Financial Management: Improvements Needed in the Navy's Reporting of
General Fund Inventory (Correspondence, 10/27/2000, GAO/GAO-01-37R).

The Navy improved the reporting of its general fund inventory on its
fiscal year 1999 financial statement. The Navy properly accounted for
equipment and supplies that were not reported in the prior year's
statement, which included inventories held by contractors and the Coast
Guard. Improvements in the Navy's financial reporting, however, are
still needed. GAO found many errors and omissions that continue to
affect the accuracy of the Navy's financial reporting. This report
summarizes the issues that the Navy needs to address as it compiles its
fiscal year 2000 financial information.

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

 REPORTNUM:  GAO-01-37R
     TITLE:  Financial Management: Improvements Needed in the Navy's
	     Reporting of General Fund Inventory
      DATE:  10/27/2000
   SUBJECT:  Naval supplies
	     Military inventories
	     Inventory control systems
	     Financial management systems
	     Financial statement audits
	     Reporting requirements
	     Federal agency accounting systems
	     Accounting standards

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GAO-01-37R

Navy's Inventory Reporting

United States General Accounting Office Washington, DC 20548

October 27, 2000 Mr. Charles P. Nemfakos Senior Civilian Official for the
Office

of the Assistant Secretary of the Navy (Financial Management and
Comptroller)

Subject: Financial Management: Improvements Needed in the Navy's Reporting
of General Fund Inventory

Dear Mr. Nemfakos: As a part of our annual audit of the governmentwide
financial statements, we reviewed the compilation of the inventory 1 line
item included in the Department of the Navy's fiscal year 1999 Principal
Financial Statements, which report general fund operations. 2 Inventory
reported by the general fund consists primarily of operating materials and
supplies, which includes sponsor owned material, 3 ammunition, contractor
held material, and other classifications of inventory.

The Navy does not have central reporting of general fund inventory, and the
systems used to maintain accountability over inventory are not integrated
with core accounting systems. Therefore, the Navy relies on manual
“data calls” to compile inventory data for financial reporting.
To review the compilation of the inventory line item, we reviewed the Navy
information obtained through the data call process to evaluate the
completeness and accuracy of reported inventory and to determine whether
inventory was properly classified. However, because of the lack of system
integration and central inventory management, it is not possible to ensure
that all inventory owned by the Navy is identified through the data call
process or

1 Federal accounting standards define inventory as tangible personal
property that is held for sale, operating materials and supplies consumed in
normal operations, and stockpile materials held due to statutory
requirements for use in national defense.

2 General fund activities are funded by direct appropriations. In contrast,
other Navy activities are funded by working capital funds, which are
revolving funds used as a source of financing for supplies and services that
will be paid for by the customer.

3 Sponsor owned materials are items purchased, held, and managed by Navy
program managers to support mission requirements for the production, life-
cycle maintenance, and installation of weapon systems.

GAO- 01- 37R Navy's Inventory Reporting Page 2 by our review. As we have
previously testified, 4 deficient logistics systems continue to

impair the Navy's ability to both effectively maintain visibility and
prepare reliable financial reports for these assets. Over the long- term,
the Navy will need to develop and implement integrated financial and
logistical systems to provide for accurate financial reporting and improved
visibility.

We noted that the Navy has acted on a number of past audit recommendations
to improve financial reporting. For example, the Navy reported four classes
of inventory this year that were not reported previously. The newly reported
categories included sponsor owned material of $5.5 billion, residual assets
5 of $584 million, Navy material held by the Coast Guard of $101 million,
and contractor held material of $11.3 billion. 6 The inclusion of these
items, plus other changes, tripled the Navy's reported inventory value from
the previous fiscal year.

Although these changes improved the Department of the Navy's financial
reporting, we identified a number of errors and omissions in the financial
statements that continue to affect the reporting of inventory. These
problems included (1) sponsor owned material was not accurately reported,
(2) ammunition reported was not properly valued and not all ammunition was
reported, (3) property in the possession of contractors was not properly
classified, and (4) certain shipboard materials were not reported. This
letter summarizes our findings so that the Navy can address these issues as
it compiles its fiscal year 2000 financial information and to ensure that
the Navy considers these issues as it moves towards its long- term solution
of integrated systems.

Sponsor Owned Material Not Accurately Reported

The Navy reported $5.5 billion of sponsor owned material. We traced the
value reported in the financial statements to supporting data. As discussed
earlier, the Navy used a manual “data call” process to compile
data for financial statement reporting because current systems cannot
provide consolidated reporting of inventory on hand. We found that the
financial statements did not always match the information submitted by
commands that hold this inventory. For example, the Naval Sea Systems
Command (NAVSEA) submitted a figure of $3.2 billion for sponsor owned
material, but the amount used for financial statement compilation was $2.9
billion– a difference of $300 million. NAVSEA officials confirmed that
$3.2 billion should have been reported. Navy officials stated that the 1999
beginning inventory value of $2.9 billion was reported in error as the 1999
ending inventory amount. The error resulted from a lack of familiarity with
the data call document, according to Navy officials.

4 Department of Defense: Progress in Financial Management Reform (GAO/ T-
AIMD/ NSIAD- 00- 163, May 9, 2000). 5 Residual assets are excess items
stored at redistribution sites as ships are decommissioned or overhauled.
This material is redistributed free of charge from these sites. 6 Contractor
held material was incorrectly reported as property, plant, and equipment
(PP& E) in 1998.

GAO- 01- 37R Navy's Inventory Reporting Page 3 Additionally, the Naval Audit
Service reported 7 that the Naval Air Systems Command could

only estimate a value for its sponsor owned inventory because it did not
have a system in place to capture and report this material. Its estimate of
$2 billion represented over a third of the $5.5 billion of sponsor owned
material reported. Further, Navy personnel were unable to provide support
for the estimate.

Ammunition Not Properly Valued and Not Completely Reported

Our review of ammunition reported identified a number of errors, omissions,
or instances of noncompliance with financial accounting standards.

ï¿½ The Navy did not report air- launched guided missile support items or
NAVSEA ASROC (anti- submarine rocket) material. 8 The value of these items
at September 30, 1999, according to inventory records, was $7.8 million and
$41.6 million, respectively. Officials said that this was an unintentional
omission.

ï¿½ Ammunition items needing repair, including the unserviceable items
discussed below, were not separately identified or revalued to reflect the
estimated cost of repair. The full value of items needing repair, according
to inventory records, was $1.4 billion for the four ammunition categories
that the Navy reported for fiscal year 1999. 9 Federal accounting standards
require that inventory values be reduced for estimated repair costs for
financial reporting. Navy officials stated that the ammunition items needing
repair were not revalued in accordance with federal accounting standards
because Department of Defense (DOD) regulations 10 require ammunition to be
reported at full cost, without a provision for reducing the value for
estimated repair costs. However, these regulations refer only to the
reporting of ammunition on the Supply System Inventory Report (SSIR), 11 not
to financial statement reporting. As a result, the on- hand ammunition
balance was overstated. This failure to revalue ammunition in need of repair
was also reported by the Naval Audit Service in its report on its audit of
the Department of the Navy's fiscal year 1998 financial statements. 12

ï¿½ The Navy did not completely classify, revalue, and report its excess,
obsolete, and unserviceable inventory. Statement of Federal Financial
Accounting Standard (SFFAS) No. 3, Accounting for Inventory and Related
Property, defines excess inventory as stock

7 Department of the Navy Principal Statements for Fiscal Year 1999:
Inventory and Related Property, Net (NAS report no. N2000- 0023, May 15,
2000). 8 The Navy groups its inventory and related property into categories
based upon the type of material and the organization that manages the
material. These groupings are called cognizance codes or simply COGs. The
air- launched guided missile support items discussed here are 4E COG items,
and the ASROC material is designated 8S COG.

9 The 4E and 8S COGs are not included in this figure because they were not
reported in 1999, as noted above. 10 Department of Defense Materiel
Management Regulation (DOD 4140.1- R), May 1998. 11 The SSIR is an annual
DOD inventory report to the Congress that has specific regulations on its
presentation. 12 Department of the Navy Principal Statements for Fiscal Year
1998: Inventory and Related Property, Net

(NAS report no. 98- 0004, March 31, 1999).

GAO- 01- 37R Navy's Inventory Reporting Page 4 that exceeds the demand
expected in the normal course of operations; obsolete inventory

as inventory that is no longer needed due to changes in technology, laws,
customs, or operations; and unserviceable inventory as damaged inventory
that is more economical to dispose of than to repair. SFFAS No. 3 and the
Department of Defense Financial Management Regulation (DOD 7000.14- R,
volume 4, chapter 4) require that excess, obsolete, or unserviceable
inventory be reported at its estimated net realizable value. Excess - The
Navy reported only excess items in the “Excess, Obsolete, and
Unserviceable” category of materials. Further, for the excess
ammunition reported for fiscal year 1999, the Navy did not revalue it to net
realizable value in accordance with federal accounting standards and the DOD
Financial Management Regulation. Navy officials stated that the excess
ammunition was not revalued because DOD regulations 13 require ammunition to
be reported at full cost, without a provision for revaluing excess,
obsolete, and unserviceable items to net realizable value. As stated
previously, the regulations cited by Navy officials refer only to the
reporting of ammunition on the SSIR, and not to financial statement
reporting. As a result, the value of the on- hand balance was overstated.
Obsolete - Obsolete ammunition was not reported in the fiscal 1999 financial
statements. Navy officials could not explain why obsolete ammunition items
were not reported. In 1998, inventory records indicated that obsolete
ammunition was $202 million. Unserviceable - The Navy did not identify and
revalue unserviceable ammunition items, but rather reported all ammunition
in need of repair, including unserviceable items, at full value. As noted
previously, this resulted in overstating the on- hand balance.

Property in the Possession of Contractors Not Properly Classified

As previously noted, the Navy properly reclassified its contractor held
material– comprised of property in the possession of contractors,
government furnished material, and contractor acquired material– to
the inventory line item for fiscal year 1999. The value of that material
totaled a reported $11.3 billion. However, Navy officials indicated that
items reported as property in the possession of contractors included some
items already installed on ships during construction or repair. The
installed items should not be classified as inventory but rather accounted
for as part of the ship. As a result, the inventory line item was overstated
by the value of installed items included as property in the possession of
contractors. The value of this misclassification has not been determined.

Problems classifying inventory and other property in the possession of
contractors are not limited to the Navy. The Under Secretary of Defense
(Comptroller) has asked the Defense Contract Audit Agency (DCAA) to review
the valuation and classification of property or material in the possession
of contractors. This review includes the classification and value of
materials (operating materials and supplies and inventory) in the possession
of contractors, including materials that have already entered the repair or
production process but are still reported as property in the possession of
contractors. DCAA expects to issue a report on its assessments and
conclusions in early fiscal year 2001.

13 Department of Defense Materiel Management Regulation (DOD 4140.1- R), May
1998.

GAO- 01- 37R Navy's Inventory Reporting Page 5

Certain Shipboard Materials Not Reported

The Navy continued to exclude inventory aboard some of its ships 14 from its
reporting of operating materials and supplies. Such treatment is not
consistent with federal accounting standards. According to SFFAS No. 3, an
end user is any component of a reporting entity that obtains goods for
direct use in the component's normal operations. However, SFFAS No. 3 goes
on to state that any component of a reporting entity that maintains or
stocks operating materials and supplies for future issuance shall not be
considered an end user.

In 1996, we first reported 15 that shipboard inventories were omitted from
the Navy's financial statement reporting. Since that time, the Navy has
changed the categories of inventories in its financial reporting to include
supplies aboard aircraft carriers and other large vessels as working capital
fund items held for sale. With this change in reporting, the Navy has
acknowledged that inventories maintained at storage locations onboard its
large ships that are available for future issuance are not yet in the hands
of end users and therefore represent reportable operating materials and
supplies in accordance with SFFAS No. 3. The Navy, though, has continued to
take the position that shipboard inventories held for future use aboard
smaller combatant ships should be considered in the hands of the end user
and therefore should not be reported. However, we continue to maintain that,
like inventories held in supply on the Navy's large vessels, these smaller
combatant ships also have central supply functions that maintain inventories
held for future issuance to operating units throughout the ship.
Consequently, these smaller combatant ship inventories, like those on its
large vessels, are not yet in the hands of end users and therefore should be
reported as operating materials and supplies.

The Naval Audit Service previously reported that the value of these excluded
shipboard operating materials and supplies was $9.4 billion as of September
30, 1998. We have previously reported that this issue affects not only
financial reporting but asset visibility as well. Specifically, we reported
16 that the lack of Navy- wide visibility over shipboard inventories
substantially increased the risk that the Navy may request funds to obtain
additional unnecessary inventories because responsible managers did not
receive information that excess inventories were already on hand in other
locations.

Conclusions

The Navy has made several improvements in identifying and reporting its
inventory. However, errors in the compilation and reporting of those assets
continue to affect the reliability of the Navy's financial reports.
Additionally, some policy issues, such as the revaluation of ammunition and
the reporting of shipboard inventories held for future use,

14 The excluded inventory was for smaller combatant ships such as cruisers,
frigates, destroyers, and submarines. 15 See Navy Financial Management:
Improved Management of Operating Materials and Supplies Could Yield
Significant Savings (GAO/ AIMD- 96- 94, August 16, 1996). 16 CFO Act
Financial Audits: Programmatic and Budgetary Implications of Navy Financial
Data Deficiencies

(GAO/ AIMD- 98- 56, March 16, 1998).

GAO- 01- 37R Navy's Inventory Reporting Page 6 need to be resolved to
reflect current federal accounting standards and DOD regulations as

the Navy moves forward in its efforts to produce complete and reliable
financial statements. We are making recommendations to improve, to the
extent practical, the current manual, noncentralized process used to compile
the Navy's inventory data. However, these measures, while vital in the short
term, can only be considered interim steps to improve data accuracy, given
the accountability and financial reporting limitations inherent in the
current process. The ultimate, longer term solution to providing accurate
financial reporting and improved visibility will require the development and
implementation of integrated financial and logistical systems.

Recommendations for Executive Action

We recommend that you take the following actions to correct the types of
errors and omissions that we identified in the compilation of the Navy's
inventory information.

ï¿½ Develop a review process so that data call information on sponsor owned
material is correctly reported.

ï¿½ Document the basis of any estimates of sponsor owned material to
facilitate managerial reporting and auditor review.

ï¿½ Develop a review process for ammunition reporting so that all types of
ammunition are included in the Navy's financial reports, including air-
launched guided missile support items and anti- submarine rocket material.

ï¿½ Properly classify and disclose ammunition in the “excess, obsolete,
and unserviceable” categories in accordance with SFFAS No. 3.

ï¿½ Review the reporting of contractor held material to determine what portion
of the $11.3 billion reported should not be classified as inventory and
determine proper financial statement classification. This should include
coordination with the DOD- wide DCAA project that is reviewing property in
the possession of contractors.

In addition, we recommend that you revise the Navy's policies for compiling
its financial statements so that they are in accordance with federal
accounting standards and the DOD

Financial Management Regulation. Specifically, (1) ammunition items needing
repair and those categorized as excess, obsolete, and unserviceable should
be revalued appropriately to comply with SFFAS No. 3 and the DOD Financial
Management Regulation and (2) shipboard inventories aboard smaller combatant
ships should be reported as operating materials and supplies in accordance
with federal accounting standards.

Finally, you should consider the issues discussed in this letter in the
development and implementation of the long- term systems solution for proper
accounting and improved visibility of the Navy's inventory.

Agency Comments and Our Evaluation

We requested comments on a draft of this report from the Secretary of
Defense or his designee. On October 19, 2000, the Principal Deputy,
Assistant Secretary of the Navy

GAO- 01- 37R Navy's Inventory Reporting Page 7 (Financial Management and
Comptroller) provided us with comments, which are reprinted in

the enclosure. DOD concurred with our recommendations and stated that the
Department of the Navy remains committed to producing consistent, timely,
useful, and complete data and information for its managers to use in making
decisions and processing financial reports. We are pleased that the Navy is
working to reduce the number of systems used to account for operating
materials and supplies through standardization and consolidation and to
ensure that those remaining systems meet federal accounting standards.

The DOD response also stated that the treatment of Navy shipboard
inventories aboard smaller combatant ships remains a reporting issue to be
resolved by the Navy's Operating Materials and Supplies Working Group in
coordination with the DOD Office of the Comptroller. We agree and have
clarified our position as discussed in this letter. We reiterate our long-
held position that until these items are in the hands of the end users, they
should be reported as operating materials and supplies in accordance with
federal accounting standards.

---- We would appreciate a written response within 60 days of the date of
this letter on actions you have taken or plan to take to address our
recommendations.

Copies of this letter are being sent to Nelson Toye, Deputy Chief Financial
Officer, Office of the Under Secretary of Defense (Comptroller), and to
interested congressional committees. Copies will be made available to others
upon request. If you have further questions regarding these findings, please
contact Geoffrey B. Frank, Assistant Director, at (202) 512- 9518 or me at
(202) 512- 9095. Key contributors to this assignment were William Cordrey
and Lisa Warde.

Sincerely yours, Lisa G. Jacobson Director Financial Management and
Assurance

Enclosure

Enclosure

GAO- 01- 37R Navy's Inventory Reporting Page 8

Comments From the Department of the Navy

Enclosure

GAO- 01- 37R Navy's Inventory Reporting Page 9

Enclosure

GAO- 01- 37R Navy's Inventory Reporting Page 10

Enclosure

GAO- 01- 37R Navy's Inventory Reporting Page 11

Enclosure

GAO- 01- 37R Navy's Inventory Reporting Page 12 (919527)
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