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Audited financial statements identifying uses and users: the private sector relies on financial statements, reports, and analyses to make sound financial decisions. Can the same hold true for Department of Defense financial managers?

In fiscal year (FY) 2011, 23 of the 24 major federal agencies achieved auditability on their annual financial statements. Twenty-one achieved unqualified (clean) audit opinions; two received qualified opinions. The Department of Defense (DoD) is the only remaining Cabinet-level department with a disclaimer from its auditors. At the same time, DoD's Financial Improvement and Audit Readiness Plan and the DoD Components' Financial Improvement and Audit Readiness Plan (FIAR) are driving to meet the FY 2010 National Defense Authorization Act requirement for auditability by 2017, as well as Secretary Leon Panetta's goal for auditability of the Statement of Budgetary Resources by 2014.

Prior research into the value of audited financial statements has shown that most of the value has come inside the financial management domain. Improvements in financial systems, policies, and processes--along with better internal controls--have resulted in financial management that is compliant with the Chief Financial Officers (CFO) Act and Federal Managers' Financial Integrity Act, including more timely and reliable financial information. Financial managers have enjoyed the reputation and benefits, since clean audit opinions serve as proxies for good financial management. (1) At the same time, the audits themselves have had value in forcing the establishment of good financial management practices and reducing information risk to users of financial information. (2)


The question that remains, however, centers on the value of financial statements and the related financial information to nonfinancial managers. The fundamental aspect is who are the users and what are the uses of the financial statements? As the DoD moves toward auditability, this will become an important question as the Department seeks to maximize the benefits from its sizeable investment in achieving auditability. To help address the issue, it is important to assess the private sector analogy and then look to other federal agencies to determine who the users are and how financial statements and financial information have been used. Let's first look at the private sector for similarities to the DoD.

The Private Sector Analogy

Arguments for CFO Act financial statements drew heavily on private sector requirements and analogies. Exploring the private sector analogy can help determine whether government and corporate financial statements are comparable in their uses and users and whether private sector types of financial analysis can provide meaningful information for the DoD.

Comparing Financial Statements

The relationship between business activities and their associated financial reports is depicted in Figure 1.


It is clear from the diagrams in Figures 1 and 2 that the governmental financial statements can be reconstructed, or forced, into a private sector model using identical categorical terminology. But differences are certainly apparent. Investing and financing contain rather dissimilar elements, operating results need to be translated into net operating costs, and the balancing entry in the balance sheet becomes net position rather than the residual value for shareholders.

Comparing Uses and Users

The users of audited financial statements in the commercial sector are external to the enterprise. Potential investors, buyers, suppliers, customers, and employees can use a company's financial statements to make investment decisions, assess the performance of management, identify financial strategies and assess financial condition and, sometimes, surface policy issues.

Is there a list of similar uses and users for audited financial statements in federal agencies or could one be developed? For instance:

* Investment Decisions: Is it possible to think that the Congress, the Office of Management and Budget (OMB), or taxpayers at large could use financial statements to make decisions about putting investments, in the form of additional appropriations, into a particular department or agency based on its audited financial report? What kind of budgetary and appropriations decisions would be influenced by audited financial reports?

* Assessment Decisions: Could the Congress, OMB, and agency leaders assess the performance of agency programs and management using the information in audited financial reports? Do audited financial statements reflect agency performance?

* Identifying Financial Issues: Can the Congress, OMB, and agency leaders use financial statements to identify issues such as long-term liabilities or stewardship over assets? How can changes in net position be interpreted?

A comparable relationship between various governmental activities and their associated governmental financial statements is shown in Figure 2.


* Policy Issues: Do external users such as the media, interest groups, policy advocates, and internal policy makers in the agency and elsewhere in the government use financial reports to identify policy issues? What kinds of policy issues are reflected in audited financial statements?

There is little evidence that any of these analogous uses and users currently exist. Nevertheless, if there is a potential for such efforts in the Federal Government, the challenge for financial managers may be to determine how best to present and analyze financial information from the financial statements that can serve those uses and users. There isn't one right answer at the moment, but let's explore a couple of alternatives.

Ratio Analysis

Ratio analysis is widely used by analysts in the private sector to understand a firm's financial condition. The analysis focuses on five categories: liquidity, leverage, operating efficiency, profitability, and market measures. (5) Most of the ratios are designed for commercial enterprises and are not applicable to government organizations. Three, however, merit a closer look:

* 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 ratio (total liabilities/stockholders equity or total liabilities/net position) measures liabilities against the organization's equity base.

Using data in the FY 2010 DoD financial statements, I calculate these ratios as:
Current ratio:                     -$522b/$31b       =16.8
Debt rat:                         -$2.3t/$1.9t      =  1.21
Debt-to-equity ratio:           -$2.3t/-$.392t      = -5.87

From these ratios one might conclude that the DoD has more than sufficient resources to meet daily demands, but that its longer-term financial health is less strong. A positive current ratio may be good news for employees, vendors, or suppliers because there are resources available to pay them. But a negative debt-to-equity ratio may be less reassuring to investors (for example, Congress, OMB, or taxpayers) who might have to share the burden of future liabilities. The Department could not retire its liabilities even if it devoted the entirety of its assets to the effort. Instead, additional appropriations in the future are required in order to meet recognized liabilities.

The Department's FY 2008 financial report provides a glimpse of the extent of this problem: Only $441 billion or 21 percent of liabilities are currently covered by budgetary resources; $1.6 trillion for liabilities, such as military retirement and health benefits and environmental liabilities remains unfunded. (6) This is the type of information that agency leadership, the OMB, and the Congress could and perhaps should address in planning efforts.


In a commercial financial statement, one might look at shareholders' equity for useful information. Is there an analogous analysis that can be applied to considerations of net position in government financial statements? Net position represents cumulative results from operations plus unexpended appropriations. The calculation of net position and shareholder equity in the balance sheets of private and Federal Government organizations is shown in Figure 3.


An analysis of the net position of DoD reporting entities (Table 1) reveals that all except the retirement funds have positive net positions. The DoD's negative net position derives from the unfunded liabilities in the Medicare-Eligible Retiree Health Fund (MERHF) and the Military Retirement Fund (MRF). This is useful information for investors (that is, Congress), as investments (appropriations) into these funds would be required to reduce the DoD's unfunded liabilities and negative net position.
Table 1. Net Position of DoD Reporting Entities (7)

                                           2008        2007

Department of the Army                  252,474     192,959

Department of the Navy                   357,301    331,076

Department of the Air Force              277,193    260,785

Defense Contract Audit Agency                 19         13

Defense Finance & Accounting Service         277        326

MERHF                                  (366,709)  (407,796)

MRF                                    (901,021)  (810,603)

Office of Inspector General, DoD              7           5

US Army Corps of Engineers                   43          40

When reviewing an equity position, one might also look at changes in net position. Between FY 2007 and FY 2008, the DoD's net position improved by 12 percent. How was this achieved and what does improvement in net position really mean? A review of the Statement of Changes in Net Position indicates that the changes were widely distributed among the cumulative results from operations and unexpended appropriations. No single explanation is apparent.

Does this have financial policy implications? Should elimination of negative net position be a financial goal for the DoD? As we approach the attainment of DoD auditable financial statements, these questions should be considered by managers and leadership. The Department is certainly different from the private sector, but we do share similarities with other federal agencies. Let's explore how those agencies have utilized their audited financial information.

Financial Information in the Federal Government

If the private sector does not provide an analogous comparison of uses and users of audited financial statements, what kind of financial information is needed for the Federal Government? An article by I.T. David suggests that there is a hierarchy of financial needs:

* Budget Information--perhaps the most important financial information for any federal official is the amount of money available for obligation or expenditure.

* Status of Funds--knowing how much of the budgeted funds are available for obligation (or expenditure) at any time--the status of funds or budget execution.

* Financial Information--financial information needed by the policy, program, and operating officials for day-to-day management, monitoring, and decision making, such as information on individual accounts, assets, liabilities, etc.

* Cost Management Information--details on how federal entities use resources to manage their organizations, programs, projects, and services.

* Cost/Performance Information--the relationship of program results with the cost of providing those results. (8)

From the previous analysis and from the preceding list, it appears that financial statements themselves may not be as important to some users as the underlying financial information that is derived from systems and processes that produce timely and accurate data. If this is the case, it is instructive to see what the other federal agencies are saying about the use of financial information from their financial statements.

An examination of the financial reports and performance and accountability reports from the 24 major federal agencies indicates some assertions that financial information related to the financial statements is being used by managers and policy makers. For instance, the Small Business Administration states, The [principal financial] statements are used, along with other financial reports, to monitor and control budgetary resources." (9) The Agency for International Development reports, "Preparing the Agency's financial state ments creates the opportunity to improve financial management and provide accurate, reliable information that is useful for assessing performance and allocating resources. (10) The Department of Education says, The Department consistently produces accurate and timely financial information that is used by management to inform decision making and drive results in key areas of operation." (11) The Social Security Administration explains, "The [financial) statements are in addition to the financial reports used to monitor and control budgetary resources, which are prepared from the same books and records." (12)

These claims from non-DoD agencies suggest there are uses and users for the financial information that is associated with the agency financial statements. It also shows that timely and accurate financial information and reports are key to agency management's decision processes. The value to policy makers and managers, then, is not in the financial statement itself but in financial information. If so, the challenge for financial managers then must be to find ways to extract and report financial information from the financial statements in ways that are useful to nonfinancial users. In the words of one senior Pentagon financial manager, "I am more encouraged than ever that we can take the balance sheet and make it highly informative to leadership so long as we interpret the data and not make them read the statements themselves. (13)


In examining the uses and users of private sector financial statements and other financial analysis to the Federal Government, the conclusion is that the private sector analogy has limited utility for the Federal Government. While making good and proper use of financial information associated with financial statements remains a challenge within the Federal Government, federal managers definitely value valid and timely financial information.

Although auditable financial statements are important, the OMB has clarified the role of federal financial reporting by noting, "Financial reporting is not the only source of information to support decision making and accountability. Neither can financial reporting, by itself, ensure that the government operates as it should. Financial reporting can, however, make a useful contribution toward those objectives." (14)

The analysis suggests that the emerging challenge in the evolution of federal agency financial reporting is to establish capabilities that utilize the underlying data supporting the financial statements. One result could be the development of government-specific analytical tools and identification of special reports and other information for policy makers and managers to use in decision making. Although there is much yet to be done to achieve DoD auditable financial statements, we all should be thinking now about how the data will be used in the future to help manage organizations. The author gratefully acknowledges the research support provided by Sarah Martin, MBA, and Lieutenant Commander Rex Aman, research assistant and student, respectively, at the Naval Postgraduate School. Thanks also for the technical assistance from faculty colleagues at NPS: John Mutt), and Danny Matthews.



(1.) Douglas A. Brock. "Exploring the Value of Financial Statement Audits," Journal of Government Financial Management, Winter 2011: 38-43.

(2.) Douglas A. Brook, "Audited Financial Statements In the Federal Government: Intentions, Outcomes and On-Going Challenges for Managers and Policy-Making." Journal of Public Budgeting, Accounting and Financial Management, vol. 22, no. I (Spring 2010): 52-83.

(3.) Adapted from C. P. Stickney, C. P., Financial Statement Analysis. (Mason. OH: Thompson Learning South-Western 2001), U.S. Securities and Exchange Commission, Beginners' Guide to Financial Statements. (On-line). Available at (Retrieved October 26. 20071: Motley Fool. Statement of Shareholders' Equity [On-line]. Available at http:/'_equity. (Retrieved February 18, 20111.

(4.) Constructed from C. P. Stickney, C. P., Financial Statement Analysis. (Mason, OH: Thompson Learning South-Western 2001); U.S. Securities and Exchange Commission, Beginners' Guide to Financial Statements. (On-line). Available at, (Retrieved Octuber 26, 20011; Motley Fool. Statement of Shareholders' Equity. [On-line]. Available at'equity (Retrieved February 18, 2011).

(5.) M. Fraser and A. Ormiston, Understanding Financial Statements, 9th ed. (Boston: Prentice Hall, 2009): 201.

(6.) U.S. Department of Defense, Fiscal Year 2009 Agency Financial Report. (Washington, DC: U.S. Department of Defense, 20081: 9.

(7.) Sources: Author from 2008 Agency Financial Statements Defense Finance and Accounting Service, 2008, p. 32, Department of Defense Office of the Inspector General, 2008, p.27; Department of the Army, 2008, p. 36; U.S. Department of Defense. 2008. p. 9).

(8.) I.T. David, "Financial Information for Policy, Program and Operating Officials: Journal of Government Financial Management, 51 (1)2002: 12.

(9.) U.S. Small Business Administration, FY 2011 Annual Financial Report, (Washington, DC: SBA, 2011): 55.

(10.) U.S. Agency for International Development. FY2011 Annual Financial Report (Washington, DC: AID, 2011): 23.

(11.) U.S. Department of Education, FY 2011 Annual Finance! Report (Washington, DC. Department of Education. 2011): 27.

(12.) Social Security Administration, FY 2011 Annual Financial Report (Washington, DC: SSA, 2011): 40-41.

(13.) (e-mail to the author, April 22. 2010).

(14.) Office of Management and Budget, Objectives of Federal Financial Reporting. Statement of Federal Financial Accounting Concepts, Number 1 (Washington, DC: OMB, 2005) para. 75.



Dr. Douglas A. Brook is a professor at the Naval Postgraduate School in Monterey, California. He is also the Director, Center for Defense Management Research at the school. Dr. Brook has had a distinguished career with the Department of Defense, serving as the Assistant Secretary of the Army (Financial Management and Comptroller), the Assistant Secretary of the Navy (Financial Management and Comptroller), and the Acting Under Secretary of Defense (Comptroller)/Chief Financial Officer. Dr. Brook is a member of ASMC's Monterey Chapter.
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Author:Brook, Douglas A.
Publication:Armed Forces Comptroller
Geographic Code:1USA
Date:Jun 22, 2012
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