United States General Accounting Office

GAO Report to the Under Secretary of

Defense (Comptroller)

December 1997 FINANCIAL

REPORTING

DOD’s Fiscal Year 1996

Financial Statements

Inventory Reporting

Does Not Meet

Standards

GAO/AIMD-98-16

GAO United States

General Accounting Office

Washington, D.C. 20548

Accounting and Information

Management Division

B-278326 

December 24, 1997

The Honorable William J. Lynn

Under Secretary of Defense (Comptroller)

Department of Defense

Dear Mr. Lynn:

Statement of Federal Financial Accounting Standards (SFFAS) No. 3,

Accounting for Inventory and Related Property, specifies different

categories of tangible property for financial reporting and disclosure. Two

of the asset categories applicable to the Department of Defense (DOD)

under the standard are “inventory” and “operating materials and supplies.”

The standard, which has been in effect since fiscal year 1994, defines

“inventory” as tangible personal property held for sale and “operating

materials and supplies” as tangible personal property to be consumed in

normal operations. In general, DOD’s working capital funds typically sell

items to other service activities, such as maintenance and tactical units,

and, therefore, would be most likely to report inventory. DOD’s general

funds activities usually hold items for their own use and would most likely

report operating materials and supplies.

Our objectives were to review the DOD’s fiscal year 1996 financial

statements to determine if its approach to reporting inventory and

operating materials and supplies meets SFFAS No. 3 requirements—for

individual military service financial statements as well as those at the

consolidated DOD-wide level. This letter presents information on how the

accounting standards are to be applied to improve the reporting of

inventory and operating materials and supplies in DOD’s financial

statements.

Results in Brief 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

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

Financial Activity and its accounting policy1 misinterpreted and were not

consistent with the accounting standard. As a result, DOD’s fiscal year 1996

financial statements overstated inventory, understated operating materials

and supplies, and overstated expenses.

About $113.7 billion out of the $115.6 billion reported as inventory by the

general funds consisted of munitions and equipment that do not meet the

SFFAS No. 3 definition of inventory and should have been classified as

operating materials and supplies or plant, property, and equipment. At the

same time, other items warehoused by service activities, such as repair

parts and consumables, that met the SFFAS No. 3 definition of operating

materials and supplies were not reported at all. We, the DOD Inspector

General (IG), and the military service auditors have reported2

 that the

military services have warehoused billions of dollars of items at bases and

on ships that meet the SFFAS No. 3 definition of operating materials and

supplies. However, these items were not considered as capitalized assets

as required but were instead expensed on the financial statements when

purchased.

The $113.7 billion of misclassified assets represents 9 percent of total

assets reported and therefore was material to DOD’s fiscal year 1996

financial statements. Continued material misclassifications and

underreporting will negatively affect the reliability and usefulness of the

military services’ and DOD’s financial statements and also the auditors’

opinions on those statements. DOD’s guidance and accounting policies

must comply with accounting standards so that inventory and operating

materials and supplies are properly classified and reported in its future

financial statements.

1

DOD Financial Management Regulation, DOD 7000.14-R, Volume 4, “Accounting Policies and

Procedures,” January 1995.

2

Navy Financial Management: Improved Management of Operating Materials and Supplies Could Yield

Significant Savings (GAO/AIMD-96-94, August 16, 1996); CFO Act Financial Audits: Increased Attention

Must Be Given to Preparing Navy’s Financial Reports (GAO/AIMD-96-7, March 27, 1996); Financial

Management: Immediate Actions Needed to Improve Army Financial Operations and Controls

(GAO/AFMD-92-82, August 7, 1992); Internal Controls and Compliance With Laws and Regulations for

the DOD Consolidated Financial Statements for FY 1996 (DOD IG Report No. 97-182, June 30, 1997);

Army’s Principal Financial Statements for Fiscal Year 1996 and 1995 Report on Internal Controls and

Compliance With Laws and Regulations (AAA Report No. AA 97-145, 30 June 1997); Opinion on Fiscal

Year 1996 Air Force Consolidated Financial Statements (AFAA Report No. 96053001, 1 March 1997);

Department of the Navy Fiscal Year 1996 Annual Financial Report: Report on Internal Controls and

Compliance With Laws and Regulations (NAS Report No. 029-97, 15 April 1997).

Page 2 GAO/AIMD-98-16 DOD’s FY 1996 Inventory Reporting
B-278326 

Objectives, Scope,

and Methodology

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

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.

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

According to the DOD IG, almost $74 billion of the misclassifications were

war reserves, which include ammunition, missiles, and munitions related

items. Only the Army’s Conventional Ammunition Working Capital Fund,

which held $1.9 billion of ammunition for sale, was appropriately

classified as inventory.

The following table, which is based on the component financial statements

and DOD IG and service auditor information, shows the misclassified

inventory by type and service.

Table 1: DOD Misclassified Inventory

Reported in Fiscal Year 1996 Dollars in billions

Asset type Army Navy Air Force Total

Equipment &

other items

$12.8 $18.7 $19.1 $50.6

Munitions $22.9 $22.8 $17.4 $63.1

Total reported $35.8 $41.4 $36.5 $113.7

Note: Although the Navy’s financial statement reported $22.8 billion of ammunition, the Naval

Audit Service reported that the Navy improperly included at least $11.6 billion of ammunition due

to a computer software problem. In addition, the Air Force Audit Agency reported that the Air

Force had overstated the reported $17.4 billion of munitions by $853 million. Totals are not

precise due to rounding.

For fiscal year 1996, the Army, Navy, and Air Force were following DOD

guidance when they reported munitions and equipment as inventory.

However, DOD’s fiscal year 1996 form and content guidance, which is

intended to supplement the Office of Management and Budget (OMB) form

and content guidance,3

 is not consistent with SFFAS No. 3 or OMB guidance.

DOD’s guidance states that the inventory line item should include

equipment purchased with procurement funds and war reserve items that

are held in wholesale or retail supply inventories. However, these items

include equipment and ammunition that are not held for sale to others. For

example, according to Army auditors, the Army’s fiscal year 1996 financial

statements inventory line erroneously included tanks and howitzers that

are stored at depots and issued to Army units without reimbursement.

In addition, both SFFAS No. 3 and OMB requirements for preparing financial

statements provide an operating materials and supplies subcategory for

items that are held in reserve for future use. This subcategory would be

the proper place to report munitions owned by the services and held in

storage by DOD.

3

OMB Bulletin No. 94-01, “Form and Content of Agency Financial Statements,” issued November 16,

1993, effective for the fiscal year ending September 30, 1994.

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

Operating Materials

and Supplies Were

Not Reported

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.

Page 5 GAO/AIMD-98-16 DOD’s FY 1996 Inventory Reporting
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Table 2: Fiscal Year 1996 Unreported

Operating Materials and Supplies Dollars in billions

Component

Misclassified

munitions

Account

overstatement

Account

understatement Total

Army $22.9 − − $22.9

Navy $22.8 $11.6 $20.5 $31.7

− − $7.8 $ 7.8

Air Force $17.4 $ 0.9 − $16.5

Total $63.1 $12.5 $28.3 $78.9

As shown in table 2, munitions totaling $50.6 billion ($63.1 billion adjusted

for the $12.5 billion of munitions overstatements reported by the military

service auditors) should have been classified as operating materials and

supplies. Further, the Naval Audit Service reported that the Navy did not

report an additional $20.5 billion of ammunition.4

 According to the

auditors, the Navy also had an estimated $7.8 billion of unreported

operating materials and supplies in storage on board ships and at Marine

Corps activities. For example, combat ships, such as frigates and cruisers,

hold material in storerooms until the work centers requisition items for

repair work or other uses. Navy supply officers store operating materials

and supplies at shore locations for subsequent issuance to aircraft carriers

and submarines.

Similarly, according to Army auditors, Army divisions could have

unreported operating materials and supplies. Army divisions are

authorized to store about $800 million of equipment components and

repair parts for aircraft, missiles, and common equipment (e.g., trucks,

tanks, and generators) in storage for future issuance to combat units.

Because Army auditors did not determine how much was on hand, DOD

does not know whether the Army divisions were holding their authorized

levels, or more or less than their authorized levels at year-end. As a result,

we could not estimate Army’s understatement of operating materials and

supplies.

Confusion regarding categorization of operating materials and supplies

may result from a DOD time limitation on holding operating materials and

supplies. SFFAS No. 3 does not directly address time limitations for holding

operating materials and supplies. However, the description of the required

disclosure subcategories—(1) held for use, (2) held in reserve for future

use, and (3) excess, obsolete, and unserviceable—indicates that operating

4

Department of the Navy Fiscal Year 1996 Annual Financial Report: Ammunition and Ashore Inventory

(NAS Report No. 048-97, 25 September 1997).

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

materials and supplies could be held for several months or even several

years. DOD Financial Management Regulation, DOD 7000.14-R, Volume 4,

“Accounting Policies and Procedures,” states that items classified as

operating materials and supplies held for current and future use “shall not

exceed the amount expected to be used within 30 days unless justifying

documentation supporting a supply in excess of 30 days is developed and

maintained for review.”

DOD’s policy restriction could mean an additional, unnecessary

documentation burden for service activities to justify keeping munitions,

which are included in war reserves, and other items in storage for more

than 30 days. The conflict between war reserves and the 30-day restriction

for operating materials and supplies may discourage the services from

complying with the accounting policy and may contribute to their not

recognizing billions of dollars of operating materials and supplies.

Conclusion 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 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

The Principal Deputy Under Secretary of Defense (Comptroller)

concurred with our finding that DOD’s form and content guidance

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

concerning inventory reporting for fiscal year 1996 was incorrect and, as a

result, that items not held for sale were misclassified as inventory. The

Deputy Comptroller stated that DOD’s final guidance for the fiscal year 1997

financial statements has been corrected and it now requires that inventory

consist only of items that are held for sale.

The Deputy Comptroller also stated that DOD partially concurred with our

two other findings. However, we do not find the Deputy Comptroller’s

comments responsive to our recommendations regarding the need for

clarifying and enforcing DOD guidance for reporting operating materials

and supplies. While the Deputy Comptroller’s response points to a lack of

specific FASAB guidance for reporting “war reserves” (consisting mainly of

munitions and equipment), it does not address unreported operating

materials and supplies warehoused on ships, at shore locations, or at other

storage facilities awaiting issuance to end users. As stated earlier in this

report, nearly $8 billion of Navy’s operating materials and supplies were

not reported in fiscal year 1996. Unless DOD clarifies and enforces guidance

requiring capitalization of warehoused operating materials and supplies,

we expect such underreporting of assets to continue.

In regard to the Deputy Comptroller’s assertion that FASAB has not issued

authoritative guidance specifically addressing munitions, we note that the

standards are intended to describe the general characteristics of various

asset types that need to be applied across a variety of government

operations. They are not intended, nor is it practical, to list every item and

how it should be reported. SFFAS No. 3 provides broad criteria for the

reporting of operating materials and supplies that clearly apply to

munitions. In our report on the liability associated with the disposal of

conventional ammunition,5

 we noted that FASAB had recently reviewed the

asset category for ammunition and reiterated its position that ammunition

should be classified as operating materials and supplies. FASAB announced

this decision in its September 1997 newsletter. In addition, the Deputy

Comptroller stated that we inappropriately cited FASAB deliberations as

authoritative guidance. We have clarified the report to indicate that we

reviewed FASAB deliberations and decisions. We did not find any

justification for DOD’s position that the reporting requirements for

munitions were not clear.

The Deputy Comptroller’s response did not specify how DOD’s war reserve

items, which the DOD IG reported had been misclassified, will be reported

5

Financial Management: DOD’s Liability for the Disposal of Conventional Ammunition Can Be

Estimated (GAO/AIMD-98-32, December 19, 1997).

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

in fiscal year 1997. The FASAB standards and OMB form and content

guidance call for munitions to be classified as operating materials and

supplies and war reserve equipment to be classified as property, plant, and

equipment.

We are sending copies of this letter to the Chairmen and Ranking Minority

Members of the Senate Committees on Governmental Affairs and Armed

Services, the House Committees on Government Reform and Oversight

and National Security, and the Director of the Office of Management and

Budget. Copies will be made available to others upon request.

Major contributors to this report are Molly Boyle and Alan Steiner. Please

contact me at (202) 512-9095 if you have any questions on this report.

Sincerely yours,

Lisa G. Jacobson

Director

Defense Financial Audits

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

Comments From the Department of Defense

Page 10 GAO/AIMD-98-16 DOD’s FY 1996 Inventory Reporting
Appendix I 

Comments From the Department of Defense

Page 11 GAO/AIMD-98-16 DOD’s FY 1996 Inventory Reporting
Appendix I 

Comments From the Department of Defense

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