The CFO Act of 1990 requires DOD and other agencies covered by the act to improve their financial management and reporting operations. One of its specific requirements is that each agency CFO develop an integrated agency accounting and financial management system, including financial reporting and internal controls. Such systems are required to comply with applicable principles and standards and provide for complete, reliable, consistent, and timely information needed to manage agency operations. Beginning with fiscal year 1991, the CFO Act required agencies, including the Navy, to prepare financial statements for their trust and revolving funds, and for their commercial activities. The CFO Act also established a pilot program under which the Army and Air Force, along with eight other federal agencies or components, were to test whether agencywide audited financial statements would yield additional benefits. The Congress concluded that agencywide financial statements contribute to cost-effective improvements in government operations. Accordingly, the Government Management Reform Act of 1994 made the CFO Act’s requirements for annual audited financial statements permanent and expanded it to include virtually the entire executive branch. Under this legislative mandate, DOD is to annually prepare and have audited DOD-wide and component financial statements beginning with fiscal year 1996. The Office of Management and Budget (OMB) has designated Navy and the other military services as “components” that will be required to prepare financial statements and have them audited. Because the Navy was not one of the pilot agencies, fiscal year 1996 was the first year for which it was required to prepare agencywide financial statements for its general funds. In October 1990, the Federal Accounting Standards Advisory Board (FASAB) was established by the Secretary of the Treasury, the Director of OMB, and the Comptroller General to consider and recommend accounting standards to address the financial and budgetary information needs of the Congress, executive agencies, and other users of federal financial information. Using a due process and consensus-building approach, the nine-member Board, which, since its formation has included a member from DOD, recommends accounting standards for the federal government. Once FASAB recommends accounting standards, the Secretary of the Treasury, the Director of OMB, and the Comptroller General decide whether to adopt the recommended standards. If they are adopted, the standards are published as Statements of Federal Financial Accounting Standards (SFFAS) by OMB and by GAO. In addition, the Federal Financial Management Improvement Act of 1996, as well as the Federal Managers’ Financial Integrity Act, requires federal agencies to implement and maintain financial management systems that will permit the preparation of financial statements that substantially comply with applicable federal accounting standards. For fiscal year 1996, the Navy prepared two separate sets of statements: one for its operations financed with general funds and another for operations financed using funds provided through the Defense Business Operations Fund (DBOF). The Defense Finance and Accounting Service-Cleveland Center supported the Navy in preparing the fiscal year 1996 financial statements for activities financed by general funds and DBOF. The Navy’s general fund financial statements encompassed those operations financed through 24 general fund accounts. These general funds included moneys the Congress appropriated to the Navy to pay for related authorized transactions for periods of 1 year, multi-years, or on a “no-year” basis. The Navy’s DBOF business activities are financed primarily through transfers from the Navy’s Operations and Maintenance appropriations, based on the costs of goods and services to be provided. The Navy has historically operated many supply and industrial facilities using a working capital fund concept. In fiscal year 1996, the Navy’s business activities comprised the largest segment of DOD’s support operations financed through DBOF. The DOD Inspector General delegated responsibility for auditing Navy’s fiscal year 1996 financial statements to the Naval Audit Service. By agreement with the DOD Inspector General, the Naval Audit Service’s fiscal year 1996 audit encompassed two separate efforts, both limited to the Navy’s Statement of Financial Position and related footnotes. The audit resulted in one set of reports focused on the Navy’s financial statement reporting for its operations financed using general funds and one overall report summarizing the results of its review of the Navy’s DBOF-financed operations. The set of general fund reports included an overall auditor’s opinion report, an overall report on internal controls and compliance with laws and regulations, and eight other more detailed supporting reports. Appendix I shows the status of Navy entities’ financial statement audits in fiscal year 1996. Appendix II provides a complete listing of the Naval Audit Service reports issued as a result of its fiscal year 1996 financial statement audit efforts. The objectives of this report were to (1) analyze the extent to which financial deficiencies detailed in the auditors’ reports may adversely impact the ability of Navy and DOD managers and congressional officials to make informed programmatic and budgetary decisions, (2) provide examples of other issues of interest to budget and program decisionmakers that can be identified by reviewing the financial statements, and (3) describe the additional financial data that, if complete and accurate, could be used to support future decision-making when the Navy implements accounting standards that are effective beginning with fiscal years 1997 and 1998. To accomplish these objectives, we obtained and analyzed the Naval Audit Service’s opinion report and other supporting reports resulting from its examination of the Navy’s fiscal year 1996 financial statements to identify data deficiencies and determine their actual or potential impact on Navy programmatic or budgetary decision-making. To do this, we compared the Naval Audit Service’s audit results with the findings and related open recommendations in our previous reports that discuss the implications of Navy’s financial deficiencies. We also obtained additional details on the Naval Audit Service’s findings through discussions with cognizant Naval Audit personnel, and we discussed the status of our previous findings and recommendations with cognizant Navy and DFAS personnel. Further, we independently reviewed Navy’s financial statements to identify other issues of interest to budget and program decisionmakers, particularly those areas that may indicate the need for future budget resources or that may provide the opportunity to reduce resource requirements. Finally, we analyzed recently adopted federal accounting standards to identify areas where Navy program and budget managers will have additional useful information available to support decision-making, if the standards are effectively implemented as required. Our work was conducted from December 1997 through February 1998 in accordance with generally accepted government auditing standards. We requested comments on a draft of this report from the Secretary of Defense or his designee. On March 9, 1998, the Principal Deputy Under Secretary of Defense (Comptroller) provided us with written comments, which are discussed in the “Agency Comments and Our Evaluation” section and are reprinted in appendix III. To an even greater extent than the other military services, the Navy has been plagued for years by troublesome financial management problems involving billions of dollars. For example, our 1989 report on the results of our examination of Navy’s fiscal year 1986 financial reporting detailed numerous problems, such as understating the value of Navy’s assets by $58 billion, that we attributed to carelessness and the failure to perform required rudimentary supervisory reviews and reconciliations. Seven years later, we found that such problems persisted. In our reporton the Navy’s fiscal year 1994 financial reporting, we reported that the Navy had not taken advantage of the 5 years that had passed since the enactment of the CFO Act or the experiences of its counterparts, the Army and the Air Force, in preparing financial statements. Our report identified a minimum of $225 billion of errors in the $506 billion in assets, $7 billion in liabilities, and $87 billion in operating expenses reported to the Department of the Treasury in the Navy’s fiscal year 1994 consolidated financial reports. Consequently, we concluded that the Navy and DFAS had to play “catch up” if they were to successfully prepare reliable financial statements on the Navy’s operations. Most recently, the Naval Audit Service’s April 1997 report on the results of its audit of the Navy’s fiscal year 1996 financial reporting disclosed that errors, misstatements, and internal control weaknesses continued. A number of the financial data and control deficiencies disclosed in the Naval Audit Service’s reports not only adversely affect the reliability and usefulness of the Navy’s financial reporting but also have significant programmatic or budgetary implications. Our analysis of the auditors’ reports, along with additional examples from our own audit work, is provided in the following sections. The Naval Audit Service report on the results of its financial audit of the Navy’s fiscal year 1996 financial statements disclosed numerous problems with inventory data reported by the Navy, including the following. “The Department of the Navy did not report an estimated $7.8 billion in Operating Materials and Supplies items aboard ships or with Marine Corps activities on the FY 1996 Statement of Financial Position.” We previously reported that DOD has spent billions of dollars on inventory that is not needed to support war reserve or current operating requirements and burdened itself with managing and storing the unneeded inventory. The financial reporting error disclosed by the Naval Audit Service has implications for the budget process because the inventory data used both for the financial statements and as the starting point for the Navy’s process to develop budget requests for additional inventory are incomplete. A Stratification Report is used to prepare data on the quantity and value of the Navy’s inventories, such as operating materials and supplies, included in the Navy’s financial statements. It is also used as the starting point to forecast budget requirements for inventories that will be needed in supply warehouses. To determine Navy-wide inventory requirements, responsible managers must also have accurate, reliable information on the quantities of inventories on ships, including any quantities in excess of needs. However, the auditors found that information on $7.8 billion in inventories, including those on board ships was not included in the Navy’s year-end financial statements.