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Performance and Accountability Report Fiscal Year 2005

Financial Statements, Notes, Supplemental and Other Accompanying Information

The accompanying “Notes to the Principal Financial Statements” are an integral part of these statements.

The accompanying “Notes to the Principal Financial Statements” are an integral part of these statements.

The accompanying “Notes to the Principal Financial Statements” are an integral part of these statements.

Notes to the Principal Financial Statements for the Years Ended September 30, 2005 and 2004

Note 1. Summary of Significant Accounting Policies

Reporting Entity
The Department of Health and Human Services (HHS or Department) is a cabinet-level agency of the executive branch of the Federal Government. Its predecessor, the Department of Health, Education and Welfare (HEW), officially came into existence on April 11, 1953. In 1979, the Department of Education Organization Act of 1979 (Public Law 96-88) was signed into law, providing for a separate Department of Education. HEW officially became HHS on May 4, 1980. The Department is responsible for protecting the health of all Americans and providing essential human services.

Organization and Structure of HHS

HHS is comprised of 11 Operating Divisions (commonly referred to as OPDIVs) with diverse missions and programs. Each OPDIV is considered a responsibility segment representing a component of a reporting entity that is responsible for carrying out a mission, conducting a major line of activity, or producing one or a group of related products or services. The managers of the responsibility segments report to the entity’s top management directly, and its resources and results of operations can be clearly distinguished from those of other responsibility segments of the entity. The 12 responsibility segments are:

1. Administration for Children and Families
2. Administration on Aging
3. Agency for Healthcare Research and Quality
4. Centers for Disease Control and Prevention/Agency for Toxic Substances and Disease Registry
5. Centers for Medicare & Medicaid Services
6. Food and Drug Administration
7. Health Resources and Services Administration
8. Indian Health Service
9. National Institutes of Health
10. Office of the Secretary - excluding Program Support Center, a separate responsibility segment
11. Program Support Center
12. Substance Abuse and Mental Health Services Administration

Even though it is part of the Office of the Secretary, the Program Support Center reports on its activity separately because its business activities encompass offering services to other OPDIVs and Federal agencies. The Agency for Toxic Substances and Disease Registry is combined with the Centers for Disease Control and Prevention for financial reporting purposes; therefore, these footnotes will refer to them as one responsibility segment.

Basis of Accounting and Presentation

The accompanying financial statements have been prepared to report the financial position and results of operations of the Department, pursuant to the requirements of the Chief Financial

Officers Act of 1990 (Public Law 101-576), as amended by the Reports Consolidation Act of 2000 (Public Law 106-531) and presented in accordance with the requirements contained in the Office of Management and Budget (OMB) Circular No., A-136 (Revised), Financial Reporting Requirements. These statements have been prepared from the Department’s financial records on an accrual basis in conformity with accounting principles generally accepted in the United States (GAAP). The GAAP for Federal entities are the standards prescribed by the Federal Accounting Standards Advisory Board (FASAB) and recognized by the American Institute of Certified Public Accountants (AICPA) as Federal GAAP. These statements are therefore different from financial reports prepared pursuant to other OMB directives that are primarily used to monitor and control HHS’ use of budgetary resources.

The financial statements consolidate the balances of about 140 appropriations and fund accounts, and a number of accounts used for suspense, collection of receipts, and general government functions. Transactions and balances among HHS OPDIVs have been eliminated in the presentation of the Consolidated Balance Sheet, Consolidated Statement of Net Cost, Consolidated Statement of Changes in Net Position, and the Consolidated Statement of Financing. The Combined Statement of Budgetary Resources (SBR) is presented on a combined basis. Supplemental information is accumulated from the OPDIV reports, regulatory reports, and other sources within HHS.

Transactions are recorded on an accrual and budgetary basis of accounting. Under the accrual method of accounting, revenues are recognized when earned, and expenses are recognized when incurred, without regard to receipt or payment of cash. Budgetary accounting principles, on the other hand, are designed to recognize the obligation of funds according to legal requirements, which in many cases is prior to the occurrence of an accrual-based transaction. The recognition of budgetary accounting transactions is essential for compliance with legal constraints and controls over the use of Federal funds. The Centers for Medicare & Medicaid Services (CMS) uses the cash basis of accounting in the Medicare program to record benefit payments disbursed during the fiscal year, supplemented by the accrual method to estimate the value of benefit payments incurred but not yet paid as of the fiscal year-end. CMS also uses the cash basis of accounting in the Medicaid and the State Children’s Health Insurance Program (SCHIP) to record funds paid to the states during the fiscal year, supplemented by the accrual method to estimate the value of expenses (net of recoveries) not yet reported to CMS as of the end of the fiscal year. A number of other HHS OPDIVs also use the cash basis of accounting for some programs with an accrual adjustment made by recording year-end estimates of unpaid liabilities.

Unified Financial Management System

HHS has taken a step in streamlining and integrating its financial management systems with the implementation of the Unified Financial Management System (UFMS). HHS’ overarching

financial management goals seek to (1) provide decision makers with timely, accurate, and useful financial and program information; and (2) ensure that HHS resources are used appropriately, efficiently, and effectively. With UFMS, HHS will also standardize business processes for all core functions including general ledger, accounts payable, accounts receivable, cost management, budget execution, and financial reporting. UFMS went live with the Centers for Disease Control and Prevention (CDC) and the Food and Drug Administration (FDA) in April 2005 for core financials, including general ledger, accounts payable, and accounts receivable; and in addition, Projects for CDC and iProcurement for FDA.

Transition of Payroll System to Defense Finance and Accounting Service

HHS has completed its payroll conversion for civilian payroll, except for Public Health Service Commissioned Corps, from the HHS legacy payroll system to the Defense Finance and Accounting Service (DFAS) on April 17, 2005. HHS is the single largest civilian agency payroll conversion ever completed by the DFAS.

The DFAS offers an array of multi-functional payroll processing applications and services, in compliance with existing Joint Financial Management Improvement Program SR-99-5, Human Resources & Payroll Systems Requirements for payroll management activities. These include:

1. Time and Attendance, Leave, and Pay Processing;
2. Labor Cost and Distribution;
3. Reporting, Reconciliation, and Records Retention;
4. Employee Self Service (My Pay);
5. Integrated Garnishment System and Debt Processing; and
6. Client-specific non-recurring reporting.

Use of Estimates in Preparing Financial Statements

Preparation of financial statements in accordance with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities as of the date of the financial statements. Estimates and assumptions also affect the revenues and expenses accrued and reported in the financial statements. Actual results may differ from those estimates.

Entity and Non-Entity Assets

Entity assets are assets that the reporting entity has authority to use in its operations. The authority to use funds in an entity’s operations means entity management has the authority to decide how funds are used, or management is legally obligated to use funds to meet entity obligations.

Non-entity assets are those assets that are held by the reporting entity, but are not available for use by the entity. An example of a non-entity asset is the interest accrued on overpayments and cost settlements reported by the Medicare contractors.

The HHS financial statements do not report entity and non-entity assets separately on the face of the statement. Instead, such detail is presented in Note 2, Non-Entity Assets.

Fund Balance with Treasury

The Department maintains its available funds with the Department of the Treasury (Treasury) except for the Medicare Benefit accounts maintained at commercial banks - see Note 4, Cash and Other Monetary Assets. The Fund Balance with Treasury is available to pay current liabilities and finance authorized purchases. Cash receipts and disbursements are processed by Treasury, and

HHS’ records are reconciled with those of Treasury on a regular basis. Note 3, Fund Balance with Treasury, provides additional information.

Investments

Investments consist of U.S. Treasury securities including the CMS Par Value securities carried at face value, and other securities carried at amortized cost. Federal law requires that trust fund balances that are not necessary to meet current expenditures be invested in interest-bearing obligations of the U.S. Government or in obligations guaranteed as to both principal and interest by the U.S. Government. No provision is made for unrealized gains or losses on these securities since it is the Department’s intent to hold investments to maturity. Interest income is compounded semiannually in June and December and is adjusted to include an accrual for interest earned from July 1 to September 30.

Note 5, Investments, Net, provides additional information on investments.

Accounts Receivable, Net

Accounts receivable consists of the amounts owed to HHS by other Federal agencies and the public as the result of the provision of goods and services. Intragovernmental accounts receivable arise generally from the provision of reimbursable work to other Federal agencies and no allowance for uncollectible accounts is established as they are considered to be fully collectible. Accounts receivable also includes interest due to HHS that is directly attributable to delinquent accounts receivable.

Accounts receivable from the public typically result from overpayments to Medicare providers and beneficiaries, amounts due from cost disallowance for Medicaid, and amounts due from organizations for civil monetary penalties not yet remitted to the Department of Justice. They are presented net of an allowance for uncollectible accounts. The allowance for uncollectible accounts is determined based on past collection experience and an analysis of outstanding balances.

Note 6, Accounts Receivable, Net, provides additional information on accounts receivable.

Loan Guarantee Receivables and Liabilities

HHS administers guaranteed loan programs for the Health Center and the Health Education Assistance Loans (HEAL) programs. Loans receivables represent defaulted guaranteed loans

which have been paid to lenders under this program. Loans receivable also include interest due to HHS on the defaulted loans. Loans guarantee liabilities are valued at the present value of the cash outflows from HHS less the present value of related inflows.

As required under the Federal Credit Reform Act of 1990 (FCRA), for loan guarantees committed on or after October 1, 1991, guaranteed loans are reduced by an allowance for subsidy representing the present value of the amounts not expected to be recovered and thus having to be subsidized by the government for loan guarantees. The FCRA also requires that the subsidy cost estimate be based on the net present value of the specified cash flows discounted at the interest rate of marketable Treasury securities of similar maturities. The liability for loan guarantees committed on or after October 1, 1991 is reported at present value.

For loan guarantees committed prior to October 1, 1991, loan guarantee principal and interest receivable are reduced by an allowance for estimated uncollectible amounts. The allowance is estimated based on past experience and an analysis of outstanding balances. The liability for loan guarantees committed prior to October 1, 1991 is established based upon an average default rate. The liability is adjusted each year for the change in default rates.

Note 8, Loan Guarantee Receivables and Liabilities, provides additional information.

Advances to Grantees/Accrued Grant Liability

HHS awards grants to various grantees and provides advance payments to grantees to meet their cash needs to carry out their programs. Advance payments are recorded as “Advances to Grantees” and are liquidated upon grantees’ reporting expenditures. Grantees sometime incur expenditures before drawing down funds that, when claimed, would reduce the “Advances to Grantees” account. An accrued grant liability occurs when the accrued grant expenses exceed the outstanding advances to grantees, resulting in a negative balance in the “Advances to Grantees” account. HHS grants are classified into two categories: “Grants Not Subject to Grant Expense Accrual” and “Grants Subject to Grant Expense Accrual.” Progress payments on work in process are not included in grants.

Grants Not Subject to Grant Expense Accrual: These grants represent formula grants (also referred to as “block grants”) under which grantees provide a variety of services or payments to individuals and local agencies. Expenses are recorded as the grantees draw funds. These grants are funded on an allocation basis determined by budgets and agreements approved by the sponsoring OPDIV as opposed to a reimbursable basis. Therefore, they are not subject to grant expense accrual.

Grants Subject to Grant Expense Accrual: For grants subject to grant expense accrual (commonly referred to as “non-block grants”), grantees draw funds (recorded as Advances to Grantees in HHS’ accounting systems) based on their estimated cash needs. As grantees report their actual disbursements (quarterly), the amounts are recorded as expense, and the advance balance is

reduced. At year-end, the OPDIVs report both actual payments made through the third quarter and an unreported grant expenditures estimate for the fourth quarter based on historical spending patterns of the grantees. The year-end accrual estimate equals the estimate of fourth quarter disbursements plus an average of two weeks annual expenditures for expenses incurred prior to the cash being draw down.

Exceptions to the definition of “block” or “non-block” grants for reporting purposes are the Temporary Assistance for Needy Families program and the Child Care Development Fund program. These two programs are referred to as “block” grants but since the programs report expenses to HHS, they are treated as “non-block” grants for the estimate of the grant accrual.
HHS reports advances other than grant advances in Note 11, Other Assets. Note 15, Accrued Grant Liability, provides additional information on the accrued grant liability.

Inventory and Related Property, Net

Inventory and Related Property primarily consists of Inventory Held for Sale, Operating Materials and Supplies, and Stockpile Materials.

Inventory Held for Sale consists of small equipment and supplies held by Service and Supply Funds for sale to HHS components and other Federal entities. Inventories held for sale are valued at historical cost using the first-in first-out (FIFO) cost flow assumption with the exception of the National Institutes of Health, which uses the moving average cost flow assumption method.

Operating Materials and Supplies consist of pharmaceuticals, biological products, and other medical supplies used in providing medical services and conducting medical research. Operating materials and supplies are recorded as assets when purchased, and are expensed when they are consumed. Operating materials and supplies are valued at historical cost using the
FIFO cost flow assumption.

As required by the Project BioShield Act of 2004, the Department of Homeland Security transferred Strategic National Stockpile materials to HHS in FY 2004. These materials are held in reserve to respond to local and national emergencies. In addition, the Centers for Disease Control and Prevention (CDC) maintain a stockpile of vaccines to meet unanticipated needs in the cause of a national emergency. The CDC’s stockpile of vaccine materials are valued at historical cost using a specific identification cost flow assumption and the Strategic National Stockpile materials are valued at historical cost using First-In First-Out (FIFO) cost flow assumption.

Note 9, Inventory and Related Property, Net, provides additional information.

General Property, Plant and Equipment, Net
General Property, Plant and Equipment (PP&E) consists of buildings, structures, and facilities used for general operations; land acquired for general operating purposes; equipment; assets under

capital lease; leasehold improvements; construction-in-progress; and internal use software. The basis for recording purchased PP&E is full cost, which includes all costs incurred to bring the PP&E to a form and location suitable for its intended use. The cost of PP&E acquired under a capital lease is the amount recognized as a liability for the capital lease at its inception. The cost of PP&E acquired through donation is the estimated fair value when acquired. The cost of PP&E transferred from other Federal entities is the net book value of the transferring entity. All PP&E with an initial acquisition cost of $25,000 or more and an estimated useful life of two years or more are capitalized, except for internal use software discussed below.

PP&E is depreciated using the straight-line method over the estimated useful life of the asset. Land and land rights, including permanent improvements, are not depreciated. Normal maintenance and repair costs are expensed as incurred.

Statement of Federal Financial Accounting Standards (SFFAS) No. 10, Accounting for Internal Use Software, requires that the capitalization of internally-developed, contractor-developed, and commercial off-the-shelf (COTS) software begin in the software development phase. In FY 2004, HHS incurred development costs for the Unified Financial Management System (UFMS), a COTS software package, and began capitalizing the cost. In FY 2001 the CMS began the HIGLAS project to replace the Medicare contractors’ and CMS’ current accounting systems with a single, unified system. HIGLAS will eventually replace the different systems now in use by contractors that process and pay claims, in addition to CMS’ current mainframe-based administrative accounting financial system. The estimated useful life for internal use software was determined to be seven to ten years for amortization.

SFFAS No. 10 also requires that amortization begins when the asset is placed in use. In April 2005, UFMS was implemented at the Centers for Disease Control and Prevention and the Food and Drug Administration. In FY 2005, Centers for Medicare & Medicaid Services began amortizing the Healthcare Integrated General Ledger Accounting System (HIGLAS) over 10 years using the straight-line method in accordance with HHS policy for UFMS. In addition, CMS has other capitalized internal use software that are currently being amortized over a useful life of 5 years.

The capitalization threshold for internal use software costs for appropriated fund accounts is $1 million or more. The internal use software capitalization threshold for revolving funds is
$500,000. Costs below the threshold levels are expensed. The software is depreciated for a period of time consistent with the estimated useful life used for planning and acquisition purposes.

Additional information is provided in Note 10, General Property, Plant and Equipment, Net.

Liabilities
Liabilities are recognized for amounts of probable and measurable future outflows or other sacrifices of resources as a result of past transactions or events. Since HHS is a component of the

U.S. Government, a sovereign entity, its liabilities cannot be liquidated without legislation that provides resources to do so. Payments of all liabilities other than contracts can be abrogated by the sovereign entity. In accordance with public law and existing Federal accounting standards, no liability is recognized for future payments to be made on behalf of current workers contributing to the Medicare Health Insurance Trust Fund, since future Medicare benefits are not tied to prior Medicare contributions. The Department’s liabilities are classified as covered by budgetary resources or not covered by budgetary resources.

Liabilities Covered by Budgetary Resources:Liabilities funded by available budgetary resources include: (1) new budget authority, (2) spending authority from offsetting collections, (3) recoveries of expired budget authority, (4) unobligated balances of budgetary resources at the beginning of the year, and (5) permanent indefinite appropriation or borrowing authority.

Liabilities Not Covered by Budgetary Resources: Sometimes funding has not yet been made available through Congressional appropriations or current earnings. The major liabilities in this category include employee annual leave earned but not taken, and amounts billed by the Department of Labor (DOL) for Federal Employees’ Compensation Act (FECA) disability payments, and for portions of the Entitlement Benefits Due and Payable liability (discussed below) for which no obligations have been incurred. Also included in this category is the actuarial FECA liability determined by DOL but not yet billed. For HHS revolving funds, all liabilities are funded as they occur.

Liabilities Covered by Budgetary Resources and Liabilities Not Covered by Budgetary Resources are combined on the balance sheet. The breakout of these resources is presented in Note 12, Liabilities Not Covered by Budgetary Resources; Note 13, Entitlement Benefits Due and Payable; Note 14, Federal Employee and Veterans’ Benefits; and Note 16, Other Liabilities.
  
Accounts Payable
Accounts Payable primarily consists of amounts due for goods and services received, progress in contract performance, interest due on accounts payable, and other miscellaneous payables.

Accrued Payroll and Benefits
Accrued Payroll and Benefits consist of salaries, wages, leave and benefits earned by employees, but not disbursed as of September 30. Liability for annual and other vested compensatory leave is accrued when earned and reduced when taken. At the end of each fiscal year, the balance in the accrued annual leave liability account is adjusted to reflect current pay rates. Annual leave earned but not taken is considered an unfunded liability since this leave will be funded from future appropriations when it is actually taken by employees. Sick leave and other types of leave are not accrued and are expensed when taken.

Entitlement Benefits Due and Payable
Entitlement Benefits Due and Payable represent the liability for Medicare and Medicaid for medical services incurred but not reported as of the balance sheet date. The abbreviation IBNR is periodically used in these statements in place of “incurred but not reported.”

Medicare Incurred But Not Reported, or Medicare IBNR

The Medicare liability is developed by the Office of Actuary of the Centers for Medicare & Medicaid Services (CMS) and represents (1) an estimate of claims incurred, which may or may not have been submitted to the Medicare contractors, but which were not yet approved for payment, (2) actual claims that have been approved for payment by the Medicare contractors for which checks have not yet been issued, (3) checks that have been issued by the Medicare contractors in payment of a claim and that have not yet been cashed by payees, (4) periodic interim payments for services rendered in current fiscal year but paid in subsequent fiscal year, and (5) an estimate of
retroactive settlements of cost reports submitted to the Medicare contractors by health care providers.

Medicaid Incurred But Not Reported, or Medicaid IBNR

The Medicaid estimate represents the net of unreported expenses incurred by the states less amounts owed to the states for overpayment of Medicaid funds to providers, anticipated rebates from drug manufacturers, and settlements of probate and fraud and abuse cases. FY 2005 estimate was developed based on historical relationships between prior Medicaid net payables and current Medicaid activity.

Note 13, Entitlement Benefits Due and Payable, provides additional information.

Federal Employee and Veterans’ Benefits
Most HHS employees participate in either the Civil Service Retirement System (CSRS) - a defined benefit plan, or the Federal Employees Retirement System (FERS) - a defined benefit and contribution plan. For employees covered under CSRS, the Department contributes a fixed percentage of pay. Most employees hired after December 31, 1983 are automatically covered by FERS. For employees covered under FERS, the Department contributes the employer’s matching share for Social Security and Medicare Insurance. A primary feature of FERS is that it offers a Thrift Savings Plan (TSP) into which the Department automatically contributes one percent of employee pay and matches employee contributions up to an additional four percent of pay.

The U.S. Office of Personnel Management is the administering Agency for both of these benefit plans and, thus, reports CSRS or FERS assets, accumulated plan benefits, or unfunded liabilities applicable to Federal employees. Therefore, HHS does not recognize any liability on its balance sheet for pensions, other retirement benefits, and other post-employment benefits with the exception of Commission Corps (see below). HHS does, however, recognize an expense in the Consolidated Statement of Net Cost and imputed financing source for the annualized unfunded portion of pension and post-retirement benefits in the Consolidated Statement of Changes in Net Position.

HHS administers the Public Health Service (PHS) Commissioned Corps Retirement System, a defined noncontributory benefit plan, for its active duty officers and retiree annuitants or survivors.

The plan does not have accumulated assets, and funding is provided entirely on a pay as you go basis by Congressional appropriations. HHS records the actuarial liability based on the present value of accumulated pension plan benefits and the post-retirement health benefits.

The liability for Federal employee and veterans’ benefits also includes a liability for actual and estimated future payments for workers’ compensation pursuant to FECA. FECA provides income and medical cost protection (1) to Federal employees who were injured on the job or who have sustained a work-related occupational disease and (2) to beneficiaries of employees whose death is attributable to job-related injury or occupational disease. The FECA program is administered by the DOL, which pays valid claims and subsequently bills the employing Federal agency. The
FECA liability consists of two components - the actual claims paid by DOL but not yet disbursed, and the estimated liability for future benefit payments as a result of past events, such as death, disability, and medical costs.

Note 14, Federal Employee and Veterans’ Benefits, provides additional information.

Revenue and Financing Sources

The Department receives the majority of funding needed to support its programs through Congressional appropriation and through reimbursement for the provision of goods or services to other Federal agencies. The United States Constitution prescribes that no money may be expended by a Federal Agency unless and until funds have been made available by Congressional appropriation. Appropriations are recognized as financing sources when related expenses are incurred or assets are purchased. Revenues from reimbursable agreements are recognized when the goods or services are provided by the Department. Other financing sources, such as donations and transfers of assets without reimbursements, are also recognized on the consolidated statement of changes in net position.

Appropriations. The Department receives annual, multi-year, and no-year appropriations that may be used within statutory limits. For example, funds for general operations are generally made available for one fiscal year, funds for long-term projects such as major construction will be available for the expected life of the project, and funds used to establish revolving fund operations are generally available indefinitely (i.e., no year funds). The Statement of Budgetary Resources presents information about the resources appropriated to the Department.

Exchange and Non-Exchange Revenue. HHS classifies revenues as either exchange revenue or non-exchange revenue. Exchange revenues are recognized when earned, i.e., when goods have been delivered or services have been rendered. These revenues reduce the cost of operations borne by the taxpayer.

Non-exchange revenues result from donations to the government and from the government’s sovereign right to demand payment, including taxes. Non-exchange revenues are recognized when a specifically identifiable, legally enforceable claim to resources arises, but only to the extent that collection is probable and the amount is reasonably estimable. Non-exchange revenues are not considered to reduce the cost of the Department’s operations and are reported in the Statement of Changes in Net Position.

For periods after December 31, 1993, employees and employers are each required to contribute

1.45 percent of employee wages, and self-employed persons are required to contribute 2.90 percent of net income, with no limitation, to the Hospital Insurance (HI) trust fund. The Social Security Act requires the transfer of these contributions from the General Fund of Treasury to the HI trust fund based on the amount of wages certified by the Social Security Administration (SSA) from SSA records of wages established and maintained by SSA in accordance with wage information reports. The SSA uses the wage totals reported annually by employers via the quarterly Internal Revenue Service Form 941 as the basis for conducting quarterly certification of regular wages.

With minor exceptions, all receipts of revenues by Federal agencies are processed through Treasury’s central accounting system. Regardless of whether they derive from exchange or non-exchange transactions, all receipts that are not earmarked by Congressional appropriation for immediate departmental use are deposited in the general or special funds of the Treasury. Amounts not retained for use by HHS are reported as transfers to other government agencies on the HHS Statement of Changes in Net Position.

Imputed Financing Sources. In certain instances, operating costs of HHS are paid out of funds appropriated to other Federal agencies. For example, by law, certain costs of retirement programs are paid by the Office of Personnel Management, and certain legal judgments against HHS are paid from the Judgment Fund maintained by Treasury. When costs that are identifiable to HHS and directly attributable to the Department’s operations are paid by other agencies, the Department recognizes these amounts as imputed costs of HHS, and at the same time, this amount is recognized as an imputed financing source on the Consolidated Statement of Changes in Net Position.

Other Financing Sources. Medicare’s HI program, or Medicare Part A, is financed through the HI trust fund, whose revenues come primarily from the Medicare portion of payroll and from self-employment taxes collected under the Federal Insurance Contribution Act (FICA) and under the Self-Employment Contribution Act (SECA). The Medicare payroll tax rate is 2.9 percent of annual wages. Contribution rates are discussed under Exchange and Non-Exchange Revenue.

Medicare’s Supplemental Medical Insurance (SMI) program, or Medicare Part B, is financed primarily by general fund appropriations (Payments to the Health Care Trust Funds) provided by Congress and by monthly premiums paid by beneficiaries. Premium payments from Medicare beneficiaries are matched approximately three to one by Congressional appropriations.

Aggregate non-exchange revenues consist primarily of FICA taxes of $157,702 million and $142,659 million, SECA taxes of $11,252 million and $10,789 million, and Trust Fund investment interest of $16,484 million and $16,574 million for FY 2005 and FY 2004, respectively.

Contingencies

A loss contingency is an existing condition, situation, or set of circumstances involving uncertainty as to possible loss to the Department. The uncertainty should ultimately be resolved when one or more future events occur or fail to occur. The likelihood that the future event or events will confirm the loss or the incurrence of a liability can range from probable to remote. Statement of Federal Financial Accounting Standards (SFFAS) No. 5, Accounting for Liabilities of the Federal Government, as amended by SFFAS No. 12, Recognition of Contingent Liabilities from Litigation, contains the criteria for recognition and disclosure of contingent liabilities. With the exception of pending, threatened, or potential litigation, a contingent liability is recognized when a past transaction or event has occurred, a future outflow or other sacrifice of resources is more likely than not to occur, and the related future outflow or sacrifice of resources is measurable. For pending, threatened, or potential litigation, a liability is recognized when a past transaction or event has occurred, a future outflow or other sacrifice of resources is likely to occur, and the related future outflow or sacrifice of resources is measurable.

Note 23, Contingencies, provides additional information.

Reclassifications

Certain reclassifications were made to the presentation of the September 30, 2004 financial statements and footnotes to improve their comparability with September 30, 2005 statements and footnotes, in compliance with the form and content prescribed by the OMB Circular No. A-136, the effect of which is immaterial. The Prior Period Adjustments reported in FY 2004 have been reported as Adjustment, Correction of Errors in the FY 2005 Statement of Changes in Net Position. In addition, the Status of Fund Balance section of the Note 3, Fund Balance with Treasury from the prior year was reclassified based on the revised format in the OMB Circular No. A-136.

Reconciliation of FACTS II to the Statement of Budgetary Resources

Management recognizes that the Federal Agencies’ Centralized Trial-balance System II (FACTS II) submission of budgetary data does not agree with HHS’ Statement of Budgetary Resources as presented in the audited financial statements. There are many known recurring differences that contribute to the differences that are properly reported on the SBR and are appropriately not included in the FACTS II submission. Some of these reconciling items include: accounts payable adjustments, estimated Grantee Expenditure Reports (SF 272s) not yet received for the fourth quarter, estimated grantee expenses incurred but not reported, and certain intra-departmental transactions, such as Intra-Departmental Delegations of Authority.

Intragovernmental Relationships and Transactions

In the course of its operations, HHS has relationships and financial transactions with numerous Federal agencies. The more prominent of these are the Social Security Administration (SSA) and the Department of the Treasury. The SSA determines eligibility for Medicare programs and also allocates a portion of Social Security benefit payments to the Medicare Part B Trust Fund for Social Security beneficiaries who elect to enroll in the Medicare Part B program. The Treasury receives the cumulative excess of Medicare receipts and other financing over outlays and issues interest-bearing securities in exchange for the use of those monies. At the government-wide level, the assets related to the trust funds on HHS’ financial statements and the corresponding liabilities on the Treasury’s financial statements would be eliminated.

Medicare Hospital Insurance (HI) Trust Fund

Medicare contractors are paid by Centers for Medicare & Medicaid Services to process Medicare claims for hospital inpatient services, hospice, and certain skilled nursing and home health services. Benefit payments made by the Medicare contractors for these services as well as any related administrative costs are charged to the HI trust fund. The CMS payments to managed care plans are also charged to this fund. The financial statements include HI trust fund activities administered by the Treasury. This trust fund has permanent indefinite budgetary authority.

Medicare Supplementary Medical Insurance (SMI) Trust Fund

Medicare contractors are paid by CMS to process Medicare claims for physicians, medical suppliers, hospital outpatient services and rehabilitation, end-stage renal disease treatment providers, rural health clinics, and certain skilled nursing and home health services. Benefit payments made by the Medicare contractors for these services, as well as administrative costs, are charged to the SMI trust fund. The CMS payments to managed care plans are also charged to this fund. The financial statements include SMI trust fund activities administered by Treasury. This trust fund has permanent indefinite budgetary authority.

Medicare Prescription Drug Discount Card and Transitional Assistance

The Medicare Prescription Drug Discount Card and Transitional Assistance Program was enacted into law in December 2003 with passage of the Medicare Modernization Act of 2003 (MMA). The Drug Discount Card program enables Medicare beneficiaries to obtain discounts of 10 to 25 percent on prescription drugs.

Medicare Integrity Program (MIP)

The Health Insurance Portability and Accountability Act (Public Law 104-191) established the MIP and codified the program integrity activities previously known as “payment safeguards.” This account is also referred to as the Health Care Fraud and Abuse Control (HCFAC) program or simply “Fraud and Abuse.” To safeguard the Medicare system, the CMS contracts with eligible entities to perform such activities as medical and utilization reviews, fraud reviews, cost report audits, and the education of providers and beneficiaries with respect to payment integrity and benefit quality assurance issues. The MIP is funded by the HI trust fund.

Medicaid

Medicaid, the health care program for low-income Americans, is administered by CMS in partnership with the states. Grant awards limit the funds that can be drawn by the states to cover current expenses. The grant awards, which are prepared at the beginning of each quarter and are amended as necessary, are an estimate of the CMS share of states’ Medicaid costs. At the end of each quarter, states report their expenses (net of recoveries) for the quarter, and subsequent grant awards are issued by CMS for the difference between approved expenses reported for the period and grant awards previously issued.

Note 2. Non-Entity Assets

Non-entity assets at September 30, 2005 and 2004 consisted of the following:

The $23 million non-entity asset Fund Balance with Treasury includes: $13 million of tax refunds collected by the Internal Revenue Service for past due child support payments that were transferred to HHS’ Administration for Children and Families for distribution to the states; $9 million in collections of royalties from licenses for which a portion is paid to inventors under the Federal Technology Transfer Act; and $1 million representing withholdings for state payroll deductions, collections of interest, and other miscellaneous receipts. The majority of the $14 million accounts receivable represents the interest accrued on overpayments as well as any cost settlements reported by the Medicare contractors.

The amount of unused funds that were transferred to Treasury due to cancelled appropriations or no longer available at the end of FY 2005 and FY 2004 were approximately $5.3 billion and $600 million, respectively.

Note 3. Fund Balance with Treasury

The Fund Balance with Treasury (FBWT) and the status of the fund balance at September 30, 2005 and 2004 are listed below by fund type.

Other Funds include balances in deposit, suspense, clearing, and related non-spending accounts.

The Unobligated Balance includes $2.1 billion, which is restricted for future use and is not apportioned for current use. These funds are: Contingency Fund for State Welfare Programs of the Administration for Children and Families; the Program Management Funds of the Centers for Medicare & Medicaid Services; the Federal Interest Subsidies for Medical Facilities, Medical Facilities Guarantee and Loan Fund of the Health Resources and Services Administration; and the Service and Supply Funds of the Program Support Center.

The Non-Budgetary FBWT negative balance is due primarily to CMS Medicare trust funds temporarily precluded from obligation.

Note 4. Cash and Other Monetary Assets

Cash and Other Monetary Assets consist primarily of the time account balances at the Medicare contractors’ commercial banks. CMS uses the “Checks Paid Letter-of-Credit” method for reimbursing Medicare contractors for the payment of covered Medicare services. Medicare contractors issue checks against Medicare Benefits Accounts maintained at commercial banks. To compensate the commercial banks for handling the Medicare Benefits Accounts, Medicare funds are deposited into non-interest bearing time accounts. The interest foregone by the CMS on these time accounts is used to reimburse the commercial banks for the service. The account balances as of September 30, 2005 and 2004 were $204 million and $460 million, respectively.

Note 5. Investments, Net

HHS’ investments at September 30, 2005 and 2004 are summarized below.

HHS invests entity trust fund balances in excess of current needs in U.S. Treasury securities. The majority of HHS investments in securities are redeemed at maturity and no provision is made for unrealized gains or losses. The Department of Treasury acts as the fiscal agent for the U.S. Government’s investments in securities. HHS securities purchased and redeemed include Marketable, Non-Marketable (Par Value), and Non-Marketable Market-based (MK) securities.

Par value securities purchased by the Centers for Medicare & Medicaid Services (CMS) are recorded at cost, interest is earned based on a statutory formula, and securities are redeemed at face value. CMS invests in U.S. Treasury Special Issue bonds (Par value securities) that are special public obligations for exclusive purchase by the Medicare trust funds. Section 1817 (for Hospital Insurance) and section 1841 (for Supplemental Medical Insurance) of the Social Security Act require that trust fund investments not necessary to meet current expenditures be invested in interest-bearing obligations of the United States or in obligations guaranteed as to both principal and interest by the United States. These investments are carried at face value as determined by Treasury. Interest income is compounded semiannually (June and December). The Medicare bonds paid from 3 ½ percent to 8 ? percent in FY 2005 and 3 ½ percent to 8 ¾ in FY 2004. The One Day Certificates are short-term and paid 4 ? percent in FY 2005 and 4 ½ percent in FY 2004.

Health Resources and Services Administration (HRSA) invests in One Day Certificates, Market Based Notes and Market Based Bills. MK securities purchased by HRSA mirror marketable securities terms that are not traded on any securities exchange, and include Non-Marketable, MK, and One Day Certificates. MKs are purchased by HRSA’s Vaccine Injury Compensation Program (VICP) trust fund. Discounts and premiums are recorded and amortized on a straight-line basis. Currently, securities held by the VICP will mature in fiscal years 2005 through 2009. The Market Based Notes paid from 1.625 percent to 6.25 percent in FY 2005 and FY 2004. One Day Certificates paid from 1.71 percent to 3.17 percent in FY 2005 and from .91 percent to 1.77 percent in FY 2004.

Marketable securities purchased by the National Institutes of Health gift funds are recorded at cost based on market terms.

Note 6. Accounts Receivable, Net

HHS’ accounts receivable as of September 30, 2005 and 2004 are summarized below.

Note 6. Accounts Receivable, Net (continued)