Financial Reporting: DOD's Fiscal Year 1996 Financial Statements
Inventory Reporting Does Not Meet Standards (Letter Report, 12/24/97,
GAO/AIMD-98-16).

GAO reviewed the Department of Defense's (DOD) fiscal year (FY) 1996
financial statements, focusing on whether its approach to reporting
inventory and operating materials and supplies complied with the
Statement of Federal Financial Accounting Standards (SFFAS) No. 3
requirements, both in individual military service financial statements
and those at the consolidated DOD-wide level.

GAO noted that: (1) DOD did not fully comply with SFFAS No. 3 in FY
1996; (2) its consolidated and component financial statements
misclassified operating materials and supplies and some equipment as
inventory and did not include all operating materials and supplies; (3)
for FY 1996, the Army, Navy, and Air Force general fund financial
statements collectively reported $115.6 billion of inventory; (4) the
Army and Air Force did not report any amounts for operating materials
and supplies and the Navy reported only $27,000; (5) one reason for
these errors is that DOD's "Guidance on Form and Content of Financial
Statements for FY 1996 Financial Activity" and its accounting policy
misinterpreted and were not consistent with the accounting standard; (6)
as a result, DOD's FY 1996 financial statements overstated inventory,
understated operating materials and supplies, and overstated expenses;
(7) about $113.7 billion out of the $115.6 billion reported as inventory
by the general funds consisted of munitions and equipment that met the
SFFAS No. 3 definition of inventory and should have been classified as
operating materials and supplies or plant, property, and equipment; (8)
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; (9) GAO, the
DOD Inspector General, and the military service auditors have reported
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; (10) however, these items were not considered as
capitalized assets as required, but were instead expensed on the
financial statements when purchased; (11) the $113.7 billion of
misclassified assets represents 9 percent of total assets reported and
therefore was material to DOD's FY 1996 financial statements; (12)
continued material misclassification 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; and (13) 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.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  AIMD-98-16
     TITLE:  Financial Reporting: DOD's Fiscal Year 1996 Financial 
             Statements Inventory Reporting Does Not Meet Standards
      DATE:  12/24/97
   SUBJECT:  Reporting requirements
             Military materiel
             Military inventories
             Financial statements
             General fund accounts
             Accounting procedures
             Spare parts
             Materiality
             Noncompliance

             
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Cover
================================================================ COVER


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

DOD's FY 1996 Inventory Reporting

(919157)


Abbreviations
=============================================================== ABBREV

  DOD - Department of Defense
  FASAB - Federal Accounting Standards Advisory Board
  IG - inspector general
  OMB - Office of Management and Budget
  SFFAS - Statement of Federal Financial Accounting Standards

Letter
=============================================================== LETTER


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. 


   RESULTS IN BRIEF
------------------------------------------------------------ Letter :1

DOD did not fully comply with SFFAS No.  3 in fiscal year 1996.  Its
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 Financial Activity and its accounting
policy\1 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 reported\2 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). 


   OBJECTIVES, SCOPE, AND
   METHODOLOGY
------------------------------------------------------------ Letter :2

Our objectives were to determine whether DOD, in its fiscal year 1996
financial statements, (1) properly classified inventory and related
property 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. 


   ASSETS MISCLASSIFIED AS
   INVENTORY HELD FOR SALE
------------------------------------------------------------ Letter :3

SFFAS No.  3 defines inventory as tangible personal property that is
(1) held for sale, (2) in the process of production for sale, or (3)
to be used in the production of goods for sale or in the provision of
services for a fee.  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. 
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 & other            $12.8       $18.7       $19.1       $50.6
 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. 


   OPERATING MATERIALS AND
   SUPPLIES WERE NOT REPORTED
------------------------------------------------------------ Letter :4

According to SFFAS No.  3, operating materials and supplies consist
of tangible personal property to be consumed in normal operations. 
The standard requires that expenses for operating materials and
supplies be 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. 



                                Table 2
                
                 Fiscal Year 1996 Unreported Operating
                         Materials and Supplies

                         (Dollars in billions)

                          Misclassif     Account     Account
                                 ied  overstatem  understate
Component                  munitions         ent        ment     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 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. 


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


   CONCLUSION
------------------------------------------------------------ Letter :5

DOD's financial reporting would be improved if its guidance and
policies 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. 


   RECOMMENDATIONS
------------------------------------------------------------ Letter :6

We recommend that you

  -- 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. 


   AGENCY COMMENTS AND OUR
   EVALUATION
------------------------------------------------------------ Letter :7

The Principal Deputy Under Secretary of Defense (Comptroller)
concurred with our finding that DOD's form and content guidance
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 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. 


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


---------------------------------------------------------- Letter :7.1

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




(See figure in printed edition.)Appendix I
COMMENTS FROM THE DEPARTMENT OF
DEFENSE
============================================================== Letter 



(See figure in printed edition.)



(See figure in printed edition.)

*** End of document. ***