Federal Deposit Insurance Corporation
Division of Finance
Washington, D.C. 20439

DATE: September 24, 2004

MEMORANDUM TO: Russell A. Rau, Assistant Inspector General for Audits

FROM: Fred S. Selby [Electronically produced version; original signed by Thomas E. Peddicord for Fred S. Selby], Director, Division of Finance

SUBJECT: Response to Draft Report Entitled,FDIC's Allocation of Records Storage Costs (Assignment No.
2004-036)

The Division of Finance has reviewed your draft audit report entitled FDIC's Allocation of Records Storage Charges (Assignment No. 2004-036). The report suggests that the FDIC consider adjusting the fund balances to reflect retroactive restatement of fund allocations back to 1996, prospective direct charging of record storage costs to the funds, and consideration of related prior-year adjustments to the financial statements. As discussed below, we do not agree with the recommendations provided in the report. The memorandum provides our comments on the draft report, including an explanation of our reasons for rejecting the recommendations.

We believe that any restatement of prior year fund split allocations would be inappropriate due to the repeated "pooling" methodology used to determine allocation averages applied to heterogeneous component elements of cost. We also believe that the current methodology, which has been validated through numerous financial statement audits, provides a reasonable, efficient, and consistent basis for allocating costs to the funds. Finally, we challenge the conclusion that funds could be put to better use, since the audit takes issue with the fund allocation only and does not question the expenditures themselves, identify monetary savings or suggest that there could be more appropriate uses of the funds. Below you will find a brief discussion of our allocation methodology, followed by responses to each of your recommendations.

Allocation Methodology

During 1996, after five consecutive years of financial statement reportable conditions stemming from improper direct charges of operating expenses to the insurance funds, the fund allocation methodology was approved by all levels of FDIC executive management and the Board of Directors. In addition, the annual planning and budget process included Board Deputy and Board member briefings regarding fund allocation methodology. As certain program initiatives such as the Recovery Task Force and the Service Costing program were being approved by FDIC executive management, Board Deputies and Board Members, changes made to the fund allocation methodology as a result of those programs were also included as part of the briefings.

Since the beginning of 1998, Records storage costs have represented only about 30% of CL71 - Corporate Support Section costs. The remaining 70% has primarily consisted of library, public information, design, and printing costs. Under our allocation methodology all CL71 costs combined are driven/spread to non-support line activities (program codes 11-69), prior to any allocation to the insurance funds. Likewise, other program code 71 shared service costs (including most corporate administrative and information technology costs) are also driven to these line activities.

For each line activity (11-69 program code), subject matter experts (SME's) from each division directly responsible for these functions then collaborate to set appropriate and mutually acceptable blended rates to use in allocating costs for each program code to each insurance fund. Once these rates are established, fund splits are managed through very efficient, largely automated processes which avoid the needless costs and errors associated with the direct charging methods they replaced. Since the beginning of 1997 over $7.2 billion has been allocated to the insurance funds using this methodology, with over $835 million allocated to the FRF. Furthermore, since the FDIC began using the allocation methodology in 1996, every financial statement audit has received a "clean" opinion.

These blended rates are never intended to be appropriate for elements of cost (such as records storage) taken individually, but rather are averages that are expected to result in appropriate allocations for the program as a whole. The underlying premise in this methodology is that potential under-allocations to a particular fund of some cost elements will be offset by potential over-allocations of others in this blended average approach. Again, only in the aggregate are the fund splits for each program code expected to be appropriate. Since CL71 charges are spread to all line programs, their over and under allocations are offset by cost elements and organizational entities throughout the Corporation.

SME's in each program area must weigh all of the disparate cost elements and their impacts on fund splits when determining the blended allocation percentages to be applied. In this way the individual fund split characteristics of cost elements are merged, thereby losing their individual identities and characteristics. However, the fund split characteristics of each cost element do influence the overall allocation percentages applied to the entire program. If one element was to be removed from the pool and direct charged to the funds instead, it is logical to expect that the SME's would and should make appropriate and offsetting changes to the allocation percentages. Likewise, any retroactive re-statements intended to reflect the removal and direct charging of an element of cost should be fully offset by re-statements reflecting changes to prior allocations, rendering any such efforts moot.

Recommendations

In summary, we remain confident that our cost allocation methodology is sound and appropriate, and we do not agree that adoption of the audit report recommendations would result in more accurate charges to the funds. We believe that this determination complies with the requirements for a final management decision on this matter.

We appreciate the opportunity to respond to your draft audit report. My staff tells me that although we disagreed with your recommendations, the staff assigned to this audit performed with exemplary focus, courtesy and professionalism. If you decide to substantially alter your recommendations before finalizing the audit report, we would appreciate the opportunity to review the revised report and provide you with an updated response.

If you have questions, please contact Robert C. Nolan at X62099.

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