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How Government Policies Inhibit Accurate Financial Reporting and Incur Vast Costs

There’s a clear case for reforming federal accounting standards and practices. Here are five places to start.

It would probably surprise many people to learn that some of the policies and accounting standards intended to promote accurate financial reporting and “clean” audits at federal agencies actually achieve almost exactly the opposite effect. This is especially true at the Defense Department, which has long struggled to meet financial reporting requirements. What’s more, those misguided policies often incur enormous costs and hamper effective business operations. 

To achieve real financial transparency and accurate reporting, Congress and the administration should work together to revise the requirements imposed on agencies. Consider the following five areas ripe for reform:

1. Post-order Price Changes for Intra-governmental Transactions

Imagine ordering something substantial from Amazon only to be charged 150% of the agreed upon price after the item had shipped. That’s what can happen with intra-governmental transactions with GSA and the various Defense working capital funds serving as the suppliers. Each day, government organizations order goods from these intermediate suppliers, who in turn contract with commercial vendors for their inventories; however, when government resellers do not have those items in stock, their policies require them to source the goods and charge their customers the latest commercial price, even if it differs from the price on the original order. 

In contrast, commercial entities like Amazon or Grainger, having already completed the sale, would fulfill the order at the agreed-upon price and adjust future sales to deal with supply cost fluctuations. If that wasn’t possible, at a minimum the companies would notify customers of the price change and give them the option of canceling the order. Instead, government suppliers put the onus on their customers, whether they like it or not. That transfer of responsibility in dealing with commercial supplier price changes puts an immense burden on organizations to budget for unanticipated obligations. As a result, government entities every year amass many tens of thousands of unmatched transactions for which funds disbursed do not reconcile with funds obligated at the time of the order. When those obligations are covered by expiring appropriated funds, the accounting headaches become blinding migraines.  

A better approach would be to have GSA and the working capital funds fulfill their orders at the agreed-upon price and deal with the gains and losses by adjusting future prices. Though this will place a burden on the government resellers to adjust their budgets, rates and business practices, it is far preferable to the current mayhem.

2. Equipment Capitalization

To comply with federal accounting standards, agencies must value and depreciate hundreds of thousands of pieces of equipment. The valuation must include all costs incurred in bringing the equipment to the form and location of its intended use, including transportation, storage, engineering labor, support equipment, government-furnished equipment from other contracts, etc. Moreover, the valuation must be continuously updated to account for reconfiguration, recapitalization or even overhaul. This applies to military hardware such as tanks, aircraft, artillery, personnel carriers—all things that could be damaged or destroyed during their intended use. 

While the purported purpose of these accounting standards is to develop cost information for decision-making or to assess the equipment’s condition or effective maintenance, it would be a stretch to suggest that depreciation expense or the value of undepreciated assets on the balance sheet inform maintenance, condition or readiness decisions. 

Agencies spend tens of millions of dollars each year attempting to estimate the value of their assets for esoteric purposes that cannot possibly justify the resources needed. Instead, the federal accounting board should revert to prior rules that allowed federal agencies to expense mission or military equipment and other mission-support equipment. 

3. Valuation of Operating Materials 

Another accounting standard requires agencies to value their inventories of operating materials and supplies (OM&S). Unlike inventories held for resale, OM&S inventories are for the organization’s own use. The preferred practice is to use the “consumption method” of accounting to recognize an expense, not at the time of receipt, but when the OM&S materials are finally used. In the meantime, the standards require that these materials be valued using a cost flow methodology such as moving-average cost. Similar to the valuation for equipment, the objective in valuation of OM&S inventory is to account for the total cost of those materials. Further complicating this requirement is that returns to inventory must also be accounted for. 

There is a mistaken presumption that this convoluted accounting regime will somehow provide more transparency into inventory locations, quantities, and conditions, or that this is necessary for inventory cost analysis to inform resource allocation decisions, neither of which are true. 

The methods and accuracy of valuation for everything from small arms rounds to complex multi-component missiles require tortuous business rules and complex system designs that impose vast costs on government agencies. Luckily, the accounting standards do allow for a cost-benefit exception; however, that exception is rarely sought. What few benefits there may be are hardly worth the great lengths required to facilitate consumption accounting for these materials. In contrast, the cost of establishing complex business rules, customizing information systems, and repeatedly revising the system and process designs to adjust for ambiguous interpretations of what is to be valuated is astoundingly high. 

A more pragmatic approach would be to expense OM&S stocks under the “purchase method” of accounting and allocate a small share of the budget otherwise required to the much more important effort of instituting processes and systems that enable physical inventory visibility and accuracy via material tagging, sensors and warehouse management systems and instituting the cost analytics algorithms—all of which are much better suited to inform decisions around resource allocation.

4. Internal Use Software Capitalization

Under another accounting standard, federal agencies must capitalize their commercial off-the-shelf or developed software when those applications are to be used for the agencies’ internal operational needs.  The accounting standard provides guidance that is sure to confuse most software program managers. For example, costs incurred during the software development stage should be capitalized, but any such determinations should be made based on the “nature of the costs incurred,” rather than the sequence.  Additionally, costs incurred through final acceptance testing should be capitalized and expensed thereafter. Unfortunately, this guidance fundamentally misunderstands how major enterprise software is developed. For most major software used in federal agencies, the system’s full operational capability will likely not be developed for years after the initial deployment. Thereafter, major enhancement will continue forever more, apparently making it necessary to capitalize each independent major release of new capability. Since most subsequent releases will be a mix of sustainment and enhancement, every single activity will need to be evaluated to determine if its nature leans more toward an expense or capital cost. 

In addition, like the other valuation efforts, the accounting standards require that all direct and indirect costs be incorporated into the depreciable basis of the software. There are so many questions about the capital software valuation business rules that experts in the field often recommend something akin to Justice Potter Stewart’s description of his threshold for obscenity: “I know it when I see it.” This either suggests that programs take their best guess as to what to capitalize, or that agencies hire an army of accountants dedicated solely to asset value determination. That does not even account for the premium that their software contractors will charge for spending their time in distinguishing between capital and non-capital costs.  

All of this should leave the casual observer rightly wondering what benefit is to be gained by all this effort. It certainly does no good in serving the needs of the citizenry or in defending the nation. If the intent is to better understand IT expenditures, then managerial cost accounting algorithms are more sensible. They do not require capital or expense determinations but do enable systematic allocations of indirect and imputed costs. The simple prescription is to expense all internal use software and turn the page on this misguided practice.

5. Contract Financing Payments

When a federal contractor is developing a major piece of equipment, the contractor may require some incremental payment in advance of the first delivery. Such payments provide a pipeline of early funding without which some contractors would not be able to undertake engineering and production activities. 

Unfortunately, the same federal and defense procurement and financial management policies that facilitate these payments do not consider the implications for other processes. Specifically, they allow for financing payments across an entire contract without any linkage to a specific contract line and associated obligation amount. Furthermore, the policies allow for complex recoupment provisions where a vendor’s subsequent invoices result in partial offsets against prior financing payments and partial additional new disbursements. The outcome is a complex tangle that is extremely difficult to unravel. Where there is an acquisition of capital assets, it becomes nearly impossible to reconcile construction-in-progress financial recognition with the new asset capitalization. 

A more sensible approach would be to require that financing payments, deliverable invoices and recoupments always reference discrete contract and obligation lines.

Al Baharmast, Ph.D. is an adjunct professor at George Mason University’s School of Business, and an operations management and information systems consultant specializing in business process management, enterprise applications, and financial and supply chain management. Early in his career, he served as a property, plant and equipment auditor and an expert witness in asset valuation.

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