EXHIBIT I
Independent Auditors' Report
Material Weakness in Internal Control

The material weakness identified below is a reportable condition in which the design or operation of one or more of the internal control components does not reduce to a relatively low level the risk that misstatements, in amounts that would be material in relation to the consolidated financial statements being audited, may occur and not be detected within a timely period by employees in the normal course of performing their assigned functions.

The HTF consolidated financial statements are primarily comprised of the Highway Corpus Trust Fund, held by the Department of the Treasury's Bureau of Public Debt, and certain accounts of the following operating administrations (OAs) of the DOT: Federal Highway Administration (FHWA), National Highway Traffic Safety Administration (NHTSA), Federal Transit Administration (FTA), Federal Motor Carrier Safety Administration (FMCSA), Federal Railroad Administration (FRA), and Research and Innovative Technology Administration (RITA).

A. Financial Management, Reporting, and Oversight

Journal Entries

Background:

Delphi is the official accounting system for the HTF and DOT. A significant number of accounting transactions are recorded into Delphi through the use of journal entries. These entries are to be prepared in accordance with the U.S. Government Standard General Ledger (USSGL) contained in the Department of the Treasury's Financial Manual which provides a uniform chart of accounts and technical guidance used to standardize Federal agency accounting. In order to control the journal entry process, the OAs use standardized journal entry forms which include the name of the preparer, the reason for the entry, the type of supporting documentation attached and a signature box for the approver of the journal entry.

Conditions:

We noted the following internal control weaknesses related to journal entries prepared during the year:

Lack of indication of preparer:

The OAs did not have effective processes to ensure that all journal entries were properly prepared. Specifically, of the 183 journal entries selected, we noted 12 instances where the name of the preparer was not referenced on the journal entry forms related to FHWA, FRA, RITA and NHTSA.

Lack of proper supporting documentation:

The OAs did not have effective processes to ensure that all journal entries were properly supported. Specifically, for the 183 journal entries selected we noted 33 instances related to all of the OAs, where either no supporting documentation was attached to the entry or the supporting documentation was insufficient to support the entry.

Lack of proper review and approval:

The OAs did not have effective processes to ensure that all journal entries were properly reviewed and approved prior to posting to the general ledger. Specifically, for the 183 journal entries selected, we noted 16 instances related to FHWA, FTA, FRA, RITA and NHTSA where journal entries were not properly approved prior to the entry being posted in the general ledger. In addition, the process in place throughout the majority of the fiscal year allowed journal entries to be both prepared and posted by the same individual. Although the process was modified in the last quarter of the fiscal year to require approval by an individual other than the preparer prior to posting, there are no system controls currently in place which would prevent the same individual from both preparing and posting a journal entry. Lastly, we noted numerous entries related to FHWA which were prepared and then approved subsequent to posting in the general ledger.

Completeness of journal entries:

The OAs did not have effective processes to ensure that all posted journal entries were properly maintained. Although, we noted that FHWA, FMCSA, FRA and NHTSA have begun to sequentially number journal entries, we noted that there is not an effective process in place to monitor and track the status of these entries. Specifically, for a selected month, we noted 9 instances where journal entries related to FHWA, FMCSA and NHSTA were either not assigned a journal entry number or the same number was used more than once. We noted that FTA does not assign unique sequential numbers to journal entries. We also noted that the journal entries related to FRA prior to April 2006 and 8 journal entries related to FHWA and NHTSA that could not be located. We also could not trace 3 journal entries related to FRA and FMCSA to their respective postings in the general ledger.

Lastly, we noted that the OAs do not assign common numbers to routine or recurring journal entries to ensure that each routine or recurring entry is prepared each month.

Cause:

Effective policies and procedures are not in place to ensure the propriety or completeness of journal entries. Specifically, there are not effective processes in place to ensure that journal entries are properly prepared, supported, approved and monitored. Also, system controls are not in place to ensure proper segregation of duties related to the preparation and posting of journal entries.

Effect:

Financial statements amounts may be misstated and/or not properly supported. Failure to implement effective processes and procedures could increase the risks of fraud, violations of appropriation laws and mismanagement of funds.

Criteria:

The Federal Managers' Financial Integrity Act of 1982 requires that the internal accounting and administrative controls of each executive agency shall be established in accordance with standards prescribed by the Comptroller General. GAO's Standards for Internal Control in the Federal Government state internal controls and all transactions and other significant events need to be clearly documented, and the documentation should be readily available for examination. All documentation and records should be properly managed.

Recommendations:

We recommend that the OAs:

• Develop effective policies and procedures that ensure the proper preparation of journal entry forms;

• Develop effective policies and procedures that will strengthen controls over the journal entry review and approval process to ensure that all journal entries are complete, accurate, properly supported and approved prior to posting in the general ledger; and

• Develop effective policies and procedures that will ensure that all routine or recurring journal entries are properly prepared and posted each month and that all journal entries are properly maintained.

Financial Oversight and Reporting

Background:

The basic principle of the President's Management Agenda calls for improving financial performance by providing timely, reliable, and useful information to management and the public. Delphi and its associated feeder systems are designed and maintained in a manner to assist responsible officials in restricting the authorization or incurrence of commitments, obligations, and expenditures to amounts available in the apportionment or allotment.

In order to ensure compliance with the President's Management Agenda and FFMIA, the DOT's Office of Financial Management began developing a consistent and comprehensive set of proprietary and budgetary account relationship tests during Fiscal Year 2006. Where necessary, corrections to the USSGL are made based on these tests to ensure that the data in Delphi is accurate, consistent, and reliable and provides the true status of each expense, revenue, and funding for each OA.

Also, the FHWA transfers some of its budget authority associated with its Federal-Aid Highway program to other Federal agencies via the allocation transfer process as specified in OMB Circular No. A-11, Preparation, Submission, and Execution of the Budget. These Federal agencies obligate and disburse this budget authority to execute Federal-Aid Highway projects. FHWA has prepared a handbook to provide guidance to the other Federal agencies to ensure transactions are correctly recorded in the respective accounting systems and establish specific reporting requirements.

Lastly, OMB Circular No. A-136, Financial Reporting Requirements, establishes a central point of reference for all Federal financial reporting guidance and defines the form and content for Federal agency financial statements that are required to be submitted to the Director of the OMB and the Congress pursuant to the requirements of the Chief Financial Officers Act, as amended by the Reports Consolidation Act of 2000.

Conditions:

We noted the following internal control weaknesses related to financial management and oversight during the year:

Weaknesses in the consolidated financial statement preparation and analysis process:

In Fiscal Year 2006, the HTF again revised its methodology to allocate its net costs in accordance with applicable requirements. However, we determined that the proposed allocation methodology did not report costs by major program. Accordingly, officials revised the Statement of Net Cost to present costs by the three major programs, Highway (Federal-Aid Highways), Mass Transit (Formula and Bus Grants), and Other (miscellaneous HTF funded accounts) to be compliant with the related GAAP requirements in this area.

In addition, as described in more detail below, we noted that certain proprietary activity associated with allocation transfers made to other Federal agencies was incorrectly included in the Fiscal Year 2005 consolidated financial statements.

Also, consistent with the previous year, the Fiscal Year 2006 Management's Discussion and Analysis (MD&A) initially contained information that was not relevant to the programs or operation of the HTF. In addition, the discussion of performance measures contained in the MD&A initially did not accurately summarize key performance measures or adequately disclose the use of projections, estimates and changes to prior year benchmarks. Consequently, significant revisions to the MD&A and performance measures were required to conform to OMB requirements.

Inadequate analysis of abnormal balances:

During Fiscal Year 2006, the OAs did not have a fully effective process to identify and resolve abnormal USSGL account balances at the Treasury Appropriation Fund Symbol (TAFS) level. Each OA has the ability to run a standard report entitled Account Balance Exception Report at any time. However, the OAs did not routinely produce and review the exception report, and document the reviews, and/or how they resolve the issues/exceptions identified. Further, the OAs did not assess the financial reporting impact of the issues/exceptions identified. The OAs indicated that the report was not used since it was produced at the fund code level, which represents a subdivision of a TAFS. Accordingly, during the fourth quarter of Fiscal Year 2006, the OAs began a process to analyze abnormal USSGL account balances on a monthly basis at the TAFS level.

The end of year analysis disclosed abnormal balances that had a financial reporting impact on both the current-year and prior-year financial statements. For example, two TAFS had abnormal balances in SGL 4610, Allotments - Realized Resources, in the amount of $5.4 million and $18.3 million respectively. As a result the amount reported on the Combined Statement of Budgetary Resources as Unobligated Balances Apportioned and Unobligated Balances Exempt from Apportionment, were misstated by $23.7 million. In another example, there was an abnormal balance in SGL account 6100, Operating Expenses, in the amount of $56.3 million. This abnormal balance resulted from a Fiscal Year 2006 reversal included in the HTF consolidated financial statements of a Fiscal Year 2005 accrual of $94 million which should have been reflected in the Fiscal Year 2005 HTF consolidated financial statements. As a result, the opening balance related to the Cumulative Results of Operations for the HTF was misstated by $94 million. In addition, the reversal caused the Fiscal Year 2006 HTF net cost to be understated by $94 million. Although there was not a material impact on the HTF financial statements, timely identification and resolution of abnormal balances is an essential component of effective financial reporting and oversight.

Inadequate analysis of account relationships:

Account relationship tests are an effective financial management tool to help ensure USSGL integrity and that erroneous and/or incorrect transactions are not processed. To be fully effective, account relationship tests must be performed at the TAFS level, as not all relationship tests apply to all types of TAFS. For example, special and trust fund TAFS do not receive appropriations, thus account relationship tests associated with appropriations are not applicable.

During Fiscal Year 2006, the OAs did not have a consistent, comprehensive process for analyzing USSGL account relationships and identifying discrepancies. FHWA had identified 21 separate account relationship tests - the first of which is automatically performed by DELPHI, and seven are only performed at year end. Of the remaining 13 tests, 12 were in place and one was under development at June 30, 2006. We noted that the 12 tests were performed at the TAFS level. FTA had identified 16 separate account relationship tests. As of June 30, 2006 these tests were only performed at the summary level and not at the individual TAFS level. The remaining OAs only performed 6 account relationship tests at a summary level. None of the OAs assessed the impact of account relationship discrepancies at year end. For the HTF, at year end, no material account relationship discrepancies existed. However, FHWA had a $90 million discrepancy between proprietary and budgetary accounts payable. NHTSA also had discrepancies between proprietary and budgetary advances to others, and proprietary and budgetary account payable.

Inadequate controls over journal entry processing:

The use of journal entries is generally considered to be high risk as users can enter transactions that do not comply with standard USSGL posting logic. Accordingly, the use of journal entries to process transactions should be kept to an absolute minimum. During Fiscal Year 2006, the following weaknesses associated with the processing of journal entries existed:

• Manual journal entries are used to process routine transactions such as recording and distributing budget authority, recording and reversing accruals, and cash draw downs;

• The OAs do not process reversals of incorrect transactions consistently. Specifically, the OAs have 4 different methods available for making corrections as follows:

  • Using the original posting logic and entering negative amounts;
  • Reversing the journal entries at the "batch" level as journal entries are summarized and processed as a "batch." The reversal is readily identifiable as the accounting system creates a "batch" name that indicates it is a reversal of the original "batch" name;
  • Reversing the journal entries at the "journal" level as batches can be comprised of one or more journals. The reversal is not as readily identifiable as the accounting system creates a batch name that indicates it is a reversal of the "journal" name; and
  • Creating a new journal entry that is not automatically linked to the original transaction unless the user identifies it as part of the batch name; and

• There is no process in place to assess the impact that journal entries could have on opening balances due to the effect on prior year financial statements. As a result, the DOT Office of Financial Management provided technical assistance to identify and assess journal entries processed during Fiscal Year 2006 that had an impact on prior year financial statements. The Office of Financial Management identified a total of 12 journal entries that had an effect on Fiscal Year 2006 opening balances.

• There is no standard naming and numbering convention for journal entries;

Lack of oversight related to parent-child allocation transfers:

During Fiscal Year 2006, FHWA took action to resolve accounting discrepancies and errors related to allocations transfers of budgetary authority made to 17 other Federal agencies outside of DOT. Specifically, FHWA developed a handbook to provide accounting guidance to these agencies regarding the proper accounting via allocation transfers. However, during Fiscal Year 2005, FHWA incorrectly included the proprietary activity of these agencies in the HTF consolidated financial statements. For Fiscal Year 2005, OMB Circular No. A-136 required that the proprietary activity associated with allocation transfers be reported in the recipient agency's financial statements unless the recipient agency decided that the activity was not material to its financial statements. FHWA did not coordinate with these recipient agencies to determine whether or not the proprietary activity was material to the recipient's financial statements. As a result, the proprietary activity was included in both the HTF and recipient agency's financial statements. Consequently, the HTF Cumulative Results of Operations' (CRO) opening balance was overstated by approximately $101.5 million. This overstatement did not constitute a material misstatement as it represented less than 1 percent of the CRO opening balance.

During Fiscal Year 2006, OMB Circular No. A-136 included changes to the reporting of proprietary activity related to allocation transfers. Effective in Fiscal Year 2007, OMB Circular No. A-136 requires recipient agencies to discontinue reporting the proprietary activity in its financial statements. Instead, the activity will be reported in the financial statements of the agency making the transfer (i.e., FHWA). Further, OMB Circular No. A-136 indicated that early adoption was permitted provided that both agencies agreed that the recipient would not report the activity in its financial statements. Accordingly, FHWA coordinated with the recipient agencies and except for the United States Department of Agriculture's Forest Service and the United States Army Corps of Engineers, the other 15 recipient agencies agreed that FHWA should report the proprietary activity in the HTF financial statements. Although FHWA had developed a handbook to accounting guidance, FHWA does not have a process to obtain information from other Federal agencies to support HTF financial statement assertions (existence, accuracy, and completeness) related to transactions (obligations, expense, and disbursements) processed by the other Federal agencies that are included in the HTF consolidated financial statements.

Cause:

Policies and procedures are not in place to ensure the effectiveness of financial management and oversight. Specifically, there are not effective processes in place to ensure that:

• the consolidated financial statements, including MD&A, the note disclosures and related information, were prepared in accordance with accounting principles generally accepted in the United States of America and OMB guidance;
• the financial reporting impact of journal entries, abnormal USSGL account balances, and USSGL account relationship discrepancies are properly analyzed;
• all abnormal balances and account relationships are analyzed at the appropriate level, promptly addressed, evaluated, resolved, and documented; and
• transactions processed by child agencies are proper to support the HTF's financial statement assertions.

Effect:

Financial statements amounts may be misstated and or not properly supported. Failure to implement effective processes and procedures could increase the risks of fraud, violations of appropriation laws and mismanagement of funds.

Criteria:

The Federal Managers' Financial Integrity Act of 1982 requires that the internal accounting and administrative controls of each executive agency shall be established in accordance with standards prescribed by the Comptroller General. The Government Accountability Office's (GAO) Standards for Internal Control in the Federal Government state internal controls and all transactions and other significant events need to be clearly documented, and the documentation should be readily available for examination. All documentation and records should be properly managed.

OMB Circular No. A-136 prescribes guidance regarding the preparation of HTF's annual financial statements, including MD&A and the note disclosures. In addition, the OMB Circular No. A-136 prescribes that the MD&A should provide a clear and concise description of the reporting entity's performance measures, financial statements, systems and controls, compliance with laws and regulations, and actions taken or planned to address problems. Furthermore, the annual report should identify those performance goals where actual performance information is missing, incomplete, preliminary, or estimated. The OMB Circular No. A-136 also states that the Statement of Net Cost classifies revenue and cost information by major program and the related supporting schedules in the notes classify revenue and cost information by suborganization or responsibility segment and by major program. Lastly, as described above, the OMB Circular No. A-136 prescribes the proper reporting for parent-child allocation transfers.

Section 803(a) of FFMIA requires that Federal financial management systems comply with (1) Federal accounting standards, (2) Federal system requirements, and (3) the USSGL at the transaction level. FFMIA emphasizes the need for agencies to have systems that can generate timely, reliable, and useful information with which to make informed decisions to ensure ongoing accountability.

OMB Circular No. A-127, Financial Management Systems, paragraph 7(c) requires the application of the USSGL at the transaction level. Financial events shall be recorded by agencies throughout the financial management system applying the requirements of the USSGL at the transaction level. Application of the USSGL at the transaction level means that the financial management systems will process transactions following the definitions and defined uses of the general ledger accounts as described in the USSGL. Compliance with this standard requires:

• Data in Financial Reports Consistent with the USSGL. Reports produced by the systems that provide financial information, whether used internally or externally, shall provide financial data that can be traced directly to the SGL accounts.
• Transactions Recorded Consistent with USSGL Rules. The criteria (e.g., timing, processing rules/conditions) for recording financial events in all financial management systems shall be consistent with accounting transaction definitions and processing rules defined in the USSGL.
• Supporting Transaction Detail for USSGL Accounts Readily Available. Transaction detail supporting USSGL accounts shall be available in the financial management systems and directly traceable to specific USSGL account codes.

Federal agencies should perform periodic reviews to identify abnormal USSGL account balances and account relationship discrepancies to help ensure compliance with OMB Circular No. A-127.

Recommendations:

We recommend that the OAs:

• Develop effective policies and procedures to ensure that the preparation of quarterly and annual financial statements, note disclosures, and related information are in compliance with accounting standards and OMB guidance;
• Develop effective policies and procedures to review and document the resolution to any abnormal balances and account relationship discrepancies that exist at the TAFS level on a monthly basis. Specifically, each OA should (a) analyze the abnormal balances and account relationship discrepancies at the TAFS level and (b) document the review and resolution for any abnormal balances and account relationship discrepancies that exist (i.e. journal entries prepared, etc.);
• Be required to report significant abnormal balances and account relationship discrepancies on a monthly basis including a status of researching and resolving the balances;
• Develop policies and procedures to determine if any journal entries processed in the current fiscal year have a prior period impact; and
• Develop effective policies and procedures to ensure that other Federal agencies that receive material amounts of the HTF budget authority via the allocation transfer process provide sufficient evidence that the transactions processed exist, are accurate and that all transactions have been reported (i.e., completeness).

Grant Accruals

Background:

In Fiscal Year 2006, FHWA surveyed selected grantees to reestablish its estimate of the number of days between the time the grantees incur grant-related expenditures and the time the expenditures are reimbursed by FHWA. This number of days is referred to as the Incurred But Not Reported (IBNR) period and is a key factor used in developing the grant accrual estimate. Also, in Fiscal Year 2006, a new separate grant accrual was required for the FTA grant program that is now included in the HTF consolidated financial statements.

Condition:

FHWA management did not conduct a proper review of the inquiries sent by its consultant and therefore did not initially identify that the consultant limited the inquiries related to the IBNR period to begin on the day the grantee receives invoices from its contractors rather than the date the related work was accepted by the grantee's engineers. As a result, FHWA could not use the survey results as originally planned and instead had to use alternative procedures that involved confirming the accrual amount as of September 30, 2006 with each of its 52 grantees.

In addition, we noted that FTA did not properly calculate its grant accrual. Due to mathematical error and the use of improper assumptions, the originally recorded accrual of approximately $70 million was ultimately adjusted to $650 million.

Cause:

FHWA management did not ensure that the questions in the survey were structured to ensure the grant accrual would be correctly estimated. FTA management did not conduct a proper review of the grant accrual calculation to ensure that it was based on appropriate assumptions and was mathematically correct.

Effect:

The grant accrual at September 30, 2006 was initially misstated.

Criteria:

GAO's Standards for Internal Controls in the Federal Government states "Internal control should generally be designed to assure that ongoing monitoring occurs in the course of normal operations. It is performed continually and ingrained in the agency's operations. It includes regular management and supervisory activities, comparisons, reconciliations, and other actions people take in performing their duties"

In addition, The Department of Transportation, Financial Management Policies Manual, Section 2.3.3, Preparation of Accrual Estimates requires the following procedures in developing or documenting estimates:

• Documenting methods and assumptions for the estimate;
• Assuring the methodology is reasonable and approved by management. The methodology may include historical trend analysis, application of ratios, stratification, etc.;
• Analyzing and supporting assumptions;
• Defining data elements that are vital to the methodology;
• Testing actual data to estimates periodically;
• Identifying exceptions to the assumptions by considering any subsequent events;
• Including any known or projected program fluctuations and increase the range of historical data if large fluctuations are anticipated or occur;
• Assessing the validity of historical data;
• Determining which estimates must be process-specific;
• Demonstrating that the aggregate values below any established threshold are immaterial; and
• After month-end, comparing accruals to actual to ensure that monthly accruals are as accurate as possible.

Recommendation:

Given the significance of the FHWA and FTA grant accruals to the HTF consolidated financial statements, we recommend that the FHWA enhance its internal controls over the reasonableness of the grant accrual estimate to ensure that, if a survey is again used, the survey questions are appropriately comprehensive. We also recommend that FTA enhance its internal controls over its review of the grant accrual calculations to ensure that they are properly calculated.

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