Military Aircraft: Considerations in Reviewing the Air Force Proposal to Lease Aerial Refueling Aircraft

Published by the Government Accountability Office on 2003-07-23.

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

                              United States General Accounting Office

GAO                           Testimony
                              Before the Committee on Armed Services,
                              House of Representatives

For Release on Delivery
Expected at 10:00 a.m., EDT
Wednesday, July 23, 2003      MILITARY AIRCRAFT
                              Considerations in
                              Reviewing the Air Force
                              Proposal to Lease Aerial
                              Refueling Aircraft
                              Statement of Neal P. Curtin, Director
                              Defense Capabilities and Management

             Mr. Chairman and Members of the Committee:

             I appreciate the opportunity to appear before you today to discuss the Air
             Force’s report on the planned lease of 100 Boeing 767 aircraft modified for
             aerial refueling. These aircraft would be known by a new designation,
             KC-767A. Section 8159 of the Department of Defense Appropriations Act
             for fiscal year 2002 authorizes the Air Force to lease up to 100 KC- 767A
             aircraft. We received the report required by section 8159 when it was sent
             to the Congress on July 10. We subsequently received a briefing from the
             Air Force and some of the data needed to review the draft lease and lease
             versus purchase analysis. However, we were permitted to read the lease
             for the first time on July 18 but were not allowed to make a copy and so
             have not had time to fully review and analyze the terms of the draft lease.
             As a result, my testimony today will be based on very preliminary work. I
             will (1) describe the condition of the current aerial refueling fleet,
             (2) summarize the proposed lease as presented in the Air Force’s recent
             report, (3) present our preliminary observations on the Air Force lease
             report, and (4) identify related issues that we believe deserve further

             To determine the condition of the current fleet, we used data from an
             ongoing study of tanker requirements being done for this committee’s
             Subcommittee on Readiness. Specifically, we obtained and analyzed
             KC-135 and KC-10 mission capable rates, fleet inventory records,
             utilization records, maintenance records, and other documents; and we
             met with knowledgeable officials at the Air Force’s KC-135 Systems
             Program Directorate at Tinker Air Force Base in Oklahoma and the Air
             Mobility Command at Scott Air Force Base in Illinois, among other
             officials. To summarize and analyze the report of the proposed lease, we
             reviewed the report, initiated our analysis of the draft lease, and received a
             briefing from the Office of the Assistant Secretary of the Air Force
             (Acquisitions), Air Mobility Programs. To identify key issues for further
             scrutiny, we identified issues raised by the Air Force in the report of the
             proposed lease, but we believe the Air Force did not explain fully. We also
             identified additional costs the Air Force expects to incur to field the new

             While numerous military aircraft provide refueling services, the bulk of
Background   U.S. refueling capability lies in the Air Force fleet of 59 KC-10 and 543
             KC-135 aircraft. These are large, long-range aircraft that have counterparts
             in the commercial airlines, but which have been modified to turn them into
             tankers. The KC-10 is based on the DC-10 aircraft, and the KC-135 is

             Page 1                                                          GAO-03-1048T
                      similar to the Boeing-707 airliner. Because of their large numbers, the
                      KC-135s are the mainstay of the refueling fleet, and successfully carrying
                      out the refueling mission depends on the continued performance of the
                      KC-135s. Thus, recapitalizing this fleet of KC-135s will be crucial to
                      maintaining aerial refueling capability, and it will be a very expensive

                      There are two basic versions of the KC-135 aircraft, designated the
                      KC-135E and KC-135R. The R model aircraft have been re-fitted with
                      modern engines and other upgrades that give them an advantage over the
                      E models. The E-model aircraft on average are about 2 years older than
                      the R models, and the R models provide more than 20 percent greater
                      refueling capacity per aircraft. The E models are located in the Air
                      National Guard and Air Force Reserve. Active forces have only R models.
                      Over half the KC-135 fleet is located in the reserve components.

                      The rest of the DOD refueling fleet consists of Air Force HC- and MC-130
                      aircraft used by special operations forces, Marine Corps KC-130 aircraft,
                      and Navy F-18 and S-3 aircraft. However, the bulk of refueling for Marine
                      and Navy aircraft comes from the Air Force KC-10s and KC-135s. These
                      aircraft are capable of refueling Air Force and Navy/Marine aircraft, as
                      well as some allied aircraft, although there are differences in the way the
                      KC-10s and KC-135s are equipped to do this.

                      The KC-10 aircraft are relatively young, averaging about 20 years in age.
Condition of Aerial   Consequently, much of the focus on modernization of the tanker fleet is
Refueling Fleet       centered on the KC-135s, which were built in the 1950s and 1960s, and now
                      average about 43 years in age.

                      While the KC-135 fleet averages more than 40 years in age, the aircraft
                      have relatively low levels of flying hours. The Air Force projects that E and
                      R models have lifetime flying hours limits of 36,000 and 39,000 hours,
                      respectively. According to the Air Force, only a few KC-135s would reach
                      these limits before 2040, but at that time some of the aircraft would be
                      about 80 years old. Flying hours for the KC-135s averaged about 300 hours
                      per year between 1995 and September 2001. Since then, utilization is
                      averaging about 435 hours per year.

                      According to Air Force data, the KC-135 fleet had a total operation and
                      support cost in fiscal year 2001 of about $2.2 billion. The older E model
                      aircraft averaged total costs of about $4.6 million per aircraft, while the

                      Page 2                                                           GAO-03-1048T
R models averaged about $3.7 million per aircraft. Those costs include
personnel, fuel, maintenance, modifications, and spare parts.

The Air Force has a goal of an 85 percent mission capable rate. Mission
capable rates measure the percent of time on average that an aircraft is
available to perform its assigned mission. KC-135s in the active duty forces
are generally meeting the 85 percent goal for mission capable rates. Data
on the mission capable rates for the KC-135 fleet are shown in
table 1.

Table 1. Mission Capable Rates for KC-135 Aircraft in May 2003

                                                             Mission capable rate
 Component                          Number of aircraft                  (percent)
 Active                                            245                        85
 Reserve R models                                   52                        82
 National Guard R models                           115                        75
 Reserve E models                                   16                        75
 National Guard E models                           115                        79
Source: Air Force data.

For comparison purposes, the KC-10 fleet is entirely in the active
component, and the 59 KC-10s had an average mission capable rate during
the same period of 81.2 percent.

By most indications, the fleet has performed very well during the past few
years of high operational tempo. Operations in Kosovo, Afghanistan, Iraq,
and here in the United States in support of Operation Noble Eagle were
demanding, but the current fleet was able to meet the mission
requirements. Approximately 150 KC-135s were deployed to the combat
theater for Operation Allied Force in Kosovo, about 60 for Operation
Enduring Freedom in Afghanistan, and about 150 for Operation Iraqi
Freedom. Additional aircraft provided “air bridge” support for movement
of fighter and transport aircraft to the combat theater, for some long-range
bomber operations from the United States, and, at the same time, to help
maintain combat air patrols over major U.S. cities since September 11,

Page 3                                                             GAO-03-1048T
                           Section 8159 of the Department of Defense Appropriations Act for fiscal
The Air Force Report       year 2002,1 which authorized the Air Force to lease the KC-767A aircraft,
on The KC-767A             also specified that the Air Force could not commence lease arrangements
                           until 30 calendar days after submitting a report to the House and Senate
Aircraft Lease             Armed Services and Appropriations Committees (1) outlining
                           implementation plans and (2) describing the terms and conditions of the
                           lease and any expected savings. The Air Force has stated that it will not
                           proceed with the lease until it receives approval from all of the committees
                           of the New Start Notification.2 The Air Force also submitted the report of
                           the proposed lease to the committees as required by section 8159. I will
                           now summarize the key points that the Air Force made in this report to the

                       •   The Air Force pointed out that aerial refueling helps to support our
                           nation’s ability to respond quickly to operational demands anywhere
                           around the world. This is possible because aerial refueling permits other
                           aircraft to fly farther, stay aloft longer, and carry more weapons,
                           equipment, or supplies.

                       •   The Air Force indicated that KC-135 aircraft are aging and becoming
                           increasingly costly to operate due to corrosion, the need for major
                           structural repair, and increasing rates of inspection to ensure air safety.
                           Moreover, the report indicates that the Air Force believes it is incurring a
                           significant risk by having 90 percent of its aerial refueling capability in a
                           single, aging airframe.

                       •   The Air Force considered maintaining the current fleet until about 2040
                           but concluded that the risk of a “fleet-grounding” event made continued
                           operation of the fleet unacceptable, unless it began its re-capitalization
                           immediately. The Air Force considered replacing the KC-135 (E model)
                           engines with new engines but rejected this changeover since it would not
                           address the key concern of aircraft corrosion and other age-related

                            Department of Defense and Emergency Supplemental Appropriations for Recovery from
                           and Response to Terrorist Attacks on the United States Act, 2002, Pub. L. No. 107-117,
                           § 8159, 115 Stat. 2230, 2284-85 (2002).
                             The New Start Notification, submitted to the Armed Services and Appropriations
                           Committees on July 11, 2003, was required by section 133 of the Bob Stump National
                           Defense Authorization Act for Fiscal Year 2003, and is being used by the Air Force as the
                           trigger for executing the lease. Pub. L. No. 107-314, § 133, 116 Stat. 2458, 2477 (2002).

                           Page 4                                                                      GAO-03-1048T
•   The Air Force eventually plans to replace all 543 KC-135 aircraft over the
    next 30 years and considered lease and purchase alternatives to acquire
    the first 100 aircraft. The Air Force added traditional procurement funding
    to the fiscal year 2004-2009 Future Years Defense Program in order that
    100 tankers would be delivered between fiscal years 2009 and 2016.
    Conversely, the report states that under the lease option, all 100 aircraft
    could be delivered from fiscal years 2006 to 2011. To match that delivery
    schedule under a purchase option, the Air Force stated that it would have
    to reprogram billions of dollars already committed to other uses.

•   Office of Management and Budget Circular A-94 directs a comparison of
    the present value of lease versus purchase before executing a lease. In its
    report, the Air Force estimated that purchasing would be about
    $150 million less than leasing on a net present value basis.

•   The Air Force plans to award a contract to a special purpose entity created
    to issue bonds needed to raise sufficient capital to purchase the new
    aircraft from Boeing and to lease them to the Air Force.3 The lease will be
    a three-party contract between the government, Boeing, and the special
    purpose entity. The entity is to issue bonds on the commercial market
    based on the strength of the lease and not the creditworthiness of Boeing.

•   Office of Management and Budget Circular A-11 requires that an
    operating lease meet certain terms and conditions including a prohibition
    on paying for more than 90 percent of the fair market value of the asset
    over the life of the lease at the time that the lease is initiated. The report to
    Congress states that the Defense Department believes the proposed lease
    meets those criteria.

•   If Boeing sells comparable aircraft during the term of the contract to
    another customer for a lower price than that agreed to by the Air Force,
    the government would receive an “equitable adjustment.” The report also
    states that Boeing has agreed to a return-on-sales cap of 15 percent and
    that an audit of its internal cost structure will be conducted in 2011, with
    any return on sales exceeding 15 percent reimbursed to the government.

•   According to the report, if the government were to terminate the lease, it
    must do so for all of the delivered aircraft and may terminate any planned
    aircraft for which construction has not begun, must give 12-months
    advance notification prior to termination, return the aircraft, and pay an

        The Air Force would pay the interest on the bonds through its lease payments.

    Page 5                                                                       GAO-03-1048T
                        amount equal to 1 year’s lease payment for each aircraft terminated. If
                        termination occurs before all aircraft have been delivered, the price for the
                        remaining aircraft would be increased to include unamortized costs
                        incurred by the contractor that would have been amortized over the
                        terminated aircraft and a reasonable profit on those costs.

                    •   The government will pay for and the contractor will obtain commercial
                        insurance to cover aircraft loss and third party liability, as part of the lease
                        agreement. Aircraft loss insurance is to be in the amount of $138.4 million
                        per aircraft in calendar year 2002 dollars. Liability insurance will be in the
                        amount of $1 billion per occurrence per aircraft. If any claim is not
                        covered by insurance, the Air Force will indemnify the special purpose
                        entity for any claims from third parties arising out of the use, operation, or
                        maintenance of the aircraft under the contract.

                    •   At the expiration of the lease, the Air Force will return the aircraft to the
                        special purpose entity after removing, at government expense, any Air
                        Force unique configurations.

                    •   The contractor will warrant that each aircraft will be free from defects in
                        materials and workmanship, and the warranty will be of 36 months
                        duration and will commence after construction of the commercial Boeing
                        767 aircraft, but before they have been converted into aerial refueling
                        aircraft. Upon delivery to the Air Force, each KC-767A aircraft will carry a
                        6-month design warranty, 12-month material and workmanship warranty
                        on the tanker modification, and the remainder of the original warranty on
                        the commercial components of the aircraft, estimated to be about 2 years.

                        Because we have only had the Air Force report for a few days, we do not
Considerations in       have any definitive analytical results. However, we do have a number of
Reviewing the           questions and observations about the report that we believe are important
                        for the Congress to explore in reaching a decision on the Air Force
Proposed Lease          proposal.

                        1. What is the full cost to acquire and field the KC767A aircraft
                           under the proposed lease (and assuming the exercising of an
                           option to purchase at the conclusion of the lease)?

                            While the report includes the cost of leasing, the report does not
                            include the costs of buying the tankers at the end of the lease. The
                            report shows a present value of the lease payments of $11.4 billion and
                            a present value of other costs, such as military construction and
                            operation and support costs of $5.8 billion. This totals to $17.2 billion.

                        Page 6                                                            GAO-03-1048T
    If the option to purchase were exercised, the present value of those
    payments would be $2.7 billion. Adding these costs to the present
    value of the lease payments and other costs, this would total $19.9
    billion in present value terms.

    The costs of the leasing plan have also been presented as $131 million
    per plane for the purchase price, with $7.4 million in financing costs
    per plane, both amounts in calendar year 2002 dollars. If the option to
    purchase were exercised, the price paid would be $35.1 million per
    plane in calendar year 2002 dollars. Adding all of these costs together,
    the cost of leasing plus buying the planes at the end of the lease would
    total $173.5 million per plane in calendar 2002 dollars or $17.4 billion
    for the 100 aircraft.

2. How strong is the Air Force’s case for the urgency of this

    As far back as our 1996 report, we said that the Air Force needed to
    start planning to replace the KC-135 fleet, but until the past year and a
    half, the Air Force had not placed high priority on replacement in its
    procurement budget. While the KC-135 fleet is old and is increasingly
    costly to maintain due mainly to age-related corrosion, there has been
    no indication that mission capable rates are falling or that the aircraft
    cannot be operated safely. By having 90 percent of its refueling fleet in
    one aircraft type, the Air Force for some years now has been accepting
    the risk of fleet wide problems that could ground the entire fleet; it is
    really a question of how much risk and how long the Air Force and the
    Congress are willing to accept that risk.

3. How will the special purpose entity work?

    Under the Air Force proposal, the 767 aircraft would be owned by a
    special purpose entity and leased to the Air Force. This is a new
    concept for the Air Force, and the details of the workings of this entity
    have not been presented in detail. It is important for the Congress to
    understand how this concept will work and how the government’s
    interests are protected under such an arrangement. For example, what
    audit rights does the government have? Will financial records be
    available for public scrutiny?

Page 7                                                          GAO-03-1048T
4. What process did the AF follow to assure itself that it obtained
   a reasonable price?

    Because this aircraft is being acquired under the Federal Acquisition
    Regulations, the Air Force is required to assure itself through market
    analysis and other means that the price it is paying is reasonable and
    fair. To assess this issue, we would need to know how much of the
    $131 million purchase price is comprised of the basic 767 commercial
    aircraft and how much represents the cost of modifications to convert
    it to a tanker. There is an ample market for commercial 767s, and the
    Air Force should have some basis for comparison to assess the
    reasonableness of that part of the price. The cost of the modifications
    is more difficult to assess, and the Air Force has not provided us the
    data to analyze this cost. It would be useful for the Congress to
    understand the process the Air Force followed.

5. Does the proposed lease comply with the OMB criteria for an
   operating lease?

    Office of Management and Budget Circular A-11 provides criteria
    that must be met for an operating lease. The Air Force report says that
    the proposal complies with the criteria, but the report points out that
    one of the criteria is troublesome for this lease. This criterion, in
    particular, provides that in order for an agreement to be considered an
    operating lease, the present value of the minimum lease payments over
    the life of the lease cannot exceed 90 percent of the fair market value
    of the asset at the inception of the lease. Depending on the fair market
    value used, the net present value of the lease payments in this case
    may exceed 90 percent of initial value. Specifically, if the fair market
    value is considered to include the cost of construction financing, then
    the lease payments would represent 89.9 percent. If the fair market
    value were taken as $131 million per aircraft, which is the price the
    special purpose entity will pay to Boeing, then the lease payments
    would represent 93 percent. We do not have a position at this time on
    which is the more valid approach, but we believe the Air Force was
    forthright in presenting both figures in its report. Congress will need to
    consider whether this is an important issue and which figure is most
    appropriate for this operating lease.

Page 8                                                          GAO-03-1048T
                            6. Did the Air Force comply with OMB guidelines for lease versus
                               purchase analysis in its report?

                                A-94 specifies how lease versus purchase analysis should be
                                conducted. Our preliminary analysis indicates that the Air Force
                                followed the prescribed procedures, but we have not yet had time to
                                validate the Air Force’s analysis or the reasonableness of the
                                assumptions. The Air Force reported that under all assumptions and
                                scenarios considered, leasing is more expensive than purchasing, but
                                by only about $150 million under its chosen assumptions. In a footnote,
                                however, the report points out that if the comparison were to a
                                multiyear procurement, the difference in net present value would be
                                $1.9 billion favoring purchase.

                            7. Why does the proposal provide for as much as a 15 percent
                               profit on the aircraft?

                                The Air Force report indicates that Boeing could make up to 15
                                percent profit on the 767 aircraft. However, since this aircraft is
                                basically a commercial 767 with modifications to make it a military
                                tanker, a question arises about why the 15 percent profit should apply
                                to the full cost. One financial analysis published recently said that
                                Boeing’s profit on commercial 767s is in the range of 6 percent. Did the
                                Air Force consider having a lower profit margin on that portion of the
                                cost, with the 15 percent profit applying to the military-specific
                                portion? This could lower the cost by several million dollars per

                            In addition to the questions and observations presented above on the Air
Other Issues Related        Force report to the Congress, we believe there are a number of additional
to the Lease Proposal       considerations that Congress may want to explore, including the

                        •   What is the status of the lease negotiations? The Air Force has
                            informed us that the lease is still in draft and under negotiation. We
                            believe it is important for the Congress to have all details of the lease
                            finalized and available to assure that there are no provisions that might be
                            disadvantageous to the government. Just last Friday, the Air Force let us
                            read the draft lease in the Pentagon but has not provided us with a copy of
                            it, so we have not had time to review it in detail.

                        •   What other costs are associated with this lease agreement? In
                            addition to the lease payments, the Air Force has proposed about $600

                            Page 9                                                         GAO-03-1048T
    million in military construction, and it has negotiated with Boeing for
    training costs and maintenance costs related to the lease agreement that
    could total about $6.8 billion over the course of the lease. In addition, AF
    documents indicate that there are other costs for things like insurance
    premiums (estimated to be about $266 million) and government
    contracting costs.

•   Given the cost of the maintenance agreement, how has the Air
    Force assured itself that it received a good price? The Air Force
    estimates that the maintenance agreement with Boeing will cost between
    $5 billion and $5.7 billion during the lease period. It has negotiated an
    agreement with Boeing as part of the lease negotiations, covering all
    maintenance except flight-line maintenance to be done by Air Force
    mechanics. This represents an average of about $50 million per aircraft,
    with each aircraft being leased for 6 years, or over $8 million per year. We
    do not know how the Air Force determined that this was a reasonable
    price or whether competition might have yielded a better value. A number
    of commercial airlines and maintenance contractors already maintain the
    basic 767 commercial aircraft.

•   What happens when the lease expires? At the end of each 6-year lease,
    the aircraft are supposed to be returned to the owner, the special purpose
    entity, or be purchased by the Air Force for their residual value, estimated
    at about $44 million each in then-year dollars. If the aircraft were returned,
    the Air Force tanker fleet would be reduced, and the Air Force would have
    to find some way to replace the lost capability even though lease payments
    would have paid almost the full cost of the aircraft. In addition, the Air
    Force would have to pay an additional estimated $778 million if the entire
    100 aircraft were returned; this provision is intended to cover the cost of
    removing military-specific items. For these reasons, returning the aircraft
    would probably make little sense, and the Congress would almost
    certainly be asked to fund the purchase of the aircraft at their residual
    value when the leases expire.

•   How is termination liability being handled? If the lease is terminated
    prematurely, the Air Force must pay Boeing 1 year’s lease payment.
    Ordinarily, under budget scoring rules, the cost of the termination liability
    would have to be obligated when the lease is signed. Because this could
    amount to $1 billion to $2 billion for which the Air Force would have to
    have budget authority, this requirement was essentially waived by Section
    8117 of the Fiscal Year 2003 Department of Defense Appropriation Act.
    This means that if the lease were terminated, the Air Force would have to
    find the money in its budget to pay the termination amount or come to
    Congress for the appropriation.

    Page 10                                                         GAO-03-1048T
•   If the purpose of the lease is to “kick-start” replacement of the
    KC-135 fleet—as the Air Force has stated—why are 100 aircraft
    necessary, as stipulated under this lease arrangement? The main
    advantage of the lease, as pointed out by the Air Force, is that it would
    provide aircraft earlier than purchasing the aircraft and without disrupting
    other budget priorities. It is not clear, however, why 100 aircraft is the
    right number to do this. Section 8159 authorized up to 100 aircraft to be
    leased for up to 10 years. The Air Force has negotiated a shorter lease
    period, but stayed with the full 100 aircraft to be acquired from fiscal years
    2006 to 2011. The “kick-start” occurs in the early years, and by fiscal year
    2008 the Air Force would have 40 new aircraft delivered. We do not know
    to what extent the Air Force (1) considered using the lease for some
    smaller number of aircraft and then (2) planned to use the intervening
    time to adjust its procurement budget to begin purchasing rather than
    leasing. Such an approach would provide a few years to conduct the
    Tanker Requirements Study and the analysis of alternatives that the Air
    Force has said it will begin soon.

    In the coming weeks, we will continue to look into these questions in
    anticipation of future hearings by the Senate Armed Services Committee
    and the Senate Commerce Committee.

    Mr. Chairman, this concludes my prepared statement. I would be happy to
    answer any questions that you or Members of the Committee may have.

    Contacts and Staff Acknowledgments
    For future questions about this statement, please contact me at
    (757) 552-8111 or Brian J. Lepore at (202) 512-4523. Individuals making key
    contributions to this statement include Kenneth W. Newell, Tim F. Stone,
    Joseph J. Faley, Steve Marrin, Kenneth Patton, Charles W. Perdue, and
    Susan K. Woodward.

    Page 11                                                         GAO-03-1048T
Related GAO Products

             Military Aircraft: Information on Air Force Aerial Refueling Tankers.
             GAO-03-938T. Washington, D.C.: June 24, 2003.

             Air Force Aircraft: Preliminary Information on Air Force Tanker
             Leasing. GAO-02-724R. Washington, D.C.: May 15, 2002.

             U.S. Combat Air Power: Aging Refueling Aircraft Are Costly to Maintain
             and Operate. GAO/NSIAD-96-160. Washington, D.C.: Aug. 8, 1996.

             Page 12                                                    GAO-03-1048T
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