proposed scope of
such examination.
In particular, comments are requested on the costs
and benefits of the following alternatives to the
proposed examination by an independent public
accountant:
1. A requirement for an examination which
would be sufficient to enable the independent
22 As to the basic proposal fora statement of management on internal
accounting control, the Commission believes that this proposal will
not establish requirements for maintenance of systems of internal
accounting control which exceed those already required by the
FCPA. Consequently, the costs of providing the proposed statement
of management on internal accounting control should not be
substantial.
23 However, registrants' selections of independent accountants for
examinations of statements of management on internal accounting
control would not be restricted to the same independent accountants
who are engaged to examine the financial statements.
public accountant to express an opinion as to
whether the representations of management
in response to proposed Item 7(a) are
reasonable. In effect, this would require the
independent public accountant to reach
independent conclusions as to whether the
systems of internal accounting control
provided reasonable assurances (cost-benefit
judgments not limited to material amounts) of
achievement of the broad objectives of
internal accounting control.
2. No requirement for an examination by an
independent public accountant. Rather, re-
quire registrants to state whether or not the
statement of management on internal accoun-
ting control had been examined by an
independent public accountant, and require
the filing of the related accountant's report if
an affirmative statement is made. This would,
of course, also require development of
professional standards for examinations by
independent public accountants of statements
of management on internal accounting
control. It might also necessitate specific
professional standards for responsibilities of
an independent accountant as a result of
association with such a statement of
management which accompanies audited
financial statements.
To the extent possible, commentators are requested to
supply empirical data in support of their comments.
In addressing this issue, commentators also are
requested to consider whether certain registrants
should be exempted from the requirement that the
proposed statement of management be examined and
reported on by an independent public accountant. The
costs of such an examination may fall with the greatest
severity on smaller registrants; however, systems of
internal accounting control of smaller registrants may
be generally less sophisticated and less well docu-
mented so that examination by an independent public
accountant may be particularly needed.
As part of its response to issues relating to the impact
on small businesses of the disclosure requirements of
the federal securities laws, the Commission recently
announced the adoption of a simplified form, Form S-
18, under the Securities Act.Yt Form S-18 is available to
issuers not subject to the Commission's continuous
reporting requirements when they register securities to
be sold for cash not exceeding an aggregate offering
amount of $5 million. Comments are also specifically
requested on whether a registrant filing on Form S-18,
and thereby becoming subject to the reporting
provisions of section 15(d) of the Securities Exchange
Act, should be exempt from the requirement for an
examination by an independent public accountant with
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respect to the statement of management on internal
accounting control contained in its initial annual report
on Form 10-K.25
B. Disclosure of Basis for Management Opinion
In addition to the opinion which would be required by
proposed Item 7(a) of Regulation S-K (and, in the initial
stage, the disclosures relating to uncorrected "material
weaknesses" which would be required by proposed
Item 7(b)), registrants are encouraged to include in the
statement of management on internal accounting
control whatever information they believe would make
the statement most useful. Some may believe that
disclosure of the basis for the management opinion,
including a description of the general approach applied
in evaluating internal accounting controls and the
extent to which the procedures comprised by such
approach were performed in the periods encompassed
by such opinion, should be required. Comments on this
issue are specifically requested.
C. Signing of Management Statement
Some may believe that the statement of management
should be required to be signed by a certain
representative or representatives of management, such
as the chief executive officer or the chief financial
officer. Comments on this issue are specifically
requested.
IV. PROPOSED EFFECTIVE DATES
The Commission recognizes that the enactment of
the FCPA has prompted many registrants to reevaluate
their procedures for reviewing, monitoring and
evaluating their systems of internal accounting control
and that issuance of these rule proposals may provide
additional focus for such reevaluation. The Commission
also recognizes that, as a result of recently establishing
sound procedures for reviewing, monitoring and
evaluating their systems of internal accounting control,
some registrants may have identified and corrected
conditions which had not provided reasonable
assurance of achievement of the objectives of internal
accounting control.
Accordingly, these amendments are proposed to be
effective with respect to reports for fiscal periods ending
after December 15, 1979. Statements of management
on internal accounting control would not be required
for reports for periods ending prior to December 15,
1979. In addition, by proposing to adopt these
amendments in two stages as discussed herein,
representations regarding the effectiveness of systems
of internal accounting control would be required to
encompass only conditions existing as of and after the
xe Similarly, the Commission has amended its requirements to permit
Form S-18 registrants to include in their initial filing on Form 10 K. in
lieu of similar information called for by Form 10-K, information
concerning the registrant's business, the remuneration of its officers
and drectors, and the interest of management and others in certain
transactions which had been provided in the registration statement on
Form 5-18.
end of the first fiscal period for which the amendments
would be effective.
Nevertheless, it again should be emphasized that the
FCPA was effective upon enactment in December 1977.
Registrants would be well advised to ensure that any
weaknesses in internal accounting control are identified
and corrected on the most timely basis.
V. AUTHORITY FOR, AND REQUEST FOR
COMMENT ON SCOPE OF, PROPOSED
AMENDMENTS
The Commission is not at this time proposing to
require the disclosures outlined in this release in
registration statements filed pursuant to the Securities
Act of 1933. The Commission recognizes, however,
that much of the rationale which supports the furnishing
of this information to investors in Securities Exchange
Act filings may apply with equal force to Securities Act
registration statements. The Commission therefore
invites comments concerning whether these proposals
should be extended to filings under that Act. In that
connection, the Commission invites commentators to
consider whether the applicability of these proposals to
Securities Act registration statements would have any
impact - whether favorable or unfavorable - on the
capital formation process and whether the Commission
should consider exempting any category of issuers from
those requirements, should it determine to extend them
to Securities Act registration statements.
The Commission also invites comment concerning
whether it would be appropriate to extend these
requirements to Forms N-1 and N-2 for use by open-
end and closed end management investment compa-
nies; Form N-1R for annual reports of registered
management investment companies; Form N-5R for
annual reports of small business investment companies;
and to Forms USA, USB, U5S, and U-6B-Z promulgated
under the Public Utility Holding Company Act of 1935.
Similarly, commentators are requested to consider
whether these disclosure items should be incorporated
in Forms 20 and 20-K for use by certain foreign private
issuers.
The Commission is proposing these amendments
pursuant to its general rulemaking authority contained
in Section 23(a) of the Securities Exchange Act of 1934,
15 U.S.C. 78w(a). That provision empowers the
Commission to promulgate "such rules and regulations
as may be necessary or appropriate to implement the
provisions" of the Act.
The internal accounting control requirements of the
Foreign Corrupt Practices Act - which these
amendments would, in part, implement - appear in
Section 13(b)(2)[B) of the Securities Exchange Act, 15
U.S.C. 78m(b)(2). The various disclosure forms and
schedules which these proposals would amend have
been promulgated pursuant to Sections 12, 13, 14 and
15(d) of the 1934 Act, 15 U.S.C. 781, 78m, 78n, 78o.
Section 23(a) of the Securities Exchange Act requires
the Commission to consider the impact which any
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proposed rule would have on competition. While the
Commission is not aware of any competitive impact
likely to result from the proposals described in this
release, commentators are invited to address that issue.
VI. REQUEST FOR COMMENTS
All interested persons are invited to submit their
views and comments on the foregoing in triplicate to
George A. Fitzsimmons, Secretary, Securities and
Exchange Commission, Washington, D.C. 20549 on or
before July 31, 1979. Such communications should refer
to File S7-779 and will be available for public inspection.
VII. TEXT OF PROPOSED RULES
In consideration of the foregoing, it is proposed to
amend 17 CFR Chapter 11 as follows:
PART 229 -STANDARD INSTRUCTIONS FOR
FILING FORMS UNDER SECURITIES ACT OF
1933 AND SECURITIES EXCHANGE ACT OF
1934 - REGULATION S-K
1. By amending ?229.20 by adding Item 7 to read as
follows:
?229.20 Information required in document.
Item 7. Statement of management on internal
accounting control.
(a) State management's opinion as to whether,
as of any date after December 15, 1979, and prior
to December 16, 1980, for which an audited
balance sheet is required, and for periods ending
after December 15, 1980, for which audited
statements of income are required, the systems of
internal accounting control of the registrant and
its subsidiaries provided reasonable assurances
that:
(1) Transactions were executed in ac-
cordance with management's general or
specific authorization;
(2) Transactions were recorded as nec-
essary (i) to permit preparation of financial
statements in conformity with generally
accepted accounting principles (or other
applicable criteria), and (ii) to maintain
accountability for assets;
(3) Access to assets was permitted only in
accordance with management's general or
specific authorization; and
(4) The recorded accountability for assets
was compared with the existing assets at
reasonable intervals and appropriate action
was taken with respect to any differences.
(b) For statements of management on internal
accounting control as of dates after December 15,
1979, and prior to December 16, 1980, describe
any material weaknesses in internal accounting
control which have been communicated by the
independent accountants of the registrant or its
subsidiaries which have not been corrected, and
state the reasons why they have not been
corrected.
(c) For periods ending after December 15, 1980,
the statement of management on internal
accounting control shall be examined and
reported on by an independent public accountant.
The examination shall be sufficient to enable the
independent public accountant to express an
opinion as to (1) whether the representations of
management in response to paragraph (a) are
consistent with the results of management's
evaluation of the systems of internal accounting
control; and (2) whether such representations of
management are, in addition, reasonable with
respect to transactions and assets in amounts
which would be material when measured in
relation to the registrant's financial statements.
Instructions.
1. The statement of. management on internal
accounting control should accompany the financial
statements.
2. The independent public accountant's report of
examination shall accompany or be included within the
accountant's report on the financial statements.
PART 240 - GENERAL RULES AND
REGULATIONS, SECURITIES EXCHANGE ACT
OF 1934
2. By amending ?240.14a-3 by adding anew paragraph
(b)(4), renumbering present paragraphs (b)(4) to (12) as
(b)(5) to (13), and amending the references to the
renumbered paragraphs as follows (changes italicized):
?240.14a-3 Information to be furnished to security
holders.
(b)
(4) The report shall contain a statement of
management on internal accounting control
prepared in accordance with the provisions
of Item 7 of Regulation S-K.
(5) Note 1: Subparagraph (b)(11) permits
(6) (No change.)
(7) Note: Subparagraph (b)(11) permits ....
(8) (No change.)
(9) (No change.)
(10) Note: Pursuant to the undertaking
required by the above paragraph, (b)(10)
(11) Subject to the foregoing requirements,
the report may be in any form deemed
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suitable by management and the information * * ? +
required by subparagraphs (b)(5) to (b)(10)
Item 13. Statement of Management on Internal
(12) Subparagraphs (b)(5) through (b)(11) Accounting Control. A statement of management on
shall not apply. . . internal accounting control shall be furnished in
(13) (No change.) accordance with the provisions of Item 7 of Regulation
S-K.
PART 249 - FORMS, SECURITIES EXCHANGE
ACT OF 1934 By the Commission.
3. By amending ?249.310 by renumbering Items 13-15
of Part 11 as Items 14-16 and by adding a new Item 13 to George A. Fitzsimmons
Part I to read as follows: Secretary
?249.310 Form 10-K, annual report pursuant to section
13 or 15d of the Securities Exchange Act of 1934. April 30, 1979
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SUGGESTED READINGS ON
FOREIGN CORRUPT PRACTICES
ACT OF 1977 *
Reports and
Committee on Corporate Law and Accounting, Section
of Corporation, Banking, and Business Law, A Guide to
the New Section 13(b)(2) Accounting Requirements of
the Securitites Exchange Act of 1934 (Section 102 of
the Foreign Corrupt Practices Act of 1977). Chicago:
American Bar Association, August 18, 1978.
Special Advisory Committee on Internal Accounting
Control, Report of the Special Advisory Committee on
Internal Accounting Control, New York: American
Institute of Certified Public Accountants, Inc., 1979.
Ernst & Whinney. Foreign Corrupt Practices Act of
1977 - An Overview of the Law and its Implications.
Ernst & Whinney. The Foreign Corrupt Practices Act
- Focus on Internal Controls.
Ernst & Whinney. Evaluating Internal Control - A
Guide for Management and Directors.
Ernst & Whinney. Evaluating Internal Control -
Documentation Supplement.
Copies of the following reports and publications can
be obtained by contacting the local offices of the
companies.
Arthur Andersen & Co. A Guide for Studying and
Evaluating Internal Accounting Controls.
Arthur Andersen & Co. An Analysis of the Foreign
Corrupt Practices Act of 1977.
Arthur Andersen & Co. Internal Accounting Controls.
What Are They? What Should Management Do About
Them?
Arthur Young & Company. Foreign Corrupt Practices
Act of 1977 - Toward Compliance With the
Accounting Provisions.
Arthur Young & Company. Internal Control and the
Foreign Corrupt Practices Act. An Executive Briefing.
Coopers & Lybrand. Coping With the Foreign Corrupt
Practices Act: A Management Plan for 1979.
Deloitte Haskins & Sells. Internal Accounting Control
- Current Developments and Implications of the
Foreign Corrupt Practices Act.
Peat, Marwick, Mitchell & Co. Evaluating Internal
Accounting Controls.
Peat, Marwick, Mitchell & Co. Action Plan for
Reviewing Internal Accounting Controls.
Price Waterhouse & Co. Overview of Management
and Directors' Responsibilities for Monitoring Compli-
ance With Control Systems Under the Foreign Corrupt
Practices Act.
Price Waterhouse & Co. A Discussion of Management
and Directors' Responsibilities for Monitoring Compli-
ance With Control Systems Under the Foreign Corrupt
Practices Act.
Price Waterhouse & Co. Guide to Accounting
Controls. Establishing, Evaluating and Monitoring
Control Systems. A series of nine booklets.
Touche Ross & Co. The New Management Imperative
- Compliance With the Accounting Requirements of
the Foreign Corrupt Practices Act.
? Supplied by the Los Angeles Chapter, The Institute of Internal
Auditors, Inc., May, 1979.
Baruch, Hurd. "The Foreign Corrupt Practices Act."
Harvard Business Review, January-February 1979.
Beresford, David R., and Bond, James D. "The Foreign
Corrupt Practices Act - Its Implication to Financial
Management." Financial Executive, August, 1978.
Cook, J. Michael, and Kelley, Thomas P. "Internal
Accounting Control: A Matter of Law." Journal of
Accountancy, January, 1979.
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Estey, John S., and Marston, David W. "Pitfalls (and
Loopholes) in the Foreign Bribery Law." Fortune,
October 9, 1978.
Guttry, Jr., Harvey V, and Foster, Jesse R. "Internal
Controls and the Financial Executive." Financial
Executive, April, 1978.
Hershman, Arlene. "New Accounting Headache."
Dun's Review, September, 1978.
Marsh, Hugh L. "The Foreign Corrupt Practices Act: A
Corporate Plan for Compliance." The Internal Auditor,
April, 1979.
Martin, Jr., Albert S., and Johnson, Kenneth P.
"Assessing Internal Accounting Control: A Workable
Approach." Financial Executive, May, 1978.
MacKay, A. E. "Management Control in a Changing
Environment." Financial Executive, March, 1979.
Ricchiute, David N. "Foreign Corrupt Practices: A New
Responsibility for Internal Auditors." The Internal
Auditor, December, 1978.
Mautz, Robert K., and White, Bennard, Jr. "Internal
Control - A Management Viewpoint." Financial
Executive, June, 1979.
Proceedings
The Institute of Internal Auditors, Inc., Proceedings of
the Conferences on U.S. Foreign Corrupt Practices
Act of 1977, Altamonte Springs, Florida: 1979.
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Mr. HoRTON. We want to thank you for your testimony. It has
been very succinct, precise, and helpful. We certainly thank you for
the support of your organization.
On behalf of Chairman Brooks, I have a couple questions which I
would like to submit to you and you can perhaps give us answers
in writing for the record.
Mr. WATSEN. Very well.
[The questions and submissions follow:]
The Institute of Internal Auditors
Washington Chapter
P. O. Box 14013 JOHN K. WATSEN
Ben Franklin Station VI. Ftrs.,0p.0.. FRANCIS J. KENNEY
Washington, D.C. 20044 W.P-M -t-Ed ..tw MICHAEL StACHTA.JP_
s.eue.e FRANCIS A. NAUGHTON
Tn.._ JEROME I. SUBKOW
Committee on Government Operations
Legislation and National Security
Subcommittee
House of Representatives
Room B-373
Rayburn Office Building
Washington, DC 20515
RECEIVED
1PR 24 1981
Legislation and National
Security Subcommittee
The following are my responses to the two questions submitted
by you regarding H.R. 1526.
Question 1 - The Accounting and Auditing Act of 1950 mandated
that agencies maintain internal administrative and control
systems approved by the GAO. How will the requirements
of this legislation correlate with that Act?
Response - Neither The Institute of Internal Auditors nor I
are especially well qualified to comment on the techni-
calities of this legislation, including how it would
correlate with the Accounting and Auditing Act of 1950.
It is my impression, however, that H.R. 1526 neither con-
flicts with nor duplicates the provisions of the earlier
Act. H.R 1526 seems to provide a method whereby com-
pliance with the provisions of the earlier Act can be
monitored by the President and by Congress.
Question 2 - Can you give us examples of the type of ques-
tionable practices which might develop as a result of
ineffective or lax Internal controls?
Response - Yes; however, it is not practicable to compile
a comprehensive list, because the possibilities are so
numerous. Here are a few examples of questionable prac-
tices which might develop as a result of ineffective or
lax controls:
-- Agency personnel could fail to obtain competitive
bids on contracts or purchases, and thereby fail to
obtain the most favorable prices or terms.
it # Jt The Nation's Capital Chapter: Your Host For The 1982 International Conference it it it
- "D.C. and YOU in '82" -
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Agency personnel could fail to independently verify
information on various benefit application forms,
and thereby cause improper disbursements to unquali-
fied applicants.
Agency personnel could fail to follow procedures for
following up on delinquent loan repayments, which
could lead to inability to collect the amounts owed
to the government.
Agency personnel could fail to periodically inventory
equipment and supplies on hand, thereby causing unnec-
essary purchases.
C
JJdfin K. Watsen
President
Mr. HORTON. Mr. Butler?
Mr. BUTLER. We have a question of stating an opinion. Is the
word "opinion" a word of art? If we simply required a report versus
an opinion as to the adequacy, would that have any significance
and would it be sufficient?
Mr. WATSEN. I think either term would be appropriate in this
legislation. That would be my own opinion. I do think there are
some advantages in requiring the executive agency head to state
whether or not he believes his system of internal controls is suffi-
cient to meet control objectives and needs of his agency. In that
sense of the word, "opinion" adds something to the requirement.
Mr. BUTLER. It has higher dignity than "report."
Mr. WATSEN. I think it adds something to what is being required
in this legislation. Otherwise, he simply would be required to
report on whatever the status of the internal control system is and
not express a personal opinion as to whether or not he feels it is
sufficient.
Mr. BUTLER. It is your perception of the word "opinion" that that
is the personal opinion of the agency head?
Mr. WATSEN. I would say it should be the opinion of the agency
and the head of the agency in effect expressing that opinion on
behalf of the agency.
Mr. BUTLER. You spent some time in law school, too?
Mr. WATSEN. No.
Mr. BUTLER. Maybe with the State Department.
I have no further questions, Mr. Chairman.
Mr. HORTON. Thank you very much. Thank you, Mr. Watsen.
This concludes the hearings today on H.R. 1526. The subcommit-
tee does plan to hold hearings on our overseas security enhance-
ment program on March 24. Since it is likely that sensitive matters
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will be discussed at the hearing, I would entertain a motion that
the hearing be closed.
Mr. BUTLER. Mr. Chairman, I move the subcommittee hearings to
be held on March 24 be closed to the public in accordance with rule
13 of the committee.
Mr. HORTON. Without objection, it is so ordered.
That concludes the meeting today.
[Whereupon, at 3:35 p.m., the subcommittee adjourned, to recon-
vene subject to the call of the Chair.]
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APPENDIX
MATERIAL SUBMITTED FOR THE RECORD
AICPA
American Institute of Certified Public Accountants
1620 Eye Street, N. W, Washington, D. G 20006 [phone]
The Honorable Jack Brooks
Chairman
Committee on Government
operations
U.S. House of Representatives
Washington, D.C. 20515
RECEIVED
MAR 2 71981
Legisiation and National
Security Sub ommittee
Dear Chairman Brooks:
Re: H.R. 1526 "The Federal Managers' Accountability Act of 1981"
The American Institute of Certified Public Accountants (AICPA)
is the national professional organization representing over 165,000
CPAs in public practice, industry, goverment and education. The
AICPA, through the efforts of volunteers working within 160 boards,
committees and task forces, is devoted to organizing the body of
accounting knowledge, conducting research, and enforcing the technical
and ethical standards of the profession along lines that serve the
broadest public interest.
Accordingly, we are constantly monitoring federal legislation
which has the potential to affect accounting and auditing. In this
vein, we are interested in the proposed bill H.R. 1526, "The Federal
Managers' Accountability Act of 1981."
The AICPA has long recognized the importance of internal control
as a means of safeguarding assets against loss, unauthorized use, or
misappropriation and has undertaken many projects and studies in this
area. Our auditing literature contains a definition of internal control
as well as procedures and guidelines dealing with studying, evaluating
and reporting on internal accounting control. In 1978, the Commission
on Auditors' Responsibilities, an independent csnnission established by
the AICPA, recommended that corporate management issue a report on the
financial statements and suggested that the report present management's
assessment of the company's accounting system and controls over it.*
It is becoming more common for companies to include a "management
report" in their annual report to shareholders. Such reports typically
include Dements on the system of internal accounting control.
Accordingly, the AICPA supports the concept of reporting on
internal control by federal managers as provided in H.R. 1526, "The
Federal Managers' Accountability Act of 1981," (introduced by you
*Commission on Auditors' Responsibilities, Report, Conclusions
and Recommendations (New York: AICPA, 1978), p. 76.
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154
The Honorable Jack Brooks
Page Two
March 27, 1981
on February 2, 1981) and applauds your efforts in this matter. As
a result of our substantial interest and involvement in this area,
we wish to submit certain comments which we believe will further
clarify the intent of Congress and assist in achieving the desired
objectives.
Our major suggestion relates to the form of the manager's
opinion and the use of the terms "adeguacy" and "inadequacy." We
believe these terms are vague and undefined. Since the internal
control system is designed to acconPTis specific objectives, we
believe that the manager should state whether or not his stem is
sufficient to irov~ reasonba Te assurance o3^meeting those objec-
#ives~.. Therefore,_._we su
to read: ggest that lines 5-~ on page be changed
..shall prepare a report stating his opinion on
whether the agency's system of internal accounting
and administrative control is sufficient to provide
reasonable assurance of meeting the objectives of
such a system [as specified in subsection (d)(4)
of this section].
We also suggest deleting the term "inadequacy" on page 3, lines
11 and 17. Since material weakness is specifically defined in auditing
literature as any weakness that prevents reasonable assurance of
achieving the objectives of a system of internal control, using the
term inadequacy may cause confusion. In addition, we believe the
report should permit the manager the opportunity to state, if appro-
priate, why a material weakness has not or will not be corrected.
Accordingly, page 3, line 17 may be modified as follows:
...the plans and schedule for correcting or the
reasons for not correcting any such weakness
described in detail.
We also have a question about how many years the managers will
be required to subanit this report. The wording on page 2, lines 7
and 8 seems to imply that the report is only due on December 31, 1982
and 1983. We understand that this is to be an annual report.
Since we believe that it is extremely difficult or impossible
for any system to provide reasonable assurance that "all" transactions
are safeguarded or properly recorded, we are attaching for your conve-
nience our suggested revision of section (d) (4) dealincr with the
definition of internal accounting and administrative controls. In
addition, we are suggesting the following definitions for the terms
"transactions" and "reasonable assurance" which may be included in the
appropriate section of the bill:
Transactions include the exchange of assets or services
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The Honorable Jack Brooks
Page Three
March 27, 1981
or the incurrence of obligations with parties outside the
executive agency and transfer or use of assets within the
agency.
Reasonable assurance is that level of assurance that
gives recognition to principle that the costs of a system
of internal control should not exceed the benefits expected
to be derived. The benefits are reduction in the risk of
failing to achieve the objectives of a system of internal
control of an executive agency. Such objectives include
the objectives of internal accounting control and those
aspects of administrative control that relate to c zipliance
with applicable law and avoidance of waste and loss.
We hope that this information will be useful to you and appreciate
the opportunity to express our views on this important topic. We would
be pleased to meet with you and members of your staff to elaborate
further on our o eu ents.
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156
I "(d)(1) To ensure that the requirements of subsection
2 (a)(3) of this section are fully complied with, the head of each
3 executive agency which the Director of the Office of Manage-
4 meat and Budget determines to be covered byyt~hissh
ssurbsection
5 shall prepare a report stating his/her.
on the adecrtacy-of-
6 the agency's systems of internal accounting and administra-
is sufficient to provide reasonable assurance of meeting the objectives of
7 tive control\by December 31, 1982, and by December 31 of such a systan [as specified
in subsection (d)(4) of this
8 the succeeding year. section]
9 "(2) The reports shall be signed by the head of each
10 executive agency and addressed to the President. Such re-
11 ports shall also be made available to Congress and the public.
12 "(3) By December 31, 1981, the Comptroller General,
13 in consultation with the Director of the Office of Management
14 and Budget, shall establish a system of reporting and guide-
15 lines for the agencies in performing evaluations on their svs-
16 tems of internal accounting and administrative control. The
17 Comptroller General, in consultation with the Director, may
18 modify the system for reporting or the guidelines for
19 conducting the evaluations from time to time as deemed
20 necessary.
21 "(4) Internal accounting and administrative controls
22 shall be established in accordance with standards prescribed
carprise the plan of organization and the
23 by the Comptroller General, and~a4a1~?pras dam r~uesxt+rble
24 procedures and records that are concerned with-
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157
AICPA Suggested Language/H.R. 1526
o Safeguarding of funds, property and other assets
against waste, loss, unauthorized use, or
misappropriation;
o Reliability of financial and statistical reports; and
o Compliance with applicable laws;
and that, accordingly, are designed to provide reasonable assurance that
the following objectives are achieved:
i. Transactions are executed in accordance with (a)
management's general or specific authorization
and (b) applicable law.
ii. Transactions are recorded as necessary -
(a) To permit the preparation of financial and
statistical reports in conformity with
generally accepted accounting principles
or other applicable criteria and
(b) to maintain accountability for assets.
iii. Access to assets is permitted only in accordance
with appropriate authorization.
iv. The recorded accountability for assets is
compared with the existing assets at reasonable
intervals and appropriate action is taken with
respect to any differences.
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AICPA Suggested Language/H.R. 1526
1
LL(i}?ali-orblig-rtimt~- ?and nrnts n2~re-irr?eonllrlianee
2
with applicabir-lam
3
(iii1~ fund; -property ~trd-ot~3er-aete~e
4
safeguarded against- waste,?doss-?~tnatrtharized?ttse;-or
5
rnisa~pro~ri~6iarr;rxl
6
'hii)-all re~entre - rrn1- expenditures ~pplic-thie to
7
agerrey-erpera i merepro sy-reeord
arx e ee Hrt
8
ed fer-to-pern t?-the?prepretioo- .f?ac
+r}ts-aid-reli-
9
able-financial and staCisticaf reperts and to-rmairrtain
10
aeeetr-rta~ility o~er?the?arets.
11 Any irtadegeaey-oe material weaknesses in an agency's sys-
12 tems of internal accounting and administrative control which
13 prevents the head of the agency from stating that the
14 agency's systems of internal accounting and administrative
15 control provided reasonable assurances that each of the ob-
16 jectives specified above were achieved shall be identified and
or the reasons for not correcting
17 the plans and schedule for correctin any such i3radeCtrraey
weakness
18 described in detail.
19 "(5)(A) The Inspector General of an executive agency
20 or, if no Inspector General exists for an agency, the head of
21 the internal audit staff, shall receive and investigate any alle-
22 gation that an employee of the agency provided false or mis-
23 leading information in connection with the evaluation of the
24 agency's systems of internal accounting and administrative
25 control or in connection with the preparation of the annual
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159
STATEMENT OF ROBERT G. CRONSON ON BEHALF OF
NATIONAL STATE AUDITORS ASSOCIATION
BEFORE
THE SUBCOMMITTEE ON LEGISLATION AND NATIONAL SECURITY
COMMITTEE ON GOVERNMENT OPERATIONS
U.S. HOUSE OF REPRESENTATIVES
MARCH 27, 1981
My name is Robert G. Cronson. I am the Auditor General
of the State of Illinois and President of the National State
Auditors Association, which is the national association of
the post audit officials of state government throughout the
United States.
I appreciate the opportunity to present our views on
H.R. 1526, "The Federal Managers'Accountability Act of 1981."
H.R. 1526 would contribute to improved accountability, ef-
ficiency and effectiveness in the administration of govern-
ment programs. Further it is consistent with general practice
of state auditors in the conduct of audits at the state level.
It is basic to almost any state audit of a state agency or
program to include a review of the systems of internal accounting
and control. This review is essential to the ability to certify
financial statements and is equally essential to a review of the
administrative structure under which the agency or program is
conducted. Accordingly, we support this proposal to impose a
clear requirement for the development of sound systems of in-
ternal control.
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The bill in its present form would require the head of an
executive agency to issue an opinion on the adequacy of the
agency systems of internal accounting and control on an annual
basis. Further, the General Accounting Office would be called
upon to establish a system of reporting and guidelines for
agency use in evaluating their own systems of internal accounting
and control.
We would suggest that this system of reporting and guide-
lines should be established solely by the Office of Management
and Budget. Further we would suggest that the General Accounting
Office be authorized or mandated to conduct periodic evaluations
and reviews of the systems of internal accounting and control and
report the results of such evaluations and reviews to the Congress.
We would suggest that the evaluation and review be in in-
tervals of no less than three years or of such shorter period as
your Committee deems appropriate. We would further suggest that
the system of reporting and guidelines be established by the Office
of Management and Budget rather than by the Comptroller General.
This would leave the Comptroller General in a position of total
independence in his ability to report on the implementation of
systems within the individual executive agencies, and on the system
and guidelines established by the Office of Management and Budget.
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