oversight

Financial Reporting: DOD's Fiscal Year 1996 Financial Statements Inventory Reporting Does Not Meet Standards

Published by the Government Accountability Office on 1997-12-24.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                 United States General Accounting Office

GAO              Report to the Under Secretary of
                 Defense (Comptroller)



December 1997
                 FINANCIAL
                 REPORTING
                 DOD’s Fiscal Year 1996
                 Financial Statements
                 Inventory Reporting
                 Does Not Meet
                 Standards




GAO/AIMD-98-16
                   United States
GAO                General Accounting Office
                   Washington, D.C. 20548

                   Accounting and Information
                   Management Division

                   B-278326

                   December 24, 1997

                   The Honorable William J. Lynn
                   Under Secretary of Defense (Comptroller)
                   Department of Defense

                   Dear Mr. Lynn:

                   Statement of Federal Financial Accounting Standards (SFFAS) No. 3,
                   Accounting for Inventory and Related Property, specifies different
                   categories of tangible property for financial reporting and disclosure. Two
                   of the asset categories applicable to the Department of Defense (DOD)
                   under the standard are “inventory” and “operating materials and supplies.”
                   The standard, which has been in effect since fiscal year 1994, defines
                   “inventory” as tangible personal property held for sale and “operating
                   materials and supplies” as tangible personal property to be consumed in
                   normal operations. In general, DOD’s working capital funds typically sell
                   items to other service activities, such as maintenance and tactical units,
                   and, therefore, would be most likely to report inventory. DOD’s general
                   funds activities usually hold items for their own use and would most likely
                   report operating materials and supplies.

                   Our objectives were to review the DOD’s fiscal year 1996 financial
                   statements to determine if its approach to reporting inventory and
                   operating materials and supplies meets SFFAS No. 3 requirements—for
                   individual military service financial statements as well as those at the
                   consolidated DOD-wide level. This letter presents information on how the
                   accounting standards are to be applied to improve the reporting of
                   inventory and operating materials and supplies in DOD’s financial
                   statements.


                   DOD did not fully comply with SFFAS No. 3 in fiscal year 1996. Its
Results in Brief   consolidated and component financial statements misclassified operating
                   materials and supplies and some equipment as inventory and did not
                   include all operating materials and supplies. For fiscal year 1996, the
                   Army, Navy, and Air Force general fund financial statements collectively
                   reported $115.6 billion of inventory. The Army and Air Force did not
                   report any amounts for operating materials and supplies and the Navy
                   reported only $27,000. One reason for these errors is that DOD’s Guidance
                   on Form and Content of Financial Statements for Fiscal Year 1996




                   Page 1                          GAO/AIMD-98-16 DOD’s FY 1996 Inventory Reporting
B-278326




Financial Activity and its accounting policy1 misinterpreted and were not
consistent with the accounting standard. As a result, DOD’s fiscal year 1996
financial statements overstated inventory, understated operating materials
and supplies, and overstated expenses.

About $113.7 billion out of the $115.6 billion reported as inventory by the
general funds consisted of munitions and equipment that do not meet the
SFFAS No. 3 definition of inventory and should have been classified as
operating materials and supplies or plant, property, and equipment. At the
same time, other items warehoused by service activities, such as repair
parts and consumables, that met the SFFAS No. 3 definition of operating
materials and supplies were not reported at all. We, the DOD Inspector
General (IG), and the military service auditors have reported2 that the
military services have warehoused billions of dollars of items at bases and
on ships that meet the SFFAS No. 3 definition of operating materials and
supplies. However, these items were not considered as capitalized assets
as required but were instead expensed on the financial statements when
purchased.

The $113.7 billion of misclassified assets represents 9 percent of total
assets reported and therefore was material to DOD’s fiscal year 1996
financial statements. Continued material misclassifications and
underreporting will negatively affect the reliability and usefulness of the
military services’ and DOD’s financial statements and also the auditors’
opinions on those statements. DOD’s guidance and accounting policies
must comply with accounting standards so that inventory and operating
materials and supplies are properly classified and reported in its future
financial statements.




1
  DOD Financial Management Regulation, DOD 7000.14-R, Volume 4, “Accounting Policies and
Procedures,” January 1995.
2
 Navy Financial Management: Improved Management of Operating Materials and Supplies Could Yield
Significant Savings (GAO/AIMD-96-94, August 16, 1996); CFO Act Financial Audits: Increased Attention
Must Be Given to Preparing Navy’s Financial Reports (GAO/AIMD-96-7, March 27, 1996); Financial
Management: Immediate Actions Needed to Improve Army Financial Operations and Controls
(GAO/AFMD-92-82, August 7, 1992); Internal Controls and Compliance With Laws and Regulations for
the DOD Consolidated Financial Statements for FY 1996 (DOD IG Report No. 97-182, June 30, 1997);
Army’s Principal Financial Statements for Fiscal Year 1996 and 1995 Report on Internal Controls and
Compliance With Laws and Regulations (AAA Report No. AA 97-145, 30 June 1997); Opinion on Fiscal
Year 1996 Air Force Consolidated Financial Statements (AFAA Report No. 96053001, 1 March 1997);
Department of the Navy Fiscal Year 1996 Annual Financial Report: Report on Internal Controls and
Compliance With Laws and Regulations (NAS Report No. 029-97, 15 April 1997).



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                        B-278326




                        Our objectives were to determine whether DOD, in its fiscal year 1996
Objectives, Scope,      financial statements, (1) properly classified inventory and related property
and Methodology         according to SFFAS No. 3 requirements, (2) reported fully its operating
                        materials and supplies, and (3) had appropriate reporting guidance and
                        accounting policy to ensure proper reporting and classification of
                        inventory and related property.

                        To determine whether DOD properly classified inventory and related
                        property and reported fully its operating materials and supplies, we
                        reviewed SFFAS No. 3 and then compared its requirements with DOD’s fiscal
                        year 1996 consolidated financial statements and the individual Army, Air
                        Force, and Navy fiscal year 1996 financial statements. Further, we
                        reviewed the DOD IG and military service auditors’ reports on these
                        financial statements.

                        To determine whether DOD’s guidance and accounting policy were
                        appropriate, we compared its Guidance on Form and Content of Financial
                        Statements for FY 1996 Financial Activity and Financial Management
                        Regulation, Volumes 4 and 11B, with SFFAS No. 3 requirements. In addition,
                        we reviewed Federal Accounting Standards Advisory Board (FASAB)
                        deliberations and decisions.

                        We performed our review from June 1997 through October 1997 in
                        accordance with generally accepted government auditing standards. We
                        requested written comments on a draft of this report from the Department
                        of Defense. On December 9, 1997, the Principal Deputy Under Secretary of
                        Defense (Comptroller) provided us with comments, which are discussed
                        in the “Agency Comments and Our Evaluation” section and are reprinted
                        in appendix I.


                        SFFAS No. 3 defines inventory as tangible personal property that is (1) held
Assets Misclassified    for sale, (2) in the process of production for sale, or (3) to be used in the
as Inventory Held for   production of goods for sale or in the provision of services for a fee.
Sale                    However, in the $115.6 billion reported in their fiscal year 1996 general
                        fund financial statements as inventory, the Army, Navy, and Air Force
                        erroneously included $113.7 billion of munitions, spare parts, and
                        equipment (such as tank and howitzer subassemblies) that were held for
                        the services’ own use and were not for sale to others. These items should
                        have been classified as operating materials and supplies or property, plant,
                        and equipment. Army and Air Force auditors cited these misclassifications
                        of assets in their fiscal year 1996 financial statement audit reports.



                        Page 3                          GAO/AIMD-98-16 DOD’s FY 1996 Inventory Reporting
                                       B-278326




                                       According to the DOD IG, almost $74 billion of the misclassifications were
                                       war reserves, which include ammunition, missiles, and munitions related
                                       items. Only the Army’s Conventional Ammunition Working Capital Fund,
                                       which held $1.9 billion of ammunition for sale, was appropriately
                                       classified as inventory.

                                       The following table, which is based on the component financial statements
                                       and DOD IG and service auditor information, shows the misclassified
                                       inventory by type and service.

Table 1: DOD Misclassified Inventory
Reported in Fiscal Year 1996           Dollars in billions
                                       Asset type                       Army                 Navy           Air Force                 Total
                                       Equipment &                       $12.8               $18.7               $19.1               $50.6
                                       other items
                                       Munitions                         $22.9               $22.8               $17.4               $63.1
                                       Total reported                    $35.8               $41.4               $36.5              $113.7
                                       Note: Although the Navy’s financial statement reported $22.8 billion of ammunition, the Naval
                                       Audit Service reported that the Navy improperly included at least $11.6 billion of ammunition due
                                       to a computer software problem. In addition, the Air Force Audit Agency reported that the Air
                                       Force had overstated the reported $17.4 billion of munitions by $853 million. Totals are not
                                       precise due to rounding.



                                       For fiscal year 1996, the Army, Navy, and Air Force were following DOD
                                       guidance when they reported munitions and equipment as inventory.
                                       However, DOD’s fiscal year 1996 form and content guidance, which is
                                       intended to supplement the Office of Management and Budget (OMB) form
                                       and content guidance,3 is not consistent with SFFAS No. 3 or OMB guidance.
                                       DOD’s guidance states that the inventory line item should include
                                       equipment purchased with procurement funds and war reserve items that
                                       are held in wholesale or retail supply inventories. However, these items
                                       include equipment and ammunition that are not held for sale to others. For
                                       example, according to Army auditors, the Army’s fiscal year 1996 financial
                                       statements inventory line erroneously included tanks and howitzers that
                                       are stored at depots and issued to Army units without reimbursement.

                                       In addition, both SFFAS No. 3 and OMB requirements for preparing financial
                                       statements provide an operating materials and supplies subcategory for
                                       items that are held in reserve for future use. This subcategory would be
                                       the proper place to report munitions owned by the services and held in
                                       storage by DOD.

                                       3
                                        OMB Bulletin No. 94-01, “Form and Content of Agency Financial Statements,” issued November 16,
                                       1993, effective for the fiscal year ending September 30, 1994.



                                       Page 4                                    GAO/AIMD-98-16 DOD’s FY 1996 Inventory Reporting
                      B-278326




                      According to SFFAS No. 3, operating materials and supplies consist of
Operating Materials   tangible personal property to be consumed in normal operations. The
and Supplies Were     standard requires that expenses for operating materials and supplies be
Not Reported          recognized when items are issued to the end user (the consumption
                      method of accounting) unless (1) operating materials and supplies are not
                      significant amounts, (2) they are in the hands of the end user for use in
                      normal operations, or (3) it is not cost-beneficial to apply the consumption
                      method of accounting. To clarify the term “end user,” SFFAS No. 3
                      specifically states that “any component of a reporting entity, including
                      contractors, that maintains or stocks operating materials and supplies for
                      future issuance shall not be considered an end user.”

                      For the most part, DOD accounting policy is consistent with SFFAS No. 3
                      regarding the definition of operating materials and supplies, and it
                      specifies that the consumption method should ordinarily be used to
                      recognize expenses for operating materials and supplies. Further, the DOD
                      Materiel Management Regulation, DOD 4140.1-R, defines end user as “that
                      individual or organizational element authorized to use supply items. This is
                      normally the terminal point in the logistics system at which action is
                      initiated to obtain materiel required for the accomplishment of an assigned
                      mission or task.” However, the accounting policy has not been properly
                      implemented at the military service level. In practice, DOD components
                      have improperly expensed significant amounts of operating materials and
                      supplies before distributing them to the end users. As a result, DOD is not
                      fully recognizing and reporting all operating materials and supplies
                      according to the accounting standard and its own regulation and is
                      overstating its expenses or net position. This practice can also contribute
                      to DOD managers not having complete information on assets for budgeting
                      and purchasing decisions.

                      As shown in the following table, which is based on information reported
                      for fiscal year 1996, operating materials and supplies were underreported
                      by about $79 billion.




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                                       B-278326




Table 2: Fiscal Year 1996 Unreported
Operating Materials and Supplies       Dollars in billions
                                                                  Misclassified           Account        Account
                                       Component                     munitions      overstatement understatement                  Total
                                       Army                                $22.9                   −                  −           $22.9
                                       Navy                                $22.8              $11.6               $20.5           $31.7
                                                                               −                   −               $7.8            $ 7.8
                                       Air Force                           $17.4               $ 0.9                  −           $16.5
                                       Total                               $63.1              $12.5               $28.3           $78.9

                                       As shown in table 2, munitions totaling $50.6 billion ($63.1 billion adjusted
                                       for the $12.5 billion of munitions overstatements reported by the military
                                       service auditors) should have been classified as operating materials and
                                       supplies. Further, the Naval Audit Service reported that the Navy did not
                                       report an additional $20.5 billion of ammunition.4 According to the
                                       auditors, the Navy also had an estimated $7.8 billion of unreported
                                       operating materials and supplies in storage on board ships and at Marine
                                       Corps activities. For example, combat ships, such as frigates and cruisers,
                                       hold material in storerooms until the work centers requisition items for
                                       repair work or other uses. Navy supply officers store operating materials
                                       and supplies at shore locations for subsequent issuance to aircraft carriers
                                       and submarines.

                                       Similarly, according to Army auditors, Army divisions could have
                                       unreported operating materials and supplies. Army divisions are
                                       authorized to store about $800 million of equipment components and
                                       repair parts for aircraft, missiles, and common equipment (e.g., trucks,
                                       tanks, and generators) in storage for future issuance to combat units.
                                       Because Army auditors did not determine how much was on hand, DOD
                                       does not know whether the Army divisions were holding their authorized
                                       levels, or more or less than their authorized levels at year-end. As a result,
                                       we could not estimate Army’s understatement of operating materials and
                                       supplies.

                                       Confusion regarding categorization of operating materials and supplies
                                       may result from a DOD time limitation on holding operating materials and
                                       supplies. SFFAS No. 3 does not directly address time limitations for holding
                                       operating materials and supplies. However, the description of the required
                                       disclosure subcategories—(1) held for use, (2) held in reserve for future
                                       use, and (3) excess, obsolete, and unserviceable—indicates that operating

                                       4
                                        Department of the Navy Fiscal Year 1996 Annual Financial Report: Ammunition and Ashore Inventory
                                       (NAS Report No. 048-97, 25 September 1997).



                                       Page 6                                   GAO/AIMD-98-16 DOD’s FY 1996 Inventory Reporting
                         B-278326




                         materials and supplies could be held for several months or even several
                         years. DOD Financial Management Regulation, DOD 7000.14-R, Volume 4,
                         “Accounting Policies and Procedures,” states that items classified as
                         operating materials and supplies held for current and future use “shall not
                         exceed the amount expected to be used within 30 days unless justifying
                         documentation supporting a supply in excess of 30 days is developed and
                         maintained for review.”

                         DOD’s policy restriction could mean an additional, unnecessary
                         documentation burden for service activities to justify keeping munitions,
                         which are included in war reserves, and other items in storage for more
                         than 30 days. The conflict between war reserves and the 30-day restriction
                         for operating materials and supplies may discourage the services from
                         complying with the accounting policy and may contribute to their not
                         recognizing billions of dollars of operating materials and supplies.


                         DOD’s financial reporting would be improved if its guidance and policies
Conclusion               were made consistent with accounting standards and modified so that they
                         do not unduly restrict reporting requirements. By making some policy
                         changes, DOD could clarify its asset reporting categories and thereby
                         minimize inconsistencies and underreporting in component and
                         consolidated financial statements.


                         We recommend that you
Recommendations
                     •   revise DOD’s Guidance on Form and Content of Financial Statements to
                         include as inventory only those items that are held for sale, consistent with
                         SFFAS No. 3;
                     •   clarify DOD’s Financial Management Regulation on the documentation and
                         reporting requirements for operating materials and supplies; and
                     •   monitor the services’ and the Defense Finance and Accounting Service’s
                         implementation of the guidance and policy to ensure that (1) amounts are
                         properly classified between SFFAS No. 3 reporting categories and
                         (2) operating materials and supplies, which includes munitions and other
                         material held in storage at all organization levels, are recognized and
                         reported as assets in DOD’s financial statements.


                         The Principal Deputy Under Secretary of Defense (Comptroller)
Agency Comments          concurred with our finding that DOD’s form and content guidance
and Our Evaluation

                         Page 7                          GAO/AIMD-98-16 DOD’s FY 1996 Inventory Reporting
B-278326




concerning inventory reporting for fiscal year 1996 was incorrect and, as a
result, that items not held for sale were misclassified as inventory. The
Deputy Comptroller stated that DOD’s final guidance for the fiscal year 1997
financial statements has been corrected and it now requires that inventory
consist only of items that are held for sale.

The Deputy Comptroller also stated that DOD partially concurred with our
two other findings. However, we do not find the Deputy Comptroller’s
comments responsive to our recommendations regarding the need for
clarifying and enforcing DOD guidance for reporting operating materials
and supplies. While the Deputy Comptroller’s response points to a lack of
specific FASAB guidance for reporting “war reserves” (consisting mainly of
munitions and equipment), it does not address unreported operating
materials and supplies warehoused on ships, at shore locations, or at other
storage facilities awaiting issuance to end users. As stated earlier in this
report, nearly $8 billion of Navy’s operating materials and supplies were
not reported in fiscal year 1996. Unless DOD clarifies and enforces guidance
requiring capitalization of warehoused operating materials and supplies,
we expect such underreporting of assets to continue.

In regard to the Deputy Comptroller’s assertion that FASAB has not issued
authoritative guidance specifically addressing munitions, we note that the
standards are intended to describe the general characteristics of various
asset types that need to be applied across a variety of government
operations. They are not intended, nor is it practical, to list every item and
how it should be reported. SFFAS No. 3 provides broad criteria for the
reporting of operating materials and supplies that clearly apply to
munitions. In our report on the liability associated with the disposal of
conventional ammunition,5 we noted that FASAB had recently reviewed the
asset category for ammunition and reiterated its position that ammunition
should be classified as operating materials and supplies. FASAB announced
this decision in its September 1997 newsletter. In addition, the Deputy
Comptroller stated that we inappropriately cited FASAB deliberations as
authoritative guidance. We have clarified the report to indicate that we
reviewed FASAB deliberations and decisions. We did not find any
justification for DOD’s position that the reporting requirements for
munitions were not clear.

The Deputy Comptroller’s response did not specify how DOD’s war reserve
items, which the DOD IG reported had been misclassified, will be reported

5
Financial Management: DOD’s Liability for the Disposal of Conventional Ammunition Can Be
Estimated (GAO/AIMD-98-32, December 19, 1997).



Page 8                                   GAO/AIMD-98-16 DOD’s FY 1996 Inventory Reporting
B-278326




in fiscal year 1997. The FASAB standards and OMB form and content
guidance call for munitions to be classified as operating materials and
supplies and war reserve equipment to be classified as property, plant, and
equipment.


We are sending copies of this letter to the Chairmen and Ranking Minority
Members of the Senate Committees on Governmental Affairs and Armed
Services, the House Committees on Government Reform and Oversight
and National Security, and the Director of the Office of Management and
Budget. Copies will be made available to others upon request.

Major contributors to this report are Molly Boyle and Alan Steiner. Please
contact me at (202) 512-9095 if you have any questions on this report.

Sincerely yours,




Lisa G. Jacobson
Director
Defense Financial Audits




Page 9                          GAO/AIMD-98-16 DOD’s FY 1996 Inventory Reporting
Appendix I

Comments From the Department of Defense




             Page 10     GAO/AIMD-98-16 DOD’s FY 1996 Inventory Reporting
Appendix I
Comments From the Department of Defense




Page 11                           GAO/AIMD-98-16 DOD’s FY 1996 Inventory Reporting
           Appendix I
           Comments From the Department of Defense




(919157)   Page 12                           GAO/AIMD-98-16 DOD’s FY 1996 Inventory Reporting
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