The Arms Export Control Act gives the President authority to sell defense articles and services to eligible foreign countries, generally at no cost to the U.S. government. While the Defense Security Assistance Agency (DSAA) has overall responsibility for administering the FMS program, the Army, Navy, and Air Force normally execute the sales agreements—commonly referred to as sales cases. Foreign military sales are made on an individual case basis. The cases are initiated by a foreign country representative sending a letter of request to DOD asking for various information, such as precise price data. Once the customer decides to proceed with the purchase, DOD prepares a Letter of Offer and Acceptance (LOA) stating the terms of the sale for the goods and services being provided. The Arms Export Control Act requires that, after September 30, 1976, letters of offer for the sale of major defense equipment shall include a proportionate amount of nonrecurring costs related to the research, development, and production of major defense equipment. DOD interpreted the act as requiring the recovery of these costs on a pro rata basis. The military services calculate the pro rata rate by dividing the total research and development and other one-time production costs by the anticipated total number of units to be produced for both domestic and foreign use. A separate charge is calculated for each item of major defense equipment and is included in the LOA as part of the price that FMS customers are to pay for the purchase of major defense equipment. After the LOA is accepted, the FMS customer is generally required to pay, in advance, amounts necessary to cover costs associated with the sales agreement, including any nonrecurring costs. These advance payments are held in an FMS trust fund by the Department of the Treasury. DOD then uses these funds to pay private contractors and reimburse DOD activities for the costs of executing and administering the FMS agreement. In addition, as deliveries of major defense equipment occur, the military services are to prepare delivery reports and related cost statements which, among other things, are used as support to charge FMS customers’ trust fund accounts for applicable nonrecurring research, development, and production costs. Nonrecurring costs collected from the FMS trust funds are to be deposited into the general fund of the Treasury. The funds are returned to the Treasury instead of to DOD since the Congress had previously provided DOD with appropriated funds to pay for the research, development, and production costs of major defense equipment. If, for some reason, DOD fails to process the charges to recover applicable nonrecurring costs from the FMS customers’ trust fund, amounts paid in advance to reimburse the U.S. government for nonrecurring costs would eventually be returned to the FMS customer. As deliveries of major defense equipment are made, the military services are to report the detailed delivery and recovery of nonrecurring costs within 30 days to a central accounting activity—the Defense Finance and Accounting Service (DFAS), Denver Center—which maintains records of each country’s trust fund balance and issues quarterly statements to foreign customers summarizing deliveries and amounts charged to their cases. The objective of this assignment was to determine if the Air Force and Navy were correctly recovering nonrecurring research, development, and production costs owed by FMS customers for purchases of major defense equipment. To determine the regulatory requirements for charging and collecting these nonrecurring costs from FMS customers, we obtained and reviewed applicable laws, policies, procedures, regulations, and guidance. During our visits to DOD locations, we gathered and analyzed financial information from pertinent accounting reports and records to identify data on reported deliveries of major defense equipment items and related charges for nonrecurring research, development, and production costs. We judgmentally selected 30 FMS cases for detailed review from a total of 93 Air Force and Navy FMS sales cases listed on their March 1998 reports entitled Recoupment of Nonrecurring Costs on Sales of USG Products and Technology (RCS DSAA (Q) 1112). According to DOD accounting officials, the quarterly reports are to include only ongoing current FMS cases since all nonrecurring costs should be recovered and transferred to the general fund of the Treasury before a case is completed and closed. The reports generally included the country, case, item description, quantity of items to be sold, scheduled delivery dates, quantity of items delivered to date, amount of nonrecurring research, development, and production costs to be collected, and amount of nonrecurring research, development, and production costs collected to date. We selected the 30 FMS cases for detailed review based on whether the unrecovered amount of nonrecurring research, development, and production costs was large and whether the report showed, among other things, that (1) items had been delivered to the customers, but that there had been little or no recovery of nonrecurring costs or (2) scheduled delivery dates were for March 1998 or earlier and no or few deliveries had been made. The 30 FMS cases accounted for about $266 million (40 percent) of the two services’ total unrecovered nonrecurring research, development, and production costs of over $655 million. For the selected cases, we contacted the staff responsible for managing the case or other responsible officials knowledgeable about the case, to determine the (1) quantity of items to be delivered, (2) quantity of items delivered to date, (3) total amount of nonrecurring costs to be recovered, and (4) total amount of nonrecurring costs recovered to date. We also asked the staff to provide an explanation for why nonrecurring research, development, and production costs that should have been recovered earlier had not yet been recovered. The dollar values of nonrecurring research, development, and production costs related to major defense equipment items discussed in this report were obtained from DOD reports or responsible program officials. We did not independently verify these costs. We performed our work at the headquarters, departments of the Navy and Air Force; Defense Security Assistance Agency; Office of the Under Secretary of Defense (Comptroller), Washington, D.C.; Naval Air Systems Command, Patuxent River, Maryland; Naval Sea Systems Command, Arlington, Virginia; Air Force Aeronautical Systems Center and Air Force Security Assistance Center, Wright Patterson Air Force Base, Dayton, Ohio; and the Defense Finance and Accounting Service centers in Denver, Colorado, and Columbus, Ohio. We performed our work between February 1998 and August 1998 in accordance with generally accepted government auditing standards. We requested written comments on a draft of this report from the Secretary of Defense or his designee. The Under Secretary of Defense (Comptroller) provided written comments. These comments are discussed in the “Agency Comments and Our Evaluation” section and throughout the report where appropriate and are reprinted in appendix I. We found that the Air Force and Navy were not following prescribed policies and procedures for reporting the delivery of items to FMS customers in order to recover the nonrecurring research, development, and production costs. As a result, FMS customers’ trust fund accounts were not being charged for millions of dollars of these costs for major defense equipment items they had received. Volume 15 of DOD’s Financial Management Regulation 7000.14-R, entitled Security Assistance Policy and Procedures, states that “Charges for nonrecurring costs are earned as items are physically delivered to the FMS customer.” It also requires that deliveries be reported to DFAS Denver within 30 days of shipment. While the DOD policy is not specific about the length of time after delivery during which an activity is to charge an FMS customer’s trust fund account for the nonrecurring costs, responsible DOD accounting officials told us that the nonrecurring costs should be recouped as items are delivered. According to the DOD accounting officials, DOD activities should prepare the delivery report, recover the nonrecurring costs, and submit both the delivery and recovery of costs data to DFAS Denver within 30 days of shipment of the items. Therefore, DOD policy recognizes delivery reporting as a key step toward initiating the charges to recover nonrecurring costs from FMS customers’ trust funds. The following describes what generally should be a typical transaction flow to report the delivery of major defense equipment and recovery of nonrecurring research, development, and production costs. The military service program office is generally responsible for reporting the delivery of items as they are made. It also prepares a cost statement, which serves as the supporting documentation for recording earnings, and forwards these data along with the delivery report to its budget or finance office. The budget or finance office reviews the information and reports the delivery to DFAS Denver. The budget or finance office also attaches a letter to the cost statement requesting that the area accounting office prepare a voucher to collect the nonrecurring costs. The letter and cost statement are then forwarded to the area accounting office for processing. The area accounting office processes the transaction to charge the FMS trust fund and transfer the amount to the general fund of the Treasury and reports the transaction to DFAS Denver, which records the charge against the FMS customer’s trust fund account. DOD’s reports on nonrecurring costs for current sales cases show that as of March 1998, the Air Force and Navy had over $655 million of nonrecurring research, development, and production costs for major defense equipment sales that had not been recovered from FMS customers. Our analysis and discussions with program officials concerning $266 million of this amount found that at least $183 million of the reported outstanding nonrecurring costs was related to equipment that had been delivered, and therefore, should have already been recovered from the FMS customers’ trust fund accounts and deposited in the general fund of the Treasury.