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RESEARCH QUESTIONS

FINANCIAL AUDITS IN THE DEPARTMENT OF DEFENSE: THE VALUE PROPOSITION Douglas A. Brook, Ph.D. American Society of Military Comptrollers Professional Development Institute Orlando, FL 3 June 2010. RESEARCH QUESTIONS. What is the value of financial audits to DoD?

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RESEARCH QUESTIONS

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  1. FINANCIAL AUDITS IN THE DEPARTMENT OF DEFENSE: THE VALUE PROPOSITIONDouglas A. Brook, Ph.D.American Society of Military ComptrollersProfessional Development InstituteOrlando, FL3 June 2010

  2. RESEARCH QUESTIONS • What is the value of financial audits to DoD? • How can financial audits best serve DoD financial and non-financial managers, leaders and decision-makers? • What are the possible next steps in the evolution of financial audits in DoD even as DoD pursues audit readiness and eventual unqualified opinions?

  3. CFO ACT 20TH ANNIVERSARY CFO Act of 1990 • Pilot project included Departments of Army and Air Force 1994 Government Management Reform Act • Expanded CFO Act financial statements to all government departments and agencies, including DoD and all Service Components and mandated consolidated audited financial statement 2002 Accountability of Tax Dollars Act • Expanded CFO Act requirements to all agencies with BA >$25 million 2004 OMB Circular A-136 • Performance and Accountability Reports for GPRA and CFO Act.

  4. MY RECORD FY 1991 Department of the Army Consolidated Financial Statement – disclaimed FY 2007 and 2008 Department of the Navy Financial Statements – disclaimed “The Assistant Secretary of the Navy (Financial Management and Comptroller) acknowledged to us that the Department of the Navy General Fund FY 2008 and FY 2007 Financial Statements would not substantially conform to accounting principles (GAAP) and that DoD financial management and feeder systems were unable to adequately support material amounts on the financial statements as of September 30, 2008.” FY 2007 and 2008 Department of Defense Financial Statement -- disclaimed “The Acting Under Secretary of Defense (Comptroller)/DoD Chief Financial Officer acknowledged to us that the DoD agency-Wide FY 2008 and FY 2007 Financial Statements would not substantially conform to accounting principles (GAAP) and that DoD financial management and feeder systems were unable to adequately support material amounts on the financial statements as of September 30, 2008.”

  5. METHODOLOGY 1. Review of scholarly and practitioner literature and reports from GAO and other government sources. • Examination of uses and users of financial audits in the private sector for comparability • Two roundtable discussions • Representatives from the offices of DoD and service component deputy chief management officers and deputy chief financial officers • Non-DoD CFOs and DCFOs • Grant-Thornton executives with prior experience as government financial officials • Telephone and e-mail interviews with DoD financial management officials 5. Today, we are asking you to participate in a short survey on issues about audited financial statements. [1] [1]

  6. TYPES OF ACCOUNTING IN DoD Financial Accounting: The focus is on the accurate and reliable capturing, recording, categorizing, and presenting of historical events. Managerial Accounting: The focus is on information for internal management decisions about the organization’s mission and scope of operations […]. Budgetary Accounting: Most familiar in government. The process of budgeting, justifying, and accounting for appropriations […].[i] [i]Candreva, P.J., “Accounting for Transformation.” Armed Forces Comptroller 49 (4), (Washington: American Society of Military Comptrollers, 2004): 7-13.

  7. AUDITS: DEFINITION “Auditing is a systematic process of objectively obtaining and evaluating evidence regarding assertions about economic actions and events to ascertain the degree of correspondence between those assertions and established criteria and communicating the results to interested users.” “Auditing is … an assurance service that objectively gathers evidence and communicates to third parties.” Rittengerg, L. E. & Schweiger, B. J. (2005). Auditing: Concepts for a Changing Environment. 5th Edition. Mason, OH: Thomson Southwestern, 4.

  8. AUDITS: PURPOSE The purpose of audits is to “reduce information risk.” Ricchiute, D. N. (2006). Auditing. 8th Edition. Mason, OH: Thomson Southwestern, 2.

  9. VALUE PROPOSITION #1 Financial audits serve to improve stewardship and accountability and perceptions about the quality of agency financial management.

  10. POSITIVE FINDINGS: VALUE PROPOSITION #1 DCAA: “a positive and significant impact attaining and maintaining the public’s trust and confidence.” GAO survey: “Substantial benefits including enhanced accountability and enhanced public perceptions.”][i]U.S. Government Accountability Office, Financial Management: Extending the Financial Statement Audit Requirement of the CFO Act to Additional Federal Agencies, (Washington, DC: GAO, May 14, 2002). AGA survey: “Higher level of accountability” Association of Government Accountants, Scoring Financial Management & Oversight Efforts. (Washington DC: Grant Thornton, LLP, 2007): 8.

  11. VALUE PROPOSITION #2 Financial audits drive improvements in financial management systems, policies and processes to produce more accurate and timely financial information.

  12. POSITIVE FINDINGS: VALUE PROPOSITION #2 DCAA: “improved internal control and reduced material weaknesses, reduced errors and improved data integrity, documentation reliability.” GAO survey: Substantial benefits including: identifying inefficiencies and weaknesses, improved internal control, and monitoring assets and liabilities.] U.S. Government Accountability Office, Financial Management: Extending the Financial Statement Audit Requirement of the CFO Act to Additional Federal Agencies, (Washington, DC: GAO, May 14, 2002). AGA survey: [Audits that] “require closing books, reconciling accounts, tracking assets, valuing inventories and receivables, recognizing long-term liabilities ... bring a discipline that enables a more effective use of resources.”][i]Association of Government Accountants, Scoring Financial Management & Oversight Efforts. (Washington DC: Grant Thornton, LLP, 2007): 8.

  13. VALUE PROPOSITION #3 Audited financial statements provide information for use by internal and external policy-makers, decision-makers, leaders and managers.

  14. MOSTLY NEGATIVE FINDINGS:VALUE PROPOSITION #3 “Financial statements are only important to the CFO and do not register high [with] the agency administrator or Congress .... Financial statements ... are ... not used to manage programs or make key decisions.”][i]Association of Government Accountants, Scoring Financial Management and Oversight Efforts, (Washington, DC: Grant Thornton, LLP, 2007): 12.

  15. TESTING THE PRIVATE SECTOR ANALOGY Who uses audited financial information? What are the uses of audited financial information? What are the main analytical tools employed to understand audited financial statements? Is any of this applicable for DoD?

  16. ACCOUNTING EQUATIONS Corporate: Assets = Liabilities + Shareholder Equity Federal Government: Assets = Liabilities + Net Position

  17. CORPORATE FINANCIAL STATEMENTS Balance Sheet – a snapshot of the enterprise’s assets and liabilities and shareholder equity at the end of the reporting period. It depicts a firm’s resources and the claims on those resources Income Statement – measures operating performance, showing revenues, expenditures and net income (or loss) over the reporting period. Statement of Cash Flow – describing net cash inflows (inflows minus outflows) for operating, investing and financing activities. [i]Clyde P. Stickney, “Financial Statement Analysis,” Security Analysis and Pricing, B3-1-B3-31.

  18. USES AND USERS OF CORPORATE FINANCIAL STATEMENTS Investment decisions Existing and potential investors and lenders, analysts, rating agencies Make decisions about financial participation Business decisions: Existing and potential suppliers, customers, venture partners, competitors, and labor unions Assess the risks, identify opportunities, benchmark their own performance. Evaluate management: Boards of directors, investors, and management Compare performance with peers. Manage financial issues: Boards of directors and management Identify issues of risk and opportunities Identify policy issues: Policy analysts and advocates, politicians, media Data and information

  19. DoD FINANCIAL STATEMENTS ARE SIMILIAR AND DIFFERENT Balance Sheet – a snapshot of the department’s financial position at the end of the fiscal year, depicting assets, liabilities and net position. Statement of Net Cost – depicting the gross costs of operations for the period minus any exchange revenues earned from its activities. Statement of Changes in Net Position – the sum of operations since inception plus unexpended appropriations at the end of the period. Statement of Budgetary Resources – reports the use and availability of budgetary resources at the end of the period.[ i] U.S. Department of Defense, Agency Financial Report for FY 2009, Addendum A: 12.

  20. ARE THERE REALLY COMPARABLE USERS AND USES OF DoD AUDITED FINANCIAL STATEMENTS? Investment Decisions: Is it really possible to think that Congress, the Office of Management and Budget, or taxpayers at large could make use of financial statements to make decisions about putting investments in DoD? Assessment Decisions: Could Congress, OMB and agency leaders really assess the performance of DoD programs and management using audited financial reports? Identifying Financial Issues: Can Congress, OMB and agency leaders use financial statements to identify financial issues? Policy Issues: Can external users such as media, interest groups, policy advocates and internal policy makers in the agency and elsewhere in the government use DoD financial reports to identify policy issues?

  21. EXAMPLE: RATIO ANALYSIS • Liquidity • Short Run LiquidityLiquidity of Current Assets • Current ratio Average collection period • Quick ratio Days inventory held • Cash flow liquidity ratio Days payable outstanding • Cash conversion cycle • Leverage (Financial Leverage Index) • Amount of DebtCoverage of Debt • Debt/assets Times interest earned • Debt/equity Cash interest coverage • Long-term debt/total capitalization Fixed charge coverage • Cash flow adequacy • Operating Efficiency Market Measures • Asset Management • Accounts receivable turnover Earnings per share • Inventory turnover Price/earnings • Accounts payable turnover Dividend payout • Fixed asset turnover Dividend yield • Total asset turnover • Return on total assets • Profitability • MarginsReturns • Gross profit margin Return on total assets • Operating profit margin Return on equity • Net profit margin Cash return on assets • Cash flow margin

  22. RATIO ANALYSIS: LIMITED USE FOR DoD Current ratio: (current assets/current liabilities) measures short term liquidity by assessing the ability of the organization to meet demands for cash as they arise. Debt ratio: (total liabilities/total assets) indicates the ability of the organization to meet its liabilities with assets, and measures the proportion of assets financed by debt. Debt to equity (total liabilities/stockholders equity or total liabilities/net position) measures liabilities against the equity base. Using data in the FY 2008 DoD financial statements we calculate: • Current ratio: ~$480b/$35b = 13.7 • Debt ratio: ~$2.2t/$1.6t = 1.375 • Debt to equity: ~$2.2t/-$.476t = -5.8

  23. CORPORATE ANALOGIES: ASKING THE WRONG QUESTION? Government financial statements have limited external uses or users. “Who uses the financial statements to decide whether to buy Treasury bonds?” Claiming usefulness is “justifying audited financial reporting for all the wrong reasons.” Grant-Thornton Roundtable on Audited Financial Statements, Washington, DC, May 6, 2010. “The Harvard Business Review should have a skull and cross bones stamped on the cover with the warning ‘not to be taken by the public sector’.” Henry Mintzberg, Academy of Management, 1995.

  24. VALUE PROPOSITION #3REVISED Financial audits reduce information risk and provide assurance about the reliability of financial information used by internal and external policy-makers, decision-makers, leaders and managers. “If you can’t trust the data, how can you rely on the analysis?” [i]Grant-Thornton Roundtable on Audited Financial Statements, Washington, DC, May 6, 2010.

  25. RETURNS ON INVESTMENT IN FINANCIAL AUDITS Validation of Financial Audits: The requirement for financial audits continues to have validity “…we have to accept some hard fiscal realities. American taxpayers and the Congress are rightfully worried about the deficit. At the same time, the Department of Defense’s track record as a steward of taxpayer dollars leaves much to be desired.” Gates, Robert, Secretary of Defense, speech at Navy League Sea-Air-Space Expo, National Harbor, MD, May 3, 2010 .

  26. RETURNS ON INVESTMENT IN FINANCIAL AUDITS Audits as a Forcing Function: The requirement for audits drives financial management improvements that would otherwise take longer or not occur at all.

  27. RETURNS ON INVESTMENT IN FINANCIAL AUDITS Audits Support Financial Management Efficiencies: Within the financial management domain, audits can have positive cost-benefit ratios based on savings generated from improved financial operations.

  28. RETURNS ON INVESTMENT IN FINANCIAL AUDITS Financial Audits as a Response to Criticism: Financial audits, with their implications for the quality of internal controls and financial management information systems can play an important role in the Department’s response to criticism.

  29. RETURNS ON INVESTMENT IN FINANCIAL AUDITS Financial audits are not program audits: Considerations of “materiality” and “reasonable assurance” provide a different viewpoint of compliance, risk and performance that support management decisions about investment priorities, and for controlling, justifying and allocating resources. Knubel, John, “Thoughts and Observations Regarding the Current Proven and Future Value of the CFO Act Financial Auditing Process to the Department of the Navy and DoD’s Warfighting Mission,” unpublished paper, April 30, 2010, p. 2.

  30. THE DoD AUDIT CHALLENGE Reach audit readiness and achieve and sustain unqualified audit opinions … while demonstrating value from financial audits.

  31. AUDITED FINANCIAL INFORMATIONAND DoD’s BUDGET CHALLENGE Secretary Gates: “…as the Defense Department begins the process of preparing next year’s Fiscal Year 2012 budget request …The goal is to cut our overhead costs and to transfer those savings to force structure and modernization within the programmed budget.  In other words, to convert sufficient “tail” to “tooth” to provide the equivalent of roughly two to three percent real growth ….  Simply taking a few percent off the top of everything on a one-time basis will not do.   In this environment, reliable and timely audited financial information becomes more important to leaders and managers. Even as the costs associated with audits will be scrutinized. [i

  32. REVISED FIAR PLAN: MOVING IN THE RIGHT DIRECTION Goals: • Achieve and sustain audit readiness by FY 2017 • Implement business or financial systems that resolve material weaknesses • Ensure effective internal controls are in place Process: Focusing on priority information that will better serve the warfighter and DoD decision makers. • (1) budgetary information – status of funds received, obligated and expended – leading to auditability for the Statement of Budgetary Resources (SBR); and • (2) mission-critical asset information – military equipment, real property, inventory, operating material and supplies, and general equipment – leading to a management assertion on existence and completeness (E&C).[i]

  33. LOOKING TOWARD THE FUTUREAUDIT REFORM PROPOSALS Reduced the costs and burdens of compliance. Develop special purpose reports for targeted users Change accounting and audit standards to make them more governmental and tailor audit practices and opinions to the revised standards. [i

  34. RECOMMENDATIONS • DoD should continue its commitment to achieving audit readiness and unqualified audit opinions. • DoD’s financial managers should proactively demonstrate the return on investments in financial audits • DoD financial managers should concentrate on extracting audited financial data and making it available to non-financial managers to help in making key budget, management and policy decisions. • Attention should be given by OMB, Congress and the audit community to reform proposals that reduce the costs and administrative burdens of CFO Act compliance, make information more relevant to users, and conform audit standards and processes more to the governmental sector.

  35. Grant Thornton Contacts Lou Crenshaw VADM USN (Ret) Vice President T 703. 637.4430 E Lou.Crenshaw@gt.com Doug Brook Ph.D. Consultant T 831.373.4975 E dougbrook@hotmail.com Thad Juszczak Director T 703.637.3079 E Thad.Juszczak@gt.com Lisa Fiely Director T 703.373.8720 E Lisa.Fiely@gt.com Global Public Sector 333 John Carlyle Street Suite 400 Alexandria, Virginia 22314 703.837.4400 35

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