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Auditing the Defense Department: A primer

May 11, 2018

The Department of Defense (DoD) has a major financial audit initiative underway.

The following Q&A can help anyone who wants to get up to speed on DoD accounting and auditing issues.  

 

Why should anyone care about this?

Our government owes the people an accurate and complete annual accounting of how their money is spent. Right now, that's not possible, mainly because of the DoD.

The DoD states that its mission is to protect the security of our country. Its annual budget, funded by our taxes, runs more than $600 billion. Counting other national security-relevant government operations, annual spending rises to more than $1 trillion a year.

Securing the productive and efficient use of national security resources should be a high priority for our government. But the DoD has effectively flunked its financial audit every year for the last 20 years.

In turn, the U.S. Government Accountability Office (GAO) has delivered disclaimers of opinion on the federal government’s overall financial statements every year for two decades as well, citing deficiencies in DoD accounting as a key reason for those disclaimers.

In the United States of America, this just doesn’t make sense.

 

Does the word “account” appear in the United States Constitution?

Yes, it does, in one of the most important provisions: the Statement and Account Clause appears in Article I, Section 9, Clause 7.  This clause states “No Money shall be drawn from the Treasury, but in Consequence of Appropriations made by Law; and a regular Statement and Account of the Receipts and Expenditures of all public Money shall be published from time to time.”

 

Why is the Statement and Account Clause so important?

The DoD is in the executive branch of the U.S. Government. But the Statement and Account Clause appears in Article I, relating to the powers and responsibilities of the Congress. The Statement and Account Clause is part of the “power of the purse” in Congress, one of the critical elements of the checks and balances that should secure accountability under our Constitution.

Writing in Federalist No. 58, James Madison said “This power over the purse may, in fact, be regarded as the most complete and effectual weapon with which any constitution can arm the immediate representatives of the people, for obtaining a redress of every grievance, and for carrying into effect every just and salutary measure.”

Writing in 1833, in his Commentaries on the Constitution, Joseph Story stated “… In arbitrary governments the prince levies what money he pleases from his subjects, disposes of it, as he thinks proper, and is beyond responsibility or reproof. It is wise to interpose, in a republic, every restraint, by which the public treasure, the common fund of all, should be applied, with unshrinking honesty to such objects, as legitimately belong to the common defence, and the general welfare. Congress is made the guardian of this treasure; and to make their responsibility complete and perfect, a regular account of the receipts and expenditures is required to be published, that the people may know, what money is expended, for what purposes, and by what authority.”

Writing in 2013, in the Yale Law & Policy Review, in her article The Statement and Account Clause: A Forgotten Constitutional Mandate for Federal Reporting, Katherine Clark Harris stated “The Statement and Account Clause was intended to provide the public with a complete understanding of the government's ‘receipts and expenditures.’ Accurate reporting is not necessary merely for responsible fiscal management; it ensures that the citizenry is informed about government spending priorities and that public officials are accountable to the people. … the Clause was intended to create transparency and accountability, ensure congressional oversight over the fisc, and prevent corruption.”

 

What is accounting, and why does it matter?

Accounting is the process of recording, summarizing, assessing, interpreting, and communicating financial information.   

Organizations produce goods and services. To do so, they have to get money in the door, and then put it to work. Accounting provides tools for measuring and communicating financial information, including information about the costs and resources for producing whatever goods and services the organization provides. Good accounting lowers costs, improves productivity, and inspires trust in capital providers.

 

Why is accounting called “the language of business?”

Accounting is called the language of business because it helps people, both internal and external, communicate and understand what is happening inside of a business. Just as language is universal to people, so is accounting in business.

“The language of business” can provide a great phrase. But accounting isn’t just a “business” thing. Accounting should also be the language of government. Indeed, accounting is language for all organized human endeavor.

 

If we are talking about “accounting,” what is an “account?”

As a noun, the definition for the word “account” includes the following: “an oral or written description of particular events or situations; narrative,” “an explanatory statement of conduct, as to a superior,” “estimation; judgment,” “an amount of money deposited with a bank, as in a checking or savings account,” and “a statement of financial transactions.”

 

Why do the words “accounting” and “accountability” share common roots?

As a verb, the definition for “account” includes the following: “to give an explanation,” “to answer concerning one's conduct, duties, etc.,” and “to provide a report on money received, kept, and spent.” And as a noun, an account is also called “an explanatory statement of conduct, as to a superior.” Accounting helps ensure the accountability of organizations and leaders in faithfully living up to their duties to others.

 

What is an audit?

Dictionary definitions of “audit” include “an official examination and verification of accounts and records, especially of financial accounts” (as a noun) and “to examine and verify an account or accounts by reference to vouchers” (as a verb).

There are different types of audits. For example, there are performance audits and financial audits. Performance audits assess the stewardship of programs, while financial audits review, assess and verify financial statements.

Audits can also be characterized as internal or external. The new DoD audit initiative blends internal as well as external characteristics. For example, the DoD is retaining (paying) private sector accounting firms for their services in its new exhaustive (and expensive) audit initiative.

 

Why are financial statements audited?

Organizations prepare financial statements to demonstrate their accountability to parties to whom they owe duties, including their sources of financing. These statements are based on relevant standards that apply to the organization. Over time, law and practice have seen fit to have independent third-party auditors certify the representations in financial statements, in the private sector as well as in government.

After investigating and reviewing the processes and underlying information for the financial statements, the independent auditor delivers an opinion as to whether or not those statements “fairly represent” the entity, and (for GAAP-based standards) whether they are “in conformance with generally accepted accounting principles.”

 

Who establishes generally accepted accounting principles (GAAP)?

There are three main sources of GAAP in the United States. The Financial Accounting Standards Board (FASB) develops standards for GAAP in the private sector.  The Governmental Accounting Standards Board (GASB) develops GAAP for state and local governments.

For both FASB and GASB, however, the fundamental underlying statutory authority lies with the Securities and Exchange Commission (SEC) under the federal securities laws.

Historically, the American Institute of Certified Public Accountants (AICPA) set accounting standards, subject to SEC regulations. The FASB was formed in 1973 and the GASB in 1984, both of which are under the umbrella of the private, not-for-profit Financial Accounting Foundation. But the SEC retains statutory authority for GAAP.

The Financial Accounting Standards Advisory Board (FASAB) was formed in 1990 to develop accounting standards for the federal government. FASAB was formed in an agreement between the Treasury Secretary, the Director of the Office of Management and Budget, and the Comptroller General of the United States.  Federal government “GAAP” is not a responsibility of the SEC.

There are other non-GAAP accounting standard-setters in the United States.  One of them is very interesting. The Federal Reserve Board of Governors sets the accounting standards for the Federal Reserve Banks. The consolidated balance sheet for those banks reported $4.4 trillion in assets at the end of 2017.

 

What are financial statements?

Financial statements provide information about the performance, stewardship, and condition of an organization. Two of the main types of financial statements are the income statement (covering performance over a period of time), and the balance sheet (representing the financial condition at a point in time).

From a stewardship perspective, an income statement can provide guidance whether an organization is living with its means, while the balance sheet can help users understand the cumulative consequences of past performance.

 

What is an income statement?

An income statement sums revenue, then sums and subtracts expenses, leading to a bottom line called (in the private sector) “net income.”

In state and local governments, this statement is called the Statement of Activities.  In it, officials report expenses, nets them against fee and grant revenue to arrive at Net Expenses, and then subtracts general revenues (taxes) to arrive at a bottom line called Change in Net Position.

For the federal government, the income statement is called the Statement of Operations and Changes in Net Position.  The basic structure starts with sources of revenue (overwhelmingly individual income tax and tax withholdings) then subtracts Net Cost to arrive at Net Operating (Cost) Revenue.

 

What is a balance sheet?

A balance sheet is a financial statement that shows a company’s financial position at the end of the accounting period. The balance sheet has three main sections. It sums “assets,” then sums and subtracts “liabilities,” leading to a bottom section called “capital,” “equity,” or (in government) the “net position.”

In its latest fiscal year, the federal government’s balance sheet listed $3.5 trillion in assets, and $23.9 trillion in liabilities.  It did not include unfunded Social Security and Medicare obligations running in the tens of trillions of dollars among those reported liabilities.

Introducing the balance sheet, the latest Financial Report of the U.S. Government included the following text: “There are, however, other significant resources available to the Government that extend beyond the assets presented in these balance sheets. Those resources include Stewardship Land and Heritage Assets in addition to the Government’s sovereign powers to tax and set monetary policy.”

The Financial Report of the U.S. Government may overstep its bounds in this statement, however, under a Constitution that begins with the three words “We the People.”

 

Where do you find the financial statements of the U.S. Government?

The financial statements of the U.S. Government are included in the Financial Report of the U.S. Government. This report has been prepared in its modern format since the late 1990s. That report also includes the auditor (GAO) opinion on the financial statements.

 

Who audits the financial statements in the Financial Report of the U.S. Government?

The Government Accountability Office is the auditing arm of the U.S. Congress, and is led by the Comptroller General of the United States.

 

What are the main types of opinions that auditors deliver on financial statements?

Under current practice, auditors issue one of four types of opinions:  unmodified, modified, adverse or a disclaimer of opinion.

  • An “unmodified” opinion is given when the financial statements are presented fairly in all aspects of GAAP and there are no material internal control deficiencies.  This is also called a clean opinion. 
  • A “modified” opinion may be given when the auditor believes most of the financial statement are presented fairly.
  • An “adverse” opinion is made by an auditor when the statements are not presented fairly or in accordance with GAAP.  
  • A “disclaimer of opinion” is given when the auditor is not able to collect sufficient evidence to provide an opinion because of major internal control deficiencies. In some ways, this can be even worse than an adverse or “flunk” opinion.

 

How clean are “clean” opinions?

Clean opinions can also be dirty opinions if generally accepted accounting principles lead to misleading reports.

And unmodified opinions may not be very clean if the auditor doesn’t do a good job. Enron received an unmodified opinion from its auditor (Arthur Andersen) soon before its share price collapsed in 2001, for example.

In the measured words of a 2013 report of the Congressional Research Service, “Across the CFO agencies, the increase in numbers of unqualified audit opinions reflects the general trend over time, but these overall opinions may be only partially revealing. Unqualified overall audit opinions can obscure material weaknesses that underlie systematic financial management issues.”

A clean audit opinion should not be the main goal for government agency financial reporting. The overarching goal for DoD and general government financial reporting should be reliable, accurate, and effective internal controls and reporting systems. Working towards a clean opinion may serve as a means to that end, but a clean opinion is not the fundamental goal.

 

Who audits the financial statements for the Department of Defense?

The DoD Office of Inspector General (IG) is responsible for the audits of the financial statements prepared by the military branches, as well as the consolidated statements for the overall DoD. While the IG is responsible for these audits, it retains private sector accounting firms to conduct those audits.

There is another layer involved, however. The Army, Navy and Air Force also prepare Schedules of Budgetary Activity.  These statements are also audited by independent public accounting firms. 

 

What opinions have the DoD Inspector General delivered on the annual financial statements of the DoD?

The DoD Inspector General has delivered a disclaimer of opinion on the DoD financial statements every year, consistently, for the last two decades.

 

What opinions has the GAO delivered on the annual financial statements of the U.S. Government?

The GAO has delivered a disclaimer of opinion on the U.S. Government’s financial statements every year, consistently, for the last two decades, citing most prominently material weaknesses and poor internal controls in the DoD.

 

What did the GAO say in its latest opinion on the federal government’s financial statements?

The Comptroller General’s letter accompanying the Financial Report of the U.S. Government was addressed to the President of the United States, the President of the U.S. Senate, and the Speaker of the House of Representatives. It included the following statement: “Certain material weaknesses in internal control over financial reporting and other limitations on the scope of our work resulted in conditions that prevented us from expressing an opinion on the accrual-based consolidated financial statements.” Material weaknesses at the Defense Department have played a material role in the GAO’s annual disclaimer of opinion.

 

What does the GAO define as a “material weakness?”

The latest Comptroller General letter included the following statement: “A material weakness is a deficiency, or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the entity’s financial statements will not be prevented, or detected and corrected, on a timely basis.”

 

What does the GAO define as a “deficiency in internal control?”

The latest Comptroller General letter says that “A deficiency in internal control exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent, or detect and correct, misstatements on a timely basis.”

 

What is worse, a “material weakness” or a “significant deficiency?”

A material weakness, apparently. A 2017 GAO report on DoD audit readiness noted “A significant deficiency is a deficiency, or a combination of deficiencies, in internal control that is less severe than a material weakness, yet important enough to merit attention by those charged with governance.”

 

 
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