An inspector general's report said the U.S.-led administration that ran Iraq until June 2004 is unable to account for the funds.

"Severe inefficiencies and poor management" by the Coalition Provisional Authority has left auditors with no guarantee the money was properly used," the report said.

"The CPA did not establish or implement sufficient managerial, financial and contractual controls to ensure that [Development Fund for Iraq] funds were used in a transparent manner," said Stuart W. Bowen Jr., director of the Office of the Special Inspector General for Iraq Reconstruction.

The $8.8 billion was reported to have been spent on salaries, operating and capital expenditures, and reconstruction projects between October 2003 and June 2004, Bowen's report concluded.

The money came from revenues from the United Nations' former oil-for-food program, oil sales and seized assets -- all Iraqi money. The audit did not examine the use of U.S. funds appropriated for reconstruction. (Full story)

Auditors were unable to verify that the Iraqi money was spent for its intended purpose. In one case, they raised the possibility that thousands of "ghost employees" were on an unnamed ministry's payroll.

"CPA staff identified at one ministry that although 8,206 guards were on the payroll, only 602 guards could be validated," the audit report states. "Consequently, there was no assurance funds were not provided for ghost employees."

The Defense Department, which was in charge of the reconstruction effort, and former Iraq civil administrator Paul Bremer have disputed the findings.

Pentagon spokesman Bryan Whitman told CNN that the provisional authority was operating under "extraordinary conditions" and relied on Iraqi ministries to manage development money that was transferred to them.

"We simply disagree with the audit's conclusion that the CPA provided less-than-adequate controls over Iraqi funds that were provided to Iraqi ministries through the national budget process for hundreds of projects, essential services, Iraqi salaries and security forces," Whitman said.

The occupation government established "major reforms" in Iraq's budgeting system, setting up a transparent mechanism for decision-making and beginning efforts to fight corruption, Whitman said.

Under a U.N. Security Council resolution, the Development Fund for Iraq was to be used for humanitarian needs, economic reconstruction and repair of infrastructure, continued disarmament, costs of civilian administration and other programs benefiting Iraqis.

Bremer, in a written response included in the report, said Bowen's report failed to recognize the difficulties of operating in wartime.

"The IG auditors presume that the coalition could achieve a standard of budgetary transparency and execution that even peaceful Western nations would have trouble meeting within a year, especially in the midst of a war," Bremer wrote.

Bremer, who received a Presidential Medal of Freedom in December for his work in Iraq, stated that auditors did not interview him, any of his budget directors or deputies in preparing their draft report.

"On the whole, the office has done excellent work," he wrote. "But I do believe my colleagues at the CPA have a right to expect a level of professional judgment and awareness, which seems to be missing in the current draft report."

Bowen's report, which was prepared for Congress, acknowledged that the insurgency in Iraq poses "the most difficult challenge" to reconstruction.

"Even under the most favorable of conditions, rebuilding Iraq would be a job of daunting proportions," he wrote.

But the provisional authority did not clearly assign managerial responsibility, and its rules lacked clear guidance on procedures and controls for dispersing funds, he concluded.

Staffing shortages and turnover also resulted in inadequate oversight of budget execution by Iraqi ministries, he found -- and allegations of corruption in the oil-for-food program should have raised concerns about the Iraqi government's ability to manage the reconstruction funds.