Netting Lost Billions

ears ago, wholesale giant Costco decided to hire an outside accounting firm to go over its records to make sure it wasn't overpaying vendors. But before the auditors even arrived, a surprising thing happened. "A few vendors showed up with large checks," remembers Costco senior vice president Vince Carney. "They wanted to come clean before we started the audit."

Recovery auditing-the practice of combing through financial records to look for overpayments, usually accomplished with proprietary software-has become standard practice in the private sector over the last 20 years. It's obvious why: A good recovery auditor typically recoups a million dollars for every billion dollars in business a company does. And a good recovery auditor will help its corporate clients find and fix the holes that inevitably exist in even the best finance and accounting procedures and software.

The practice is so productive, and the effect on the bottom line so substantial, that many corporations hire more than one recovery auditing firm to cull the same data-that's in addition to companies' own auditors, who usually find the most obvious errors. Corporations assume almost no risk because auditors are paid a percentage of what they recoup. The auditors only make money if they identify overpayments that are later recovered. Recovered overpayments are literally found money and add directly to a company's bottom line, except for the percentage paid to the recovery auditor. The only real drawback, according to Carney, who spoke at a forum for federal managers on the topic in Washington this summer, is that "it may raise uncomfortable questions about why you're losing the money in the first place."

If recovery auditing is such a good thing-and corporate leaders seem to agree that it is-why don't most federal agencies use it? According to senior executives in the private sector, federal managers have no real incentive to go to the trouble of recovering overpayments. Inviting outside auditors to find errors and shine a spotlight on an agency's shortcomings is hardly an attractive prospect for most managers, and the money lost in overpayments isn't federal managers' to lose anyway-it belongs to taxpayers, few of whom express any organized interest in the minutia of federal accounting. Contractors aren't pushing recovery auditing either, since they're the ones who benefit from overpayments.

Nevertheless, if a few members of Congress have their way, recovery auditors soon will make inroads into government operations. In March, the House passed the Government Waste Corrections Act of 2000 (H.R. 1827), which would require most agencies to use recovery auditing. While the bill's prospects in the Senate this fall are not clear, the Clinton administration supports the bill and lawmakers seem increasingly interested in holding agencies accountable for overpayments. Rep. Dan Burton, R-Ind., the bill's chief sponsor, says the bill, which passed the House with overwhelming bipartisan support, "puts common sense and a proven business practice to work to save taxpayer dollars."

Billions at Stake
While private sector firms calculate they recover losses from overpayments at a rate of about one-tenth of 1 percent of their business volume, the extent to which the government overpays contractors is anybody's guess. Most agencies are in the middle of upgrading obsolete financial manage- ment systems and integrating new procedures and software. Such turmoil, coupled with the complexity that pervades federal purchasing, contributes to the likelihood of payment errors.

Although no one knows for sure how much agencies overpay, it's a safe bet that the loss rate is higher than in the private sector. Consider the experiences of two agencies, the Defense Department and the Health Care Financing Administration, a Health and Human Services Department agency that manages Medicare. The Defense Department spends over $115 billion annually for goods and services, about two-thirds of total federal contract spending. The General Accounting Office reported that in 1998 alone, contractors voluntarily returned $746 million in overpayments to Defense. Many analysts believe the actual amount of overpayments is much higher, since contractors are not required by law to return overpayments unless they receive a letter from the department requesting they do so. HCFA officials reported making $12.6 billion in Medicare overpayments in the same year. While that figure is considerably improved over previous years, it represents an error rate of more than 7 percent.

"If recovery auditing is good enough for the private sector, it ought to be good enough for the taxpayer," says Carl DeMaio, a senior fellow at the Reason Public Policy Institute and an advocate of recovery auditing. In July, DeMaio hosted a Washington forum on the subject for federal managers, at which Carney and other corporate executives spoke.

The Office of Management and Budget seems to agree with DeMaio. In a statement of support for the Government Waste Corrections Act, OMB wrote, "If fully implemented, the bill would save at least $100 million in collection of erroneous payments." While OMB doesn't necessarily believe recovery auditing is appropriate in all areas of federal contracting, it opposes amendments to the bill "that would automatically exempt payments related to specific programs from being subject to recovery audits." The administration is also targeting Defense contractors who knowingly hold onto overpayments. In response to a recommendation by GAO, the administration published in the Aug. 28 Federal Register its intention to amend the Federal Acquisition Regulation to require contractors to notify agencies of overpayments when the contractor becomes aware of them.

As written, H.R. 1827 exempts Defense weapons contracts and grant and entitlement programs, such as Medicare, from mandatory recovery auditing. Defense contractors and health care lobbyists fought "quietly but forcefully" for the exemptions, according to one congressional staff member familiar with the negotiations over the bill. Such exemptions would leave out some of the most lucrative areas for recovering overpayments, critics contend. Nonetheless, advocates of recovery auditing believe the bill is an important step in moving federal programs toward more businesslike practices.

"This is not a sexy issue," says Jane Cobb, the staffer on the House Government Reform Committee who shepherded the bill through the House. "But any time you're talking about saving taxpayers' money, it's important."

Payment Disputes
Lawmakers' interest in recovery auditing is not new. In the 1996 Defense Authorization Act, Congress required the Defense Department to execute a demonstration program for the concept. Although the program, which was conducted at the Defense Logistics Agency's Defense Supply Center in Philadelphia, ended last November, the results are not completely clear. Recovery auditing firm Profit Recovery Group International, Inc. (PRG), initially identified more than $30 million in suspected overpayments by the supply center for food items, clothing and textiles, and medical supplies between 1993 and 1995. But supply center officials could only substantiate $17.9 million in overpayments. At the end of August, the supply center had recovered less than $6 million in overpayments, says Dennis Polimeni, the recovery audit contract manager.

Thirty-four of 59 vendors believed to have received overpayments appealed their cases to the Armed Services Board of Contract Appeals. Gale Furman, an attorney at the supply center, says the appeals were still in the discovery phase at the end of August, making it impossible to predict when they might be resolved. Several factors make recovery auditing more cumbersome in the federal government than in the private sector, says Paul Dinkins, PRG's executive vice president. In the private sector, recovery auditors work directly with vendors to identify suspected overpayments. That process becomes more difficult on government contracts, because under federal acquisition regulations, only federal contracting officers may deal directly with vendors.

In addition, on the supply center contract, many of the disputed payments were for grocery items the supply center had purchased for resale to Defense commissaries in Europe. Much time had elapsed since the items were purchased, and in the meantime, responsibility for supplying those commissaries shifted to the Defense Commissary Agency, making recovery all the more difficult. "To the extent that [the Defense Commissary Agency] was custodian of records [sought by the recovery auditor], getting access was difficult," Polimeni says.

Over time, the process becomes easier and more productive, Dinkins says. Overall, Polimeni says, he is satisfied with the way the demonstration program has worked. "We believe this makes sense. Theoretically, as we go on, we'll have fewer problems." He acknowledges some reluctance on the part of federal managers toward the process. "It's only human nature. People who make [contract] awards believe in the correctness and accuracy of what they're doing. People want to defend their actions. They see this as indirect criticism."

DLA has since expanded its use of recovery auditing to other supply centers. Critical to the success of the expanded effort will be getting all the key players from within the supply centers onboard from the beginning, says Furman.

Uncertain Future
In many ways, the supply centers are ideal candidates for recovery auditing. Because they are administered under the Defense working capital fund-a set of revolving accounts for fee-for-service organizations established to promote cost visibility and cost recovery in support operations-supply centers operate much the way commercial wholesalers do. They buy goods for resale to their customers, which are the military services and other Defense agencies. Those customers in turn pay for the goods and services using funds appropriated by Congress. The Defense Department's working capital fund agencies-such as DLA, the Defense Commissary Agency, military depots, the U.S. Transportation Command and other support operations-account for $75 billion in sales annually.

In the 1999 Defense Authorization Act, Congress directed DoD to expand its use of recovery auditing within the working capital fund agencies. John Evans, director for revolving funds in the Defense comptroller's office, says recovery auditing may prove to be a valuable tool at Defense, especially in areas of high-volume commercial purchasing. "The recovery auditing firms have expertise that we don't have, and they perform a function we haven't been performing in house," he says. The firms have access to information on volume discounts, rebates and other information that affects pricing on commercial items, he adds, and can bring considerable research tools to bear when analyzing payment records.

But recovery auditing incurs costs that sometimes are overlooked, Evans says. "You have to manage the recovery auditing contract, you have to dedicate staff to support the audit, and there are administrative costs." Besides providing records to the auditor, the agency often has to explain contract issues and when overpayments are identified, the contracting officer then has to negotiate with the vendor for payment. If negotiations are not successful, an agency may have to dedicate resources to litigation, he says.

Staff at the U.S. Transportation Command, which contracted for recovery auditing services last year, have been very frustrated with the process thus far, Evans says. The contracts the command lets to move military cargo around the world are complex and don't lend themselves to typical recovery audit techniques. TRANSCOM employees are finding that supporting the recovery auditing process requires a greater investment than they initially anticipated, Evans says. Recovery auditing just doesn't make sense in all areas, Evans explains. For example, complex performance-based service contracts and major weapons contracts, which generally have ongoing audit functions, don't lend themselves to traditional recovery auditing, he says. Nevertheless, recovery auditing does teach acquisition officials to write better contracts, he says. "Once you have a dispute with a vendor about a contract, it teaches you a lot about how you write contracts in the future."

Nothing to Lose
Private-sector executives are less inclined to dismiss the potential of recovery auditing on major weapons contracts. "I don't think anybody knows until you apply recovery auditing what kind of success you might have," says Dinkins. Today, virtually every commercial business uses recovery auditing, he says. "In the early days, there was some resistance, but once the savings were demonstrated, that point of view changed. In the government, you still have Doubting Thomases."

For recovery auditing to be successful, there must be a partnership between the recovery auditing firm and the client, says Dinkins. The support provided by the client in granting access to records is critical. "You've got to want the process to succeed," he says. Gerald Peterson, comptroller of the Army and Air Force Exchange Service, agrees: "It's important that an agency decide up front what they want the recovery auditor to do. You have to have a real partnership with the recovery auditor and you really have to want them to find errors." Peterson should know. AAFES signed its first contract with a recovery auditor in 1983, so he has as much experience with recovery auditing as anyone in government.

To make the process as productive as possible, agencies should require auditors to provide quarterly reports with recommendations for improving accounting operations. "Recovery auditors really ought to be working themselves out of a job," Peterson says. But after 17 years at AAFES, "they're always finding new things."

Because AAFES is basically a retail operation that runs military shopping centers, convenience stores, beverage outlets and military clothing sales, it closely mirrors private sector retail business models. "We have a real incentive to maximize our resources," Peterson says. Like many commercial operations, AAFES has its own internal recovery auditing unit that makes a first-sweep of payment records to harvest what industry officials call the "low-hanging fruit" of overpayments. After the initial review of records, the agency turns over its books to a commercial recovery auditing firm for an initial audit. After that audit is complete, AAFES contracts with a second recovery auditor to go over the books yet again. Because the second auditing firm has a tougher job-presumably AAFES' internal auditors and the first outside auditor have recouped the easiest overpayments-it receives a higher percentage of money recovered than the first firm does.

"Having two recovery firms is common practice in the retail industry," says Peterson. Hiring a second recovery auditor serves two functions: it serves as a check on the first firm and provides an incentive for the first firm to excel. It also recoups additional money that would otherwise be lost. Since recovery auditing is pervasive in the retail industry, AAFES suppliers have no heartburn over the process. "I can see where government contractors that haven't been subject to this in the past might not be too enthusiastic about it," he says. Although some recovery auditors believe the rate of recovery typically drops after initial recovery audits are performed, all agree that regardless of how good an organization's accounting operations, errors in payment processing are part of the cost of doing business, and the benefits of recovery auditing are ongoing.

"Do federal agencies have anything to lose? One would think not, but there clearly seems to be some resistance to this," says Elizabeth Alexander, president of the recovery auditing firm Connolly Consulting Associates. "This is a private sector practice that can provide great value to the government," she says. She recently established the Recovery Auditing Institute, which seeks to perform recovery audits for federal clients. Recovery auditors entering the federal market need to start slow and work toward recoveries that have a low potential for reversal, she says. "You don't want to create ill will with suppliers."

Questionable Incentives
More than at any other agency, officials at the Health Care Financing Administration have expressed concern about recovery auditing and its implications if mandated across government. What seems to make HCFA officials most uneasy is the contingency-fee arrangement by which recovery auditors are paid. Michelle Snyder, the chief financial officer at HCFA, testified in June 1999, about the agency's opposition to the Government Waste Corrections Act. "Paying on a contingency basis for error identification could be perceived pejoratively as a 'bounty system' by health care providers," she told the House panel on government management, information and technology. Providers have raised such concerns about even the very modest reward available to beneficiaries who uncover fraud, she told the panel. Snyder declined to discuss on the record HCFA's continued opposition to the legislation, except to say, "The concern is to look at this very carefully and see if there are things we can do to ensure the best value to the [Medicare] trust fund."

HCFA doesn't actually process Medicare claims itself, but contracts with major insurers to process payments. In 1996, the agency launched the Medicare Integrity Program, a major initiative aimed at reducing waste, fraud and abuse in Medicare. Agency officials estimate that the payment error rate has dropped 50 percent, from 14 percent in 1996, to 7 percent in 1998, as a result of their efforts to clean up the program. Private contractors are doing much of the work in identifying and recovering overpayments in the Medicare Integrity Program, although they are not paid on a contingency basis, program officials say.

HCFA is also working to calculate the error rate for each of the contractors that processes Medicare claims, says George Mills, an analyst with HCFA's program integrity group. Mills spoke at the July forum on recovery auditing sponsored by the Reason Public Policy Institute. "We're working very hard to eliminate overpayments," he says. The agency's opposition to recovery auditing stems from concerns about HCFA's relationship with health care providers. "We want nurses and doctors reviewing claims, not accountants," Mills says. "We want the provider community to believe decisions are made on the merits [of the case], not on some financial incentive."

HCFA's efforts to identify and recover overpayments are laudable, but don't preclude recovery auditing, says Michael Sick, president of Connolly Consulting Associates' health care division, which performs recovery auditing for some of the same insurers who process Medicare payments for HCFA. Because health care payment processing is so complex, the company relies on doctors and nurses, along with accountants who have specialized medical training, to conduct the audits, Sick says.

"Skilled auditors are critical. You can't just run the data through a computer and pick out overpayments," says Sick. "Ideally, an auditor is someone who, in the course of reviewing claims, understands medically what is taking place-yet has the skills of an auditor."

The techniques recovery auditors use to identify overpayments are already being used by HCFA's contractors in its Medicare Integrity Program, but HCFA would probably benefit from more focused post-payment review activities than it is currently performing, auditors at GAO reported in September (GAO/HEHS/AIMD-00-304). "HCFA may be missing opportunities to identify significant overpayments," GAO reported, noting that HCFA would need more funding to increase post-payment auditing on a non-contingency-fee basis. To give federal managers incentive for undertaking recovery auditing, the Government Waste Corrections Act would allow agencies to keep some of the funds recovered. Half of any monies recovered would be returned to the federal treasury, 25 percent would go to the recovery auditing firm, and the remaining 25 percent would be returned to the agency to invest in management improvement initiatives.

Even if the bill becomes law, its immediate effect on agencies likely will be marginal. Nonetheless, it would give recovery auditing firms a foothold in the federal marketplace. If the practice is as good as they say it is, then agencies will be under pressure to apply it more broadly, advocates say. In the meantime, overpayments to contractors for billions of dollars a year are likely to continue. "We're not doing right by the taxpayer," says DeMaio. "We need to collect that money."