Review of DOD's Report on Budgeting for Exchange Rates for	 
Foreign Currency Fluctuations (16-JUN-05, GAO-05-800R). 	 
                                                                 
The Department of Defense (DOD) expends a significant amount of  
funds overseas, particularly from its Operation and Maintenance  
(O&M) and Military Personnel (MILPERS) appropriations. As the	 
rate of overseas currencies fluctuates on a daily basis, such	 
fluctuations have an impact on the various expenditures that DOD 
makes. For budgeting purposes, DOD establishes foreign currency  
exchange rates to determine its O&M and MILPERS funding needs.	 
During the fiscal year, DOD incurs expenditures at the actual	 
exchange rate, which varies from the budgeted rate. For example, 
if the dollar depreciates in value, more dollars are needed to	 
pay for goods and services than originally budgeted. Concerned	 
about whether DOD's method for selecting foreign currency rates  
has produced realistic estimates in its budget submissions,	 
Congress required DOD to consider alternative methods.		 
Specifically, the Ronald W. Reagan National Defense Authorization
Act for Fiscal Year 2005 required the Secretary of Defense to	 
submit a report on the foreign currency exchange rate projections
used in annual DOD budget presentations. The act required that	 
DOD identify alternative approaches, including the feasibility of
using private economic forecasting and approaches used by other  
federal departments and agencies, for selecting foreign currency 
exchange rates that would produce more realistic estimates of the
amounts required for DOD to accommodate foreign currency exchange
rate fluctuations. DOD also was required to discuss the 	 
advantages and disadvantages of each approach and to identify the
department's preferred approach among the alternatives and	 
provide a rationale for preferring that approach. Finally, the	 
act further required that we review DOD's report, including the  
basis for the Secretary's conclusions for the preferred approach.
DOD submitted its report to Congress on April 15, 2005. In	 
response to the act, we examined (1) the extent to which DOD	 
evaluated alternative approaches for selecting budgeted foreign  
currency rates--such as private economic forecasting companies or
approaches used by other federal departments' and DOD's basis for
selecting its preferred rate selection approach and (2) the	 
extent to which DOD's preferred approach for forecasting foreign 
currency exchange rates would produce a more realistic estimate  
than its historical approach.					 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-05-800R					        
    ACCNO:   A26777						        
  TITLE:     Review of DOD's Report on Budgeting for Exchange Rates   
for Foreign Currency Fluctuations				 
     DATE:   06/16/2005 
  SUBJECT:   Budget obligations 				 
	     Budgeting						 
	     Defense budgets					 
	     Foreign currency					 
	     Foreign currency exchanges 			 
	     Foreign exchange rates				 
	     Defense economic analysis				 

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GAO-05-800R

United States Government Accountability Office Washington, DC 20548

June 16, 2005

The Honorable John Warner
Chairman
The Honorable Carl Levin
Ranking Minority Member
Committee on Armed Services
United States Senate

The Honorable Duncan L. Hunter
Chairman
The Honorable Ike Skelton
Ranking Minority Member
Committee on Armed Services
United States House of Representatives

Subject: Review of DOD's Report on Budgeting for Exchange Rates for
Foreign Currency Fluctuations

The Department of Defense (DOD) expends a significant amount of funds
overseas, particularly from its Operation and Maintenance (O&M) and
Military Personnel (MILPERS) appropriations. As the rate of overseas
currencies fluctuates on a daily basis, such fluctuations have an impact
on the various expenditures that DOD makes. For budgeting purposes, DOD
establishes foreign currency exchange rates to determine its O&M and
MILPERS funding needs. During the fiscal year, DOD incurs expenditures at
the actual exchange rate, which varies from the budgeted rate. For
example, if the dollar depreciates in value, more dollars are needed to
pay for goods and services overseas than originally budgeted.

Concerned about whether DOD's method for selecting foreign currency rates
has produced realistic estimates in its budget submissions, Congress
required DOD to consider alternative methods. Specifically, the Ronald W.
Reagan National Defense Authorization Act for Fiscal Year 2005 required
the Secretary of Defense to submit a report on the foreign currency
exchange rate projections used in annual DOD budget

1

presentations. The act required that DOD identify alternative approaches,
including the feasibility of using private economic forecasting and
approaches used by other federal departments and agencies, for selecting
foreign currency exchange rates that would produce more realistic
estimates of the amounts required for DOD to accommodate foreign currency
exchange rate fluctuations. DOD also was required

1 Pub. L. No. 108-375, S:1006 (2004).

to discuss the advantages and disadvantages of each approach and to
identify the department's preferred approach among the alternatives and
provide a rationale for preferring that approach. Finally, the act further
required that we review DOD's report, including the basis for the
Secretary's conclusions for the preferred approach. DOD submitted its
report to Congress on April 15, 2005.

In response to the act, we examined (1) the extent to which DOD evaluated
alternative approaches for selecting budgeted foreign currency rates-such
as private economic forecasting companies or approaches used by other
federal departments- and DOD's basis for selecting its preferred rate
selection approach and (2) the extent to which DOD's preferred approach
for forecasting foreign currency exchange rates would produce a more
realistic estimate than its historical approach.

In conducting our work, we examined the alternative approaches explored by
DOD for selecting budgeted foreign currency exchange rates and DOD's
reported advantages and disadvantages of each approach. We interviewed
responsible officials from the Office of the Under Secretary of Defense,
Comptroller to obtain DOD's rationale for deciding on its preferred rate
selection approach. We independently calculated a sample of DOD's fiscal
year 2006 budgeted foreign currency exchange rates that were generated
using DOD's preferred approach to validate that the rates could easily be
replicated. We also compared the use of DOD's preferred approach with its
historical approach to determine their impact on developing budgetary
estimates. We calculated how both the rates generated by DOD's preferred
approach and the rates used to prepare the budget submissions for fiscal
years 2004 and 2005 compared with current actual exchange rates as of May
2005. We conducted our work from November 2004 to June 2005 in accordance
with generally accepted government audit standards.

Summary

DOD evaluated several alternative approaches for selecting budgeted
foreign currency rates and selected an approach that it believed would
more accurately and objectively predict exchange rates. The alternative
approaches included (1) estimates from a private forecasting company; (2)
methods used by other federal departments, such as selecting exchange
rates on the basis of past execution data and using multiple exchange
rates for individual offices; and (3) various statistical methodologies.
DOD selected a statistical method referred to as the centered weighted
average, which combines both a long-run average of exchange rates and the
most recently observed exchange rates to predict future exchange rates.
DOD chose this approach because it was based on historical and current
data and could be universally replicated; therefore, it was not dependent
on subjective judgment. DOD used this method in developing its fiscal year
2006 budget submission. DOD believed that using a combination of both
recent and historical data would be an advantage in more accurately
predicting future exchange rates because the methodology allows DOD to
weight individual currencies to minimize the impact of their volatility
over time. According to DOD, they did not choose the private forecasting
alternative because of the lack of visibility over key assumptions used in
generating the forecast

nor did they choose one of the methods used by the other federal
departments because the other departments either did not forecast foreign
currency rates or they did not have a uniform procedure for setting
departmentwide rates.

DOD selected a reasonable approach for forecasting foreign currency rates
that can produce a more realistic estimate than its historical approach.
Unlike DOD's historical approach, the centered weighted average approach
provides a straightforward statistical calculation of historical data that
can be easily replicated with no hidden assumptions and is not dependent
on subjective judgment. In reaching our conclusion, we compared both the
new rates generated using the preferred approach and the rates DOD used to
prepare the fiscal year 2004 and 2005 budget submissions based on its
historical approach to current actual exchange rates. We found that the
new methodology generated rates that more closely reflected actual
exchange rates that occurred during the budget year.

DOD officials reviewed a draft of this report and agreed with its content.

Background

Each fiscal year, DOD establishes budgeted foreign currency exchange rates
(units of foreign currency per one U.S. dollar) to use when determining
its O&M and MILPERS funding needs. In past years, DOD tracked foreign
currency exchange rates in the Wall Street Journal on a daily basis during
the months immediately preceding the budget submission and then selected
the most favorable foreign currency exchange rates, which provide the
highest amount of foreign currency per dollar, during this timeframe. For
the fiscal year 2004 budget submission, DOD selected the most favorable
rates from August through November 2002. For the fiscal year 2005
submission, DOD did not revise its rates. It continued to use exactly the
same rate contained in the fiscal year 2004 budget submission. We have
previously briefed your office in the past that the use of the most
favorable foreign currency rates underestimates the impact of foreign
currency fluctuations and therefore results in a budget submission that
does not realistically reflect funding requirements for O&M and MILPERS
expenses. While many methods can be used to forecast foreign currency
exchange rates, some methods may produce rates that are better estimates
of actual foreign currency trends. For fiscal year 2006, DOD changed its
methodology for setting budgeted foreign currency exchange rates and used
a centered weighted average approach. This approach combines both a
long-run weighted average of exchange rates and a weighted average of the
most recently observed exchange rate to predict future exchange rates.

DOD Considered Alternative Approaches and Selected a Statistical Method

In meeting its legislative requirement, DOD considered alternate
approaches for determining foreign currency exchange rates to use in
developing its budget request. These approaches included: estimates from a
private forecasting company, methods used by other federal departments,
and various statistical methodologies for selecting budgeted foreign
currency rates. DOD selected a statistical method, the centered weighted
average that it thought would more closely reflect actual rates that occur
during the budget year. DOD used this method to set its fiscal year 2006
rates.

DOD considered using a private economic forecasting company as an approach
for establishing budgeted foreign currency exchange rates and cited
several advantages and disadvantages in its report. According to the
report, a private forecasting company would provide DOD with forecasted
foreign currency exchange rates calculated by the company using its own
assumptions and methods. It also stated that the advantage of using a
private forecasting company would be that it provides a quick way to
acquire foreign currency exchange rates because the rates are already
established by the company. The report further noted that a disadvantage
of using a private forecasting company would be that DOD would incur
additional costs since the department would have to purchase the
forecasted rates from the private company. Also, DOD stated that another
disadvantage would be that the approach would not provide a
straightforward methodology that could be explained to decision makers
because the assumptions and methods used to forecast the exchange rates
are produced and owned by the company and would not be disclosed to DOD.
Additionally, the report noted that the use of a forecasting company would
raise questions as to why a particular company was selected instead of
another one. According to DOD officials, for these reasons, DOD did not
consider using a private forecasting company to be a viable option.

In its report, DOD also evaluated approaches used by other federal
departments to set budgeted foreign currency exchange rates. DOD contacted
five federal departments but found no foreign currency budgeting
procedures in use that would meet DOD's needs. DOD contacted the
Departments of Education, Energy, Justice, State, and Agriculture. The
Departments of Education, Energy, and Justice did not purchase foreign
currency. Therefore, they had no reason to forecast. The Department of
State used past execution rates and thus did not forecast future market
foreign currency exchange rates in its budget submissions. The Department
of Agriculture used forecasted exchange rates in developing its budget.
However, the department included 80 different budget estimates from its
various offices and each office could use a different methodology to
produce the forecasted rates. Thus, Agriculture had no uniform procedure
for setting departmentwide budgeted foreign currency exchange rates.
Consequently, DOD did not choose one of the methods used by another
federal department because they either did not forecast foreign currency
rates or they did not have a uniform procedure for setting departmentwide
rates.

DOD also reviewed several statistical methodologies to forecast foreign
currency exchange rates, such as linear forecasting, moving averages,
exponential smoothing, simple average, and a centered weighted average.
All of these statistical methodologies are traditional techniques that use
data to predict future trends. DOD found that the advantages of
statistical approaches are that the methodologies are clear and can be
replicated. In addition, these statistical methods do not have hidden
assumptions and the subjectivity associated with DOD's selection of past
foreign currency exchange rates would be eliminated. We have previously
briefed your office that the use of the most favorable foreign currency
rates underestimates the impact of foreign currency fluctuations and
therefore results in a budget submission that does not realistically
reflect funding requirements for O&M and MILPERS expenses.

DOD selected the centered weighted average approach as its preferred
approach for establishing budgeted foreign currency exchange rates for
fiscal year 2006. DOD believed that this method would result in rates that
more closely reflect actual foreign currency rates because it combined
both a long-run average of exchange rates and the most recent observed
rates. This approach allowed DOD to weight individual currencies thus
minimizing volatility over time. The centered weighted average was the
only statistical methodology that used individual weighting factors for
each currency to combine recent data with the historical average to
predict exchange rates. DOD also reported that a possible disadvantage of
using this approach would be that it could produce a rate that might not
appear reasonable if the current market exchange rates significantly
increased or decreased at the time of the budget submission.

DOD Selected a Reasonable Approach That More Realistically Estimates
Foreign Currency Exchange Rates

DOD selected a reasonable approach for forecasting foreign currency rates
that can produce a more realistic estimate than its historical approach.
Unlike DOD's historical approach, the centered weighted average approach
provides a straightforward statistical calculation of historical data that
can be easily replicated with no hidden assumptions. This type of
calculation eliminates the subjectivity in the rate selection process that
was present in the method DOD used to set budget estimates in prior years,
when DOD selected only the most favorable rates for each foreign currency.
We independently verified DOD's claim that the rates can easily be
replicated using this approach. We calculated a sample of DOD's exchange
rates using its centered weighted average methodology. Our calculations
matched the same rates that DOD generated for its fiscal year 2006 budget
submission.

Our analysis shows that DOD's preferred method for developing foreign
currency exchange rates for budgetary purposes more closely approximates
actual exchange rates that occurred during the budget year. We compared
both (1) the foreign currency rates DOD included in its fiscal year 2006
budget submission using the centered weighted average approach and (2) the
rates that DOD included in its fiscal year 2004 and 2005 budget
submissions using the most favorable rates with current foreign currency
exchange rates as of May 2005. Our analysis showed a projected

loss of almost $775 million (potential difference between using the
budgeted versus actual rates) for fiscal year 2006 using the centered
weighted average rates. However, DOD would have incurred additional losses
of about $908 million, totaling about $1.7 billion, had it used the rates
it used to build its budget submissions for fiscal years 2004 and 2005 to
predict its fiscal year 2006 budget estimates.

Agency Comments

DOD officials reviewed a draft of this report and agreed with its content.
_ _ _ _ _

We are sending copies of this letter to the Senate and House Armed
Services Committees. We also will make copies available to others upon
request. In addition, this letter will be available at no charge on GAO's
Web site at http://www.gao.gov.

If you have any questions concerning this letter, please contact me at
(202) 512-9619 or [email protected]. Contact points for our Offices of
Congressional Relations and Public Affairs may be found on the last page
of this letter. Key contributors to this assignment were Bonita P.
Anderson, Renee S. Brown, Laura L. Durland, Charles W. Perdue, Gina O.
Ruidera, and Michael C. Zola.

Sharon Pickup
Director,
Defense Capabilities and Management

(350614)

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