Section 1

management’s Discussion and analysis

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Section 1

a system of identification using visual symbols, became a useful art in the Middle Ages, when warriors on the battlefield displayed an emblem on their shields and the tunics they wore over their armor. In America, heraldry symbols have been used by military forces as well as other organizational elements of the government since the beginning of the Revolution.

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Significance of the DoD Seal

of the United States is a symbol familiar to Americans. In addition, each department and agency of the government has its own seal which appears on documents and publications issued by the organization. The seal of the Department of Defense, shown above, was designed to visually depict the mission of the Department.

long associated with symbolism representing the United States of America and its military establishment, is an emblem of strength. In facing to the right, the field of honor is indicated. The eagle is defending the United States, represented by the shield of thirteen pieces. The thirteen pieces are joined together by the blue chief, representing the Congress. The rays and stars above the eagle signify glory, while the three arrows are collectively symbolic of the three component parts of the Department of Defense (Army, Navy, and Air Force). The laurel stands for honors received in combat defending the peace represented by the olive branch.

Heraldry,

The Great Seal

The American bald eagle,

�Department of Defense Agency Financial Report 2007Section 1: Management’s Discussion and Analysis

Section 1: Management’s Discussion and Analysis

TheDepartmentofDefensehaschosentoproduceanalternativetotheconsolidatedPerformanceandAccountabilityReportcalledtheAgencyFinancialReport(AFR).TheDepartmentdecidedtoparticipateintheFY2007pilotpursuanttoOfficeofManagementandBudget(OMB)CircularA-136,“FinancialReportingRequirements.”WewillincludeourFY2007AnnualPerformanceReportandFY2009AnnualPerformancePlanwiththeFY2009CongressionalBudgetJustification(CBJ)thatwillbesubmittedtotheCongressandOMBinFebruary2008.Asasupplementtothisreport,wewillissuea“Highlights”documenttobepublishedonourwebsite.TheHighlightsdocumentwillcontainbudget,performance,andfinancialinformationinabrief,user-friendlyformat.

Links to the Department’s Performance and Financial Documents

“Highlights FY 2007” summary of financial and performance information will be available February 2008, at http://www.defenselink.mil/comptroller/afr

FY 2009 Congressional Budget Justification (including the Annual Performance Report for FY 2007 and Annual Performance Plan for FY 2009) will be available February 2008, at http://www.defenselink.mil/comptroller/defbudget/FY2009/

UsingthisapproachtheDepartmentprojectsseveralsignificantimprovements:• Enhancedreadabilitybyreducingthelengthofthe

report.• Reducedduplicativeinformationinthecontentofthis

report.

• ImprovedperformanceinformationbysubmittingitwithourFY2009CBJsubmissiontoCongressandOMB.Theperformanceinformationwillbebaseduponafullyearofactualdatainsteadofestimatingfourthquarteraswehaveinthepreviousyears.

• Enhancedtransparencyusingwebsitelinks.• Reducedproductioncosts.

Tofurtherstreamlineandconsolidateitsreports,theDepartmentwillusewebsitelinksandreferencestoprovidesomeoftheperformanceandfinancialinformationassociatedwithagencymissions,functions,andstrategicplans.

Mission and Organizational Structure

ThemissionoftheUnitedStatesArmedForcesistoprovidethemilitaryforcesneededtodeterwarandtoprotectthesecurityofourcountry.SincethecreationofAmerica’sfirstarmyin1775,theDepartmenthasevolvedtobecomeaglobalpresencewithindividualsstationedinmorethan140countriesdedicatedtodefendingtheUnitedStatesanditsinterestsaroundtheworld.TheDepartmentembracesthecorevaluesofleadership,professionalism,andtechnicalknowledge.Itsemployeesarededicatedtoduty,integrity,ethics,honor,courageandcommitment.

ThechartbelowshowshowtheDepartmentisstructured.

Secretary of Defense

Deputy Secretary of Defense

Department of the Army

Secretary of the Army

UNDERSECRETARIES

ANDASST. SECRETARIES

OF THE ARMY

CHIEF OF STAFF, ARMY

Army MajorCommands & Agencies

Navy MajorCommands & Agencies

Marine Corps MajorCommands & Agencies

Air Force MajorCommands & Agencies

Department of the Air Force

Secretary of the Air Force

UNDERSECRETARIES

ANDASST. SECRETARIESOF THE AIR FORCE

CHIEF OF STAFF, AIR FORCE

Joint Chiefs of Staff (JCS)

Chairman JCS

The Joint Staff

VICE CHAIRMAN JCSCHIEF OF STAFF, ARMY

CHIEF OF NAVAL OPERATIONSCHIEF OF STAFF, AIR FORCE

COMMANDANT, MARINE CORPS

Combatant Commands

- CENTRAL COMMAND- EUROPEAN COMMAND- JOINT FORCES COMMAND- NORTHERN COMMAND- PACIFIC COMMAND- SOUTHERN COMMAND- SPECIAL OPERATIONS COMMAND- STRATEGIC COMMAND- TRANSPORTATION COMMAND

Defense AgenciesDoD Field Activities

Office of theSecretary of Defense Inspector

General

UNDER SECRETARIES,ASSISTANT SECRETARIES OF DEFENSE

AND EQUIVALENTS

Department of the Navy

Secretary of the Navy

UNDERSECRETARIES

ANDASST. SECRETARIES

OF THE NAVY

CHIEF OF NAVAL OPERATIONS

COMMANDANTOF THE

MARINE CORPS

� Department of Defense Agency Financial Report 2007 Section 1: Management’s Discussion and Analysis

The Secretary and the Office of the Secretary

TheSecretaryofDefenseandtheOfficeoftheSecretaryofDefenseareresponsiblefortheformulationandoversightofdefensestrategyandpolicy.TheOfficeoftheSecretaryofDefensesupportstheSecretaryinpolicydevelopment,strategyformulation,planning,resourcemanagement,andfiscalandprogramevaluation.

Military Departments

TheMilitaryDepartmentsconsistoftheArmy,Navy(ofwhichtheMarineCorpsisacomponent),andtheAirForce.Inwartime,theU.S.CoastGuardbecomesaspecialcomponentoftheNavy;otherwise,itispartoftheDepartmentofHomelandSecurity.TheMilitaryDepartmentsorganize,staff,train,equip,andsustainAmerica’smilitaryforces.WhenthePresidentandSecretaryofDefensedeterminethatmilitaryactionisrequired,thesetrainedandreadyforcesareassignedtoaCombatantCommanderresponsibleforconductingmilitaryoperations.

PersonnelintheMilitaryDepartmentsareassignedtoActiveDuty,Reserve,andNationalGuardforces.ActiveDutyforcesarefull-timemilitaryservicemembers.ReserveforcesandNationalGuardforces,whenorderedtoactiveduty,augmentactiveforces.ReserveandNationalGuardforcesareanextensionofActiveDutyforces.TheNationalGuardhasauniquedualmissionwithbothfederalandstateresponsibilities.InpeacetimetheGuardiscommandedbythegovernorofeachrespectivestateorterritory.Underapplicablestatelaws,theirauthorityincludestheabilitytocalltheGuardintoactionduringlocalorstatewideemergencies,suchasstorms,drought,orcivildisturbances.Whenorderedtoactivedutyformobilizationorcalledintofederalserviceforemergencies,unitsoftheGuardareplacedunderoperationalcontroloftheappropriateMilitaryDepartment.GuardandReserveforcesarerecognizedasanindispensableandintegralpartofthenation’sdefensefromtheearliestdaysofaconflict.

Chairman of the Joint Chiefs of Staff

TheChairmanoftheJointChiefsofStaff,whoistheprincipalmilitaryadvisortothePresident,theNationalSecurityCouncil,andtheSecretaryofDefense,assiststhePresidentandSecretaryinprovidingforthestrategicdirectionoftheArmedForces,includingoperationsconductedbytheCommandersoftheCombatantCommands.Aspartofthisresponsibility,theChairmanalsoassistsinthepreparationofstrategicplansandhelpstoensurethatplansconformtotheresourcelevelstheSecretaryofDefenseprojectswillbeavailable.

Combatant Commands

ThenineCombatantCommandshaveresponsibilityformissionsaroundtheworld.Forexample,U.S.CentralCommandisprimarilyresponsibleforconductingOperationEnduringFreedominAfghanistanandOperationIraqiFreedominIraq.TheArmy,Navy,AirForce,andMarineCorpssupplyforcestotheseCommands.

FiveoftheseCommandshavespecificmissionobjectivesfortheirgeographicareasofresponsibility,asshowninthemapbelow:

• U.S.EuropeanCommand(USEUCOM)isresponsibleforactivitiesinEurope,Greenland,Russia,andmostofAfrica.

• U.S.CentralCommand(USCENTCOM)isresponsiblefortheMiddleEast,easternAfrica,andseveraloftheformerSovietrepublics.

• U.S.PacificCommand(USPACOM)isresponsibleforNortheast,SouthandSoutheastAsia,aswellasOceania.

• U.S.SouthernCommand(USSOUTHCOM)isresponsibleforCentralandSouthAmerica,andtheCaribbean.

• U.S.NorthernCommand(USNORTHCOM)isresponsibleforNorthAmericaincludingCanadaandMexico.

Thisstructureundergoesperiodicreviews.In2007thePresidentorderedtheestablishmentoftheU.S.AfricaCommand,drawingterritoryfromUSEUCOMandUSCENTCOM.Theheadquarterswillbefunctionalinthecomingyear.

TheremainingfourCommandshaveworldwidemissionresponsibilities,eachfocusedonaparticularfunction:

• U.S.StrategicCommandisresponsibleforprovidingglobaldeterrencecapabilitiesandsynchronizingtheDepartment’seffortstocombatweaponsofmassdestruction.

PACOM

EUCOM

SOUTHCOM

NORTHCOM

PACOM

EUCOM

CENTCOMCENTCOM

SOUTHCOM

NORTHCOM

5Department of Defense Agency Financial Report 2007Section 1: Management’s Discussion and Analysis

• U.S.SpecialOperationsCommandisresponsibleforleading,planning,synchronizingand,asdirected,executingglobaloperationsagainstterroristnetworks.

• U.S.TransportationCommandisresponsibleformovingmilitaryequipment,supplies,andpersonnelaroundtheworldinsupportofoperations.

• U.S.JointForcesCommandisresponsiblefordevelopingfutureconceptsforjointwarfightingandtraining.

Defense Agencies and Defense Field Activities

TheseorganizationsprovidesupportDepartment-wide.DefenseAgenciesprovideavarietyofsupportservicescommonlyusedthroughouttheDepartment.Forexample,theDefenseFinanceandAccountingService(DFAS)providesaccountingservices,contractorandvendorpayments,andpayrollservices.DefenseFieldActivitiesperformmissionsmorelimitedinscope,suchastheAmericanForcesInformationServicethatservesasthefocalpointforallArmedForcesinformationprograms.Resources

NearlyhalfoftheDepartment’sworkforcearemenandwomenonActiveDuty.ToprovideAmericanswiththehighestlevelofnationalsecurity,theDepartmentemploysmorethan1.4millionmenandwomenonActiveDuty,approximately828,000intheReserveandNationalGuard,andabout729,000thousandcivilians.Thechartbelowshowstheemployeebreakdown.

*The percentages reflect data as of September 30, 2007, subject to rounding differences.

TheDepartment’sworldwideinfrastructureincludesnearly580,000facilities(buildings,structures,andutilities)locatedatmorethan5,300sitesaroundtheworld,andmorethan32millionacres.ToprotectthesecurityoftheUnitedStates,theDepartmentusesapproximately250,000vehicles,11,000aircraft,and500vessels.

Analysis of Financial Statements

TheAgencyFinancialReportaffordstheDepartmentanopportunitytoprovideits“investors”(e.g.,stakeholders,oversight,andtheAmericanpeople)withcriticalinformationtoassesscurrentfinancialperformanceaswellasitsfutureoutlook.Thoughnotacommercialentity,theDoDhasnumerousstakeholderswithinterestssimilartothoseofpubliccompanies.

Forexternalreportingpurposes,theDepartmentreportsitsfinancialinformationinfourprincipalfinancialstatements,includingaconsolidatedBalanceSheetalongwithstatementsofNetCost;ChangesinNetPosition,andBudgetaryResources.ThesestatementsreflecttheDepartment’sfinancialpositionandchangesinbothproprietaryandbudgetaryactivities.Comparatively,thestatementsaresimilartoacorporateBalanceSheet,IncomeStatement,Stockholders’Equity,andStatementofCashFlow.ThenumberofprincipalfinancialstatementshasbeenreducedfromsixinthepreviousyeartofourthisyearbypresentingtheirinformationintheNotestothefinancialstatements(seeNotes21and22).

TheDepartment’sfinancialmanagementenvironmentiscomplexanddiverse.Comparatively,theDepartment’sassetsexceedthecombinedassetsofthetopsixFortune500companies,whilegrosscostsexceedonlythoseofthetoptwo.Currentassetsexceedcurrentliabilities.Alternatively,long-termliabilitiesexceedlong-termassets.However,83%ofthelong-termliabilitiesarecoveredbyexistingassetsorwillbefundedwithresourcesoutsideofnormalDoDappropriations.

Structurally,theDepartmentconsistsof33reportingentities.TheDepartmentsubmitsnineseparatefinancialstatementstoOMB.TheseincludetheDepartment-widefinancialstatements,theMilitaryRetirementFund,theU.S.ArmyCorpsofEngineers,andthegeneralfundsandworkingcapitalfundsfortheArmy,AirForce,andNavy.Overall,theDepartmentreceivedadisclaimerofopinionfromitsauditorsforFY2007,andtheauditorshavedeterminedinformationinthefinancialstatementsmaynotbereliable.

Todate,fourofthe33reportingentitieswithintheDepartmentareprojectedtoachieveunqualifiedauditopinionsinFY2007:theDefenseFinanceandAccountingService,theDefenseContractAuditAgency,theDefenseCommissaryAgency,andtheOfficeoftheInspectorGeneral.AttheDepartment-widelevel,theDepartmentreceivedfavorablereviewsforthefourthconsecutiveyearontwofinancialstatementlineitemsinFY2007:(1)FederalEmployees’CompensationActLiabilities,and(2)AppropriationsReceived.

National Guard15%

Civilian25%

Reserve12%

Active Duty48%

Staffing for FY 2007*

� Department of Defense Agency Financial Report 2007 Section 1: Management’s Discussion and Analysis

Overthepastyear,theDepartmenthasrefinedtheauditapproachfromonethatfocusessolelyonline-itemstoonethatfocuseson“segments.”Thisalignsend-to-endbusinessprocesseswithfinancialmanagementinitiativesthatfocusonimprovingthequality,accuracy,andreliabilityoftheDepartment’sfinancialinformation.Thedepartmenthasnotyetundergonesegmentedaudits.Refertosection1-9foradditionaldetails.

TheDepartment’sfinancialstatementsforFY2007arepresentedintheirentiretyinSection2,FinancialInformation.Asummaryanalysisofthestatementsisprovidedinthefollowingsection.

Financial Analysis

Ingeneral,thefinancialstatementsfortheDepartmentreflectshort-termsolvency.TheDepartment’scurrentassetsexceedcurrentliabilitiesbyapproximately$337.6billionindicatingDoD’sabilitytosatisfyimmediaterequirements.However,long-termliabilitiesexceedlong-termassetsbyapproximately$882.0billionasthefuturecostofmilitaryretirement,health,andotheremployeebenefitssignificantlyinfluencethelong-termfinancialoutlook.

TheDepartment’sunfundedliabilitiesconsistprimarilyofmilitaryretirement,health,andotheremployeebenefits,whichcomprise$1.5trillionofDoD’stotalliabilities.Ofthisamount,$1.2trillionofunfundedactuarialliabilitiesrelatedtoestimatedfutureyearcostsfortheMilitaryRetirementFundandtheMedicare-eligibleRetireeHealthCareFundarecoveredbyappropriationsthatarenotpartoftheDepartment’sbudget.

*The amounts reflect data as of September 30, 2007, subject to rounding differences.

Withtheexceptionofthe“concurrentreceipt”benefitsgrantedtomilitaryretirees,theDepartmentreceivesresourcesforallnormalcostsofretirementandMedicare-eligibleRetireeHealthcarethroughregularappropriations.Approximately$317.3billioninunfundedliabilitiesforretireehealthprogramsremaintobefundedfromtheDepartment’sfutureappropriations.Onceactuarial

liabilitiestobecoveredbyannualappropriationsoutsidetheDepartment’sbudgetarefactoredout,theDepartment’sassetsexceeditsremainingliabilitiesbyapproximately$678.1billion.Thisamountconsistsprimarilyoffixedassetsandinventory,therefore,theyarenotnecessarilyavailabletocoverliabilities.Additionally,significantportionsoftheDepartment’sassetsareearmarkedforspecificpurposes.

DuringFY2007,theDepartmentreceived$658.6billioninappropriationsfromtheCongressandinvestedtheseresourcesinthekeyareasshownonthechartbelow.TheDepartment,theFederalGovernment’ssinglelargestagency,receivesmorethanhalfofthediscretionaryfederalbudget.

*The percentages reflect data as of September 30, 2007, subject to rounding differences.

BymakinginvestmentsinDepartmentalassetssuchaspeople,infrastructure,operationsandtechnologies,DoDcontinuestodefendnationalinterests.ThroughAugust2007,theDepartmentspentapproximately$118.2billionfortheglobalwaronterror.Overthepastyear,$5.6billionwasspentoninfrastructure,$31.2billiononmilitaryequipment,and$102.7billiononmilitarypersonnelcosts.ThecompletepictureoftheDepartment’sfinancialinformationshowsseveraltrendsandinsightsintothefinancialhealthoftheorganization.

• TotalassetsoftheDepartmenthavegrown10%overthepastyear,resultingfromanincreaseinfundsavailable,aswellasinvestmentsforlong-termassetsandmilitaryequipment.

• Liabilitieshaveincreasednearly4%primarilyduetothelong-termliabilityincreasesformilitaryretirementbenefits.

• Costsincreased5%overthepastyearmainlyduetomilitaryretirementbenefitcosts.

Funded Liabilities$411

Unfunded Liabilities$1,640

Unfunded vs. Funded Liabilities*(amounts in billions)

Other2%

Construction1%

Operations &Maintenance

23%

Global War on Terror25%

FY 2007 Resource Allocation*

Research & Development12%

Military Personnel & Benefits17%

Military Retirement Benefits7% Procurement

13%

7Department of Defense Agency Financial Report 2007Section 1: Management’s Discussion and Analysis

Long-Term Liabilities Related to Military Retirement Benefits

TheMilitaryRetirementFundwasestablishedin1984andcertaincostswerecarriedforwardfrompre-existingliabilities.ABoardofActuariesappointedbythePresidentisresponsibleforapprovingactuarialassumptionsforthefundandsettingthepaymentschedule.Historically,interestcostshavemountedbecauseannualpaymentswerelessthantotalcostofinterest.TheBoardhasdeterminedthatarevisedpaymentplanisnecessarytopaythefullcostofinterestandtheunfundedliabilitywhichwillbereducedovertimeassumingnosignificantchangesoccurinbenefits,assumptions,andactuarialexperience.

Military Equipment

TheactualchangeinmilitaryequipmentforFY2007was$9.6billion.Ofthatamount,$8.2billionintrainingequipmentwasreclassifiedtoGeneralProperty,PlantandEquipmentinaccordancewithaDoDpolicychangerefiningthedefinitionofmilitaryequipment.EffectiveFY2007,thedefinitionofmilitaryequipmentspecificallyexcludestrainingequipment.Asaresult,thenetincreaseinmilitaryequipmentwas$1.4billion.

Real Property

Ongoingeffortstoaccuratelyidentifyandreportrealpropertyresultedinanincreaseof$4.9billiontorealpropertyduringFY2007.Ingeneral,theDoDoccupiesmorethan60%ofthetotalpropertythatfederalagenciesownorlease.Managingfederalassetsdiffersfromthemanagementofprivatesectorassets.Primarily,theproceedsfromthesaleoffixedassetsarenotavailableforusebytheagency,butarereturnedtotheDepartmentoftheTreasury.Intheprivatesector,thosesameproceedsaretypicallyusedtosupportorliquidatelong-termdebt.

Summary

Insummary,theDepartmentisimprovingfinancialdecision-makingprocessesandprogressingtowardbetterfinancialmanagement.Greatstrideshavebeenmadetowardimprovingthelong-termfinancialcondition.Theshort-termoutlookistrendinginapositivedirectionasthevalueofcurrentassetsexceedsthatofcurrentofliabilities.Inaddition,equityistrendinginapositivedirectionafternotfactoringactuarialliabilitiestobecoveredfromnon-DoDresources.Whileresourcesarelimitedandtherearevastrequirementsthatgounfundedeachyear,theDepartment’scoremissionsarebeingsatisfiedbyprioritizingandfundingthemostcriticalrequirements.Foritslonger-termoutlook,theDepartmenthasbeenassuredofacontinuingsourceofappropriatedfundstocoverasignificantportionof

long-termobligations,(primarilyrelatedtohealthcareandretirementbenefitcosts).

Financial Improvement and Audit Readiness Plan

TheFinancialImprovementandAuditReadiness(FIAR)PlanistheDepartment’sguideforcomprehensivelyimprovingfinancialmanagementandpreparingforaudit.Asevidencethatprogressisbeingmade,DoDismaintainingagreenscoreforprogressinImprovingFinancialPerformanceunderthePresident’sManagementAgenda.

TheSeptember2007FIARPlanisthefifthsubmissionofthePlantotheCongressandOMB.Theplandemonstratesanincrementalapproachthatbuildsontheaccomplishmentsofpreviousefforts,incorporateslessonslearned,andadaptsasnecessarytosustainandadvanceprogressalreadyachieved.WhiletheU.S.ArmyCorpsofEngineersawaitstheresultsoftheirfirstfinancialstatementauditforFY2006,theyaresimultaneouslyundergoingtheirFY2007audit.TheDefenseLogisticsAgency’scontingentlegalliabilitieshavebeenexaminedandverifiedasauditreadybytheInspectorGeneral,andtheDefenseInformationSystemsAgencyisreadytoassertthatitsBalanceSheetisreadyforaudit.Additionally,severallargebusinessprocesssegmentsareundergoinganindependentexaminationtoconfirmauditreadiness.Theyare:

• TheNavy’snuclearandconventionalshipsenvironmentalliability,and

• TheAirForce’sappropriationsreceived,nettransfers,andfundbalancewithTreasury.

TheDepartment’soverallgoalissustainablefinancialmanagementimprovement.DoDbelievesreceivinganunqualifiedopiniononDoD’sconsolidatedfinancialstatementswilldemonstratethatthegoalhasbeenachieved.WhiletheDepartmentremainscommittedtomakingincrementalimprovements,manyofthesupportingdetailsofthatstrategyhavebeenrefined.TheDepartment’srefinedauditstrategy:

• Limitsauditstoentirefinancialstatementsratherthanauditsonfinancialstatementlines.

• Implementsalternativemethodsofverifyingincrementalprogressorauditreadiness.

• Incorporatesamodeltosustainprogressonceauditreadinessofasegmenthasbeenverified.

• Focusesonthebusinessprocesses,orsegments,thatunderlietheamountsreportedonthefinancialstatementsratherthanexclusivelyonbalancesheetlines.

� Department of Defense Agency Financial Report 2007 Section 1: Management’s Discussion and Analysis

• Recognizesthatfinancialstatementauditability,andthecorrectionofdeficienciesformanybusinessprocesses,mustbetiedtotheimplementationofEnterpriseResourcePlanningsystems.

Therefinedauditreadinessstrategytransitionsitsapproachfromonethatfocusessolelyonaline-itemtoonethatfocusesonsegments.Segmentsareformedbyeitherbringingtogethercloselyrelatedareasoffinancialmanagementorbreakingapartareasintomoremanageableportions.Segmentsmorecloselyalignfinancialimprovementinitiativestoend-to-endbusinessprocesses.TheNavyhasalreadytransitionedtoasegmentapproach,andtheDefenseLogisticsAgencyhasmadesignificantprogresstowardcompletingthetransition.

Toimprovefinancialmanagementandinternalcontrol,theFIARPlanorganizesandintegratestheDepartment’spreviouslyindependentactivitiesandalignsthemwithbusinesssystemsmodernization.IntegrationoftheFIARPlan,theEnterpriseTransitionPlan(ETP),theComponentFinancialImprovementPlans(FIPs),theEnterpriseResourcePlanningdeploymentplans,andsystemmodernizationplanshassetacomprehensivepathforcomplyingwithrequirements,improvingfinancialvisibilityintobusinessprocessesandinformation,andachievingauditreadiness.

Enterprise Transition Plan

TheEnterpriseTransitionPlan(ETP)servesastheDepartment’sroadmapforbusinesstransformationanddescribesitsstrategyforachievingtheDepartment’sEnterpriseandComponentPriorities.OneofthesixBusinessEnterprisePrioritiesdescribedintheETPisfinancialvisibility.Thegoalforfinancialvisibilityismoreefficientandeffectivedecision-makingthroughouttheDepartmentandassistanceinachievingtheDepartment-wideefforttoachievefinancialauditability.Financialvisibilitymeanshavingimmediateaccesstoaccurateandreliablefinancialinformation(planning,programming,budgeting,accounting,andcostinformation)insupportoffinancialaccountabilityandefficientandeffectivedecision-makingthroughouttheDepartmentinsupportofthewarfightersandtheirmissions.TheDepartmenthasestablishedabroadstrategytoaccomplishthegoalsoffinancialvisibility.Thisstrategyreliesonconcurrenteffortsinfourareasthatinvolve:

• DefiningandimplementingtheStandardFinancialInformationStructure(SFIS),acommonlanguagethatprovidesstandarddefinitions,lengths,values,andbusinessrulesthatenabletransparencyandinteroperabilityoffinancialinformationacrosstheDepartment.

• Implementingfinancialsystemsthatcomplywithfederalfinancialmanagementrequirements.The

DefenseAgenciesInitiative,forexample,representstheDepartment’sefforttoextenditssolutionsetforstreamliningfinancialmanagementcapabilities,reducingmaterialweaknesses,improvinginternalcontrols,andachievingfinancialstatementauditabilityto28DefenseAgenciesandFieldActivities.Theobjectiveistoachieveanauditablebusinessenvironmentwithaccurate,timely,andauthoritativefinancialdata.

• ImplementingtheBusinessEnterpriseInformationService(BEIS)toaggregatefinancialinformationandprovideDepartment-widefinancialreporting.TheBEISprovidesservicesforfinancialreporting,cashreportingandreconciliation,generalledger,referencedata,andenterprisebusinessintelligence.TheBEISwillyieldtimely,accurate,andreliablefinancialinformationandenablecomparisonoffinancialdataacrosstheDepartment.ItworkswithotherfinancialmanagementinitiativessuchastheSFIStoprovideinformationformoreinformedfinancialdecision-making.

• Implementingaudit-readyfinancialprocessesandpractices(ThiseffortincludesactivitiestiedtotheFIARPlan).

Limitations of the Financial Statements

TheprincipalfinancialstatementshavebeenpreparedtoreportthefinancialpositionandresultsofoperationsoftheDepartmentofDefense,pursuanttotherequirementsof31U.S.C.3515(b).ThestatementsarepreparedfromaccountingrecordsoftheDepartmentinaccordancewithOMBCircularA-136and,totheextentpossible,generallyacceptedaccountingprinciples.Thestatements,inadditiontothefinancialreports,areusedtomonitorandcontrolbudgetaryresourceswhicharepreparedfromthesamerecords.ThestatementsshouldbereadwiththerealizationthattheyareforacomponentoftheU.S.Government,asovereignentity.

Performance Goals, Objectives, and Results

TheOMBapprovedtheDepartment’sparticipationintheAFRpilotforFY2007.Aspartofthatpilot,theDepartmentwillincludeitsAnnualPerformanceReportinitsFY2009CongressionalBudgetJustification(CBJ).TheCBJwillbesubmittedtotheCongressinFebruary2008.ThelinksbelowtakeyoutotheDepartment’sperformanceinformation,includingplansandreports,andscoresonthePresident’sManagementAgenda.

�Department of Defense Agency Financial Report 2007Section 1: Management’s Discussion and Analysis

TheDepartment’sperformancebudgetrecognizesthateveryleveloftheDepartmentisaccountableformeasuringperformanceanddeliveringresultsatmultipletiersoftheorganizationthatsupporttheDepartment’sstrategicobjectives.Theperformancemeasuresandtargets,identifiedintheDepartment’sFY2007/2008Performance

Budget/Plan,arepresentedattheDepartment’senterpriselevel.However,somemeasuresandtargetswillundergoreevaluationforFY2009toensurethattheyareofacross-cuttingandstrategicnature.SucheffortsreflecttheevolutionarynatureoftheperformancebudgetandtheDepartment’scontinuingeffortstoensurethatperformanceassessmentislinkedtoidentifiableandmeasurablestrategicoutcomes.

TheDepartment’sFY2007/2008PerformanceBudget/Planidentifiesaselectnumberofperformancetargetsforgaugingsuccessamongalimitednumberofhighprioritystrategicobjectives.TheFY2007frameworkincludesfiveoverarchinggeneralstrategicgoals,17strategicobjectives,and42performancetargets.Inaddition,theDepartmentalsowillmonitorfiveclassifiedperformancetargetsthatarenotidentifiedinthedocumentthatisavailableonourpublicwebsite.ThisplanconstitutesthebasisagainstwhichperformanceresultsforFY2007willbeassessedintheDepartment’sCBJ.

Where and When the Department’s Performance Information Is Available

The Department of Defense Strategic Planhttp://www.defenselink.mil/qdr/report/Report20060203.pdf (Available now)

FY 2007/2008 Performance Budget/Planhttp://www.defenselink.mil/comptroller/defbudget/fy2008/fy2008_Performance_Budget.pdf (Available now)

FY 2009 Secretary’s Summary Justification (FY 2009 Performance Plan and FY 2007 Performance Report) http://www/defenselink.mil/comptroller/defbudget/FY2009 (Available February 2008)

The Department’s Scores on the President’s Management Agendahttp://www.whitehouse.gov/results/agenda/scorecard.html (Available now for the latest quarter)

10 Department of Defense Agency Financial Report 2007 Section 1: Management’s Discussion and Analysis

Analysis of Systems, Controls, and Legal Compliance

Annual Assurance Statement

UsingassessmentsaccordingtotheOMBCircularA-123,Management’sResponsibilityforInternalControlasthebasis,theDepartmentpreparedtheFY2007AnnualStatementofAssurance,presentedonthenextpage.TheDepartmentassertsthatallComponentshavereportedtotheSecretaryofDefensetheirindividualstatementsofassuranceoverinternalcontrols.ThetablesreferencedinthestatementappearinSection3:OtherAccompanyingInformation.

11Department of Defense Agency Financial Report 2007Section 1: Management’s Discussion and Analysis

Systems

TheFederalFinancialManagementImprovementAct(FFMIA)of1996requiresfederalagenciesto:

• ConformtotheU.S.GovernmentStandardGeneralLedgeratthetransactionlevel

• Complywithallapplicablefederalaccountingstandards

• EstablishfinancialmanagementsystemsthatmeetGovernment-widestandardsrequirements

• Supportfulldisclosureoffederalfinancialdata,includingthecostsoffederalprogramsandactivities

TheDepartment’sInspectorGeneralandtheauditagencieswithintheMilitaryServiceshavereportedontheDepartment’snoncompliancewiththeAct’srequirements.ManyoftheDepartment’slegacysystemsdonotcomplywiththewiderangeofrequirementsforsystemscomplianceand,therefore,donotprovidethenecessaryassurancestorelyoninformationcontainedineitherthelegacy(source)systemorthosesystemsthatwerefedinformationfromthelegacysystems.

Toresolvethesechallenges,theDepartment’sFIARPlanandtheETP,discussedpreviously,documentourstrategiesforimprovingprocessesandultimatelyachievingFFMIAcompliance.

Improper Payments Information Act Reporting

TheImproperPaymentsInformationAct(IPIA)of2002,asimplementedbyOMB,requiresfederalagenciestoreviewallprogramsandactivitiesannuallyandidentifythosethatmaybesusceptibletosignificanterroneouspayments.ForFY2007IPIAreportingresults,seeSection3:OtherAccompanyingInformation.

Other Management Information, Initiatives, and Issues

Looking Forward: Challenges for 2008 and Beyond

The“DefenseStrategyandStrategicPlanning”sectiondescribedinthe2006QuadrennialDefenseReview(QDR)incorporatestheNationalDefense,NationalMilitary,andNationalSecurityStrategies.PastQDRsfocusedontheproper“size”oftheforce.The2006QDRshapestheDepartment’sfuturewitha20-yearoutlookbylinkingstrategytodefenseresourcesandencompassingfourareasthatdrivecapabilitiesdevelopmentandforceplanning:

• Defeatingterroristnetworks• Defendingthehomelandin-depth• Shapingthechoicesofcountriesatstrategiccrossroads• Preventinghostilestateornon-stateactorsfrom

acquiringorusingweaponsofmassdestruction

TheseinterrelatedareasillustratethetypesofcapabilitiesandforcesneededtoaddressthechallengesdescribedintheNationalDefenseStrategy.TheyhavehelpedtheDepartmentshiftitsportfolioofcapabilitiestoaddressirregular,catastrophic,anddisruptivechallengeswhilesustainingcapabilitiestoaddresstraditionalchallenges.

AlthoughthesefocusareasdonotencompassthefullrangeofmilitaryactivitiesthattheDepartmentmayhavetoconduct,seniorleadershaveidentifiedthemasamongthemostpressingissues.Improvingcapabilitiesandforcestomeetthesechallengesalsowillincreasetheoveralladaptabilityandversatilityofourwarfightersinrespondingtootherthreatsandcontingencies.

BasedontheirevaluationofthefourQDRfocusareas,theDepartment’sseniorleadersdecidedtorefinethecapstoneforceplanningconstructthattranslatestheDepartment’sstrategyintoguidancetoshapeandsizemilitaryforces.ThisconstructrecognizesthattheUnitedStatesisanationatwar.TheDepartmentisusinglessonslearnedfromrecentandongoingoperationsinIraqandAfghanistanandmakingadjustmentstocapturetherealitiesofalongwarby:

• BetterdefiningtheDepartment’sresponsibilitiesforhomelanddefensewithinabroadernationalframework.

• Givinggreateremphasistothewaronterrorandirregularwarfareactivities,includinglong-durationunconventionalwarfare,counterterrorism,counterinsurgency,andmilitarysupportforstabilizationandreconstructionefforts.

• Accountingfor,anddrawingadistinctionbetween,steady-stateforcedemandsandsurgeactivitiesovermulti-yearperiods.

Atthesametime,thiswartimeconstructrequiresthecapabilitytoconductmultiple,overlappingwars.Inaddition,itcallsfortheforcesandcapabilitiesneededfordeterrence,reflectingashiftfrom“one-size-fits-all”deterrencetowardmoretailorablecapabilitiestodeteradvancedmilitarypowers,regionalweaponsofmassdestructionstates,ornon-stateterrorists.

The2006QDRprovidednewdirectionforacceleratingthetransformationoftheDepartmenttofocusmoreontheneedsofCombatantCommandersandtodevelopportfoliosofjointcapabilitiesratherthanindividualstove-piped

12 Department of Defense Agency Financial Report 2007 Section 1: Management’s Discussion and Analysis

programs.Theessenceofcapabilities-basedplanningistoidentifycapabilitiesthatadversariescouldemployandcapabilitiesthatcouldbeavailabletotheUnitedStates.Onceidentified,thepotentialintersectionsareevaluatedwhichhelpspreventover-optimizationofthejointforcesforalimitedsetofthreatscenarios.

ThisparadigmshiftcontinuesemphasisontheneedsoftheCombatantCommandersasthebasisforprogramsandbudgetarypriorities.ThegoalistoimprovetheDepartment’sabilitytomeettheneedsofthePresidentandtheCombatantCommandersthroughtheuseofjointcapabilityportfolios.Movingtowardamore“demand-driven”approachshouldreduceunnecessaryprogramredundancy,improvejointinteroperability,andstreamlineacquisitionandbudgetingprocesses.

ThisenvironmentalsoplacesnewdemandsontheDepartment’sTotalForceconcept.Althoughtheall-volunteerforcehasbeenakeytosuccessfulU.S.militaryoperationsoverthepastseveraldecades,itscontinuedsuccessisnotpreordained.TheTotalForceofActiveandReservemilitary,civilian,andcontractorpersonnelmustcontinuetodevelopthebestmixofpeopleequippedwiththerightskillsneededbytheCombatantCommanders.Tothisend,theQDRupdatestheDepartment’sworkforcemanagementpoliciestoguideinvestmentsintheforceandimprovetheworkforce’sabilitytoadapttonewchallenges.

The2006QDRwasdesignedtoserveasameanstospurtheDepartment’scontinuingadaptationandreorientation

toproduceatrulyintegratedjointforcethatismoreagile,morerapidlydeployable,andmorecapableagainstawiderrangeofthreats.Throughcontinuousimprovement,constantreassessment,andapplicationoflessonslearned,changesbasedonthisreviewwillcontinuetomeettheincreasinglydangeroussecuritychallengesofthe21stcentury.

Summary

Withoutdoubt,reshapingthedefenseenterpriseisdifficult.Thestructuresandprocessesdevelopedoverthepasthalf-centurywereforgedintheColdWarandstrengthenedovertimethroughoursuccesses.However,thestrategiclandscapeofthe21stcenturydemandsexcellenceacrossamuchbroadersetofnationalsecuritychallenges.

Militarymeansalonewillnotwintheglobalwaronterrororachieveothercrucialnationalsecurityobjectivesasdiscussedinthe2006QDR.Instead,theapplicationofdiplomacy,atthenationallevelandinconcertwithalliesandinternationalpartners,iscritical.Inadditiontocoalitionandpartner-supportedcombatandpreventiveoperations,interactionwithcivilianpopulationswillbeessential.ToachievethedesiredvisionrequiresdeterminationandperseverancewithintheDepartmentandtheAdministration,andcooperationwiththeCongress.