How to make a 6.2 billion dollar accounting error

Pentagon spokesperson Sabrina Singh announced that an accounting error was found that resulted in a total of 6.2 billion dollars correction in the aid allocation for Ukraine. According to Singh, the error was caused by using the replaced value instead of the the correct net book value on the costs of equipment used in the aid drawdown.

Why is net book value preferred over the replacement cost?

It is relatively simple. Physical goods such as equipment are inventories. When the net book value (NBV) is used, the asset is valued at a historical cost minus depreciation and impairment, so the cost would be less than replacement value.

The reason is that when the replacement cost is used, the asset is valued as if it was procured in today’s market.

In the past two year when the error occurred, the market happened to be inflationary with rising prices.

Why is there such a discrepancy between these two methods?

Replacement value is higher than NBV in an inflationary environment, using the most common inventory First In First Out valuation. For example, a car bought five years ago now is being shipped out as part of the drawdown, but the value of the car is probably increased by say 40% due to the newer production cost plus inflation. This replacement value might be true, but the impact on the balance sheet is that the sitting inventory is worth a lot more than the historical cost. As a result, the asset portion is overstated by the inventory accounting; on the other hand, the income statement on cost of goods total is lower because drawdown starts from the oldest inventory, what is not drawn would have just accumulated more value because the external environment is inflationary. This overstated value for the budget would look like this: the costs of drawdown deviates from true reflection of the costs more and more.

The net book value avoided this upward bias by using historical cost and depreciation over the useful life of the physical goods. The result is that the inventory is lower in value compared with replacement value. Cost of goods sold would be lower also given they are older stock and cheaper at the time of procurement. This concerns the program’s bottom line.

The tax payers filled the coffer of the government so that it can spend on programs according to budget. This surprise recovery of 6.2 billion dollars may not be a surprise if the external environment wasn’t inflationary and the inventory was tight. Now the 6.2 million will be recycled back to the aid program. No, it is not new found money or wasted money. It is just how accounting can impact the bottom line.

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