In performing examinations of claimed administrative costs, HEW Audit Agency objectives are fivefold:

1. To determine whether the contractor has established effective systems of internal control, accounting and reporting for administrative costs incurred.

2. To ascertain whether the final cost report presents the costs of program administration allowable in accordance with part 1-15.2 of the Federal procurement regulations as interpreted and modified by the medicare agreements.

3. To ascertain whether the contractor has complied with contractual and intermediary manual requirements governing specific items of

cost.

4. To identify the underlying causes of significant errors or problems noted and make recommendations for improvement.

5. To follow up on implementation, effectiveness, or corrective action recommended in prior reports.

Our medicare audit instructions require each examination to be sufficiently comprehensive to permit a determination that the audited cost report presents, in all material respects, only the allowable costs of administration.

Recurring examinations include, to the extent considered necessary, evaluations of the accounting system and related internal controls, and tests of the accounting records.

As is normally done in professional auditing generally, individual transactions are examined on a test basis to the extent considered necessary in the auditor's professional judgment.

Many factors influence this judgment, such as:

1. The effectiveness of internal control procedures for screening out unallowable costs.

2. The significance of the amounts.

3. The nature of the items charged.

4. The likelihood that an account or cost center may contain unallowable costs, unreasonable costs, or costs not benefitting the medicare program.

5. Prior audit findings.

6. The coverage and adequacy of SSA program reviews.

7. The extent of audit work performed by other auditors. Because these factors vary from contractor to contractor the percentages of individual transactions examined during our audits likewise vary from contractor to contractor and we do not accumulate data on these percentages.

On all audits we verify that claimed expenses are supported by the books and records and make comparisons of claimed costs, in total and by line item, to approved budgets and the prior year cost report. These overall checks are preliminary to the selection of accounts, cost accumulations, and allocation methods for detailed examination. The administrative costs of intermediaries and carriers are reimbursed in accordance with the "Principles of Reimbursement for Administrative Costs" prescribed for the medicare program.

These cost principles are contained in the program regulations and in the agreements with the contractors. They are based on the Federal Procurement Regulations.

As the previous witness stated, these program principles are the criteria we use in our auditing to evaluate the allowability of claimed

costs and on which we base any recommendations for financial adjustments.

Using our audit reports, SSA is responsible for final settlements with the contractors.

During fiscal years 1973 through 1976, the Audit Agency issued 283 audit reports on medicare contractors. In addition, to selected aspects of contractors' operations, the reports covered our examination of $1,031 million of contractors' administrative costs proposed for final reimbursement settlement.

Of this amount, we recommended net downward financial adjustments of $16.4 million.

Almost all of these reports either questioned costs or contained one or more recommendations for improving various aspects of the contractors' operations.

A summary by year of the costs audited, costs questioned, and the numbers of reports containing findings, is attached as Exhibit I to my statement.

[Exhibit I follows:]

EXHIBIT I

CONTRACTOR ADMINISTRATIVE COSTS AUDITED AND QUESTIONED AND NUMBER OF ISSUED AUDIT REPORTS YEARS 1973-76

Mr. STEPNICK. It should be noted that, since costs questioned are subject to negotiation between SSA and the contractors, actual disallowances may be less. Also, determinations are still pending on many reports.

Mr. STARK. Where you have those pending, and they come up year after year where there is some question as to whether they use firstclass air travel or something like that, and a ruling is finally passed, I assume you will go back and collect.

Would you then apply that ruling to all the other intermediaries or do you handle them one at a time?

Mr. STEPNICK. To the extent that a general rule does emerge, then that rule would in effect govern future audits. Frequently, the settlements are based on negotiations individually with each contractor, and it is not that clear to us whether or not we can apply the situation generally.

So, we would in that case then repeat, if we had found the same mistake again.

Mr. STARK. Just take that one more step.

If your opinion, are the regulations that exist tight enough?

76-614-76

I know sometimes you can define regulations so complexly that people can beat the spirit of the law while adhering to the letter if they don't leave the auditor enough judgment.

Do you think that we could define in regulation this whole question of overhead allocation to make your job easier then and make it a little clearer, without unnecessarily hamstringing the intermediaries?

Mr. STEPNICK. I would guess that every time we attempted to pin something down and prescribe that, the danger is we might cure a specific problem but I am a little bit concerned in some areas, particularly in the allocation area, whether in the process we would create three more.

Mr. STARK. You think using good judgment and aggressive auditing is probably a better way to control it, then?

Mr. STEPNICK. Yes; but I would have to at the same time say that in the final analysis the judgments which have to be based on reasonableness are subjective and that this becomes quite frustrating to the auditor because he knows that, unless he can clearly show that something is unreasonable, he is likely to lose in the negotiation process. So, I am ambivalent to that extent, sir.

Mr. STARK. Bank examining is much the same way. The only tool that the bank examiner has is to become a pest, to keep coming back and auditing till the management gets the idea.

Do the contractors pay for your audits?

Mr. STEPNICK. No, sir.

Mr. STARK. After two or three times does their audit bill go up? Mr. STEPNICK. No. The contractors don't incur the cost of our audits.

Mr. STARK. Thank you.

Mr. STEPNICK. Most of the administrative costs we have questioned have been in two general categories: (1) Costs which are specifically unallowable under the applicable rules, and (2) inequitable and incorrect allocations of contractors' costs to the medicare program.

Some typical examples of unallowable costs questioned are occupancy costs in excess of prevailing fair rentals, entertainment expenses, first-class air fares in excess of lower rates, and travel for nonmedicare business.

Out of $6.1 million questioned in reports issued in fiscal year 1976, almost $1 million pertained to these four types of unallowable costs. Occupancy costs were a predominant item, and with the trend toward new building construction by the contractors, we are giving this our particular attention.

Another cost item we have regarded as unallowable is referred to as "Premium Taxes".

Some States have enacted legislation providing for a tax on the gross insurance premiums collected from subscribers of nonprofit insurance carriers which had previously been tax exempt.

Typically, these carriers are Blue Cross and Blue Shield Plans. Mr. STARK. May I interrupt there?

In other words, while we grant these carriers exemption from Federal income tax, some of the States tax them as profitmaking associations; is that correct?

Mr. STEPNICK. This is in the guise of a franchise tax based on their gross commercial receipts.

Mr. STARK. Out of how many which you have looked at does this occur?

Mr. STEPNICK. There are 19 States that have done this, sir.

Mr. STARK. So, they consider them taxable as it were, either under the franchise concept or profit.

This is an association concept and we exempt them on the Federal level?

Mr. STEPNICK. Sort of a tax of being in business.

Mr. STARK. Thank you.

Mr. STEPNICK. While the tax is imposed usually as a percentage of gross premiums collected, the State laws sometimes refer to this tax as a franchise tax which is ordinarily an allowable cost for allocation to the medicare program.

However, we questioned that they were franchise taxes in the traditional sense of the term and we suggested that they really were a gross receipts tax applicable entirely to the contractors' regular commercial business.

Mr. STARK. Like a sales tax?

Mr. STEPNICK. Exactly.

While the contractors did not agree with our view, SSA and the Secretary made a determination disallowing the cost. The matter has been appealed to the Armed Services Board of Contract Appealswhich has been designated to handle contract disputes on cost issues and such matters-where a decision is pending.

Through 1975, about $7 million of charges to medicare is involved. Inequitable and incorrect allocations of costs to the medicare program are the second general category of costs we have questioned.

Problems of cost allocation occur more frequently than unallowable costs and relate principally to cost-finding methods for identifying costs applicable solely to medicare or solely to the contractors' business, or allocating costs that are common to or benefit more than one program or activity.

For example, contractors sometimes erroneously or inequitably in our opinion charge medicare for such things as: (1) Data processing costs applicable directly to their own lines of business; (2) communication expenses allocated on a general rather than a specific basis; and (3) general and administrative expenses which we think would be inappropriately grouped for cost allocation.

These kinds of problems are not peculiar to medicare contractors and are quite similar to those experienced in audits of cost reimbursement contracts under other Federal programs.

Our reports contain specific recommendations to SSA for correcting weaknesses in cost allocation procedures on a contractor-by-contractor basis.

In response to information made available to us by the Oversight Subcommittee staff, we initiated a limited special audit in April 1976 at 21 Blue Cross contractors to review auto and contractor-owned aircraft travel costs, with specific reference to possible overcharges to medicare for "luxury" and excessive automobile or aircraft travel costs.

This special audit-which was separate from our regular cyclical audits was aimed at determining as quickly as possible the extent to which problems may exist in these areas.

While prior audits had raised questions from time to time on automobile and airplane costs, a special audit was considered necessary because, under the selective testing techniques normally applied, our audit coverage of the alleged specific problems could have been limited. This special audit is not completed and a final report has not been prepared, but we believe that certain observations can be made based on the work done thus far.

With respect to luxury automobile costs, it should be noted that no official program definition of a luxury auto has been established.

While medicare reimbursement principles require the contractor's automobile costs to be reasonable, specific criteria do not exist to define or illustrate costs that would be considered unreasonable.

In the audit, therefore, we considered luxury autos to be top-of-theline full-size automobiles that had high acquisition cost in relation to other automobiles in use at the individual contractors.

On this basis, 11 contractors were found to have been operating luxury vehicles, but in only two cases did it appear that medicare was charged any appreciable excess costs.

In these cases, the excess cost at one contractor was $439 in 1975, and at the other contractor it totaled $848 for the years 1973-75.

At some locations employee cost sharing or longer depreciation periods resulted in less program costs for luxury cars than for other automobiles in use.

Audit information available thus far indicates also that one contractor operated 11 general-use vehicles with low annual mileage which, based on the contractor's established minimum use policy, indicated that some automobiles may not be needed.

In addition, at this contractor we found low mileage/high rentals for 21 leased executive automobiles which were used for nonbusiness as well as business purposes.

According to our calculations, this resulted in $2,758 additional costs to medicare in 1975 than would have been charged had the contractor reimbursed its officials 15 cents a mile for business use of their privately-owned automobiles.

Mr. STARK. Could I interrupt there?

That's just the costs to medicare, but if you extend that to, say, CHAMPUS, medicaid, to Federal employee health benefit programs or just to the private /public sector who pay their Blue Cross premiums, all of those programs are sharing the cost of these items; are they not?

Mr. STEPNICK. This is correct. The $2,700 figure would just be the cost to medicare.

There were some charges to other Federal programs.

Mr. DUNCAN. The luxury vehicles you are referring to, are they owned by the agency or the contractor?

Mr. STEPNICK. In the 11 contractors that we referred to, they were owned by the contractor and then in addition

Mr. DUNCAN. Were they bought with medicare funds?

Mr. STEPNICK. They were purchased out of their general funds but the costs of operating them, including the depreciation, which would be a portion of the acquisition cost, was allocated to medicare along with the other programs.

Mr. DUNCAN. Some place, I heard that the plan owned two luxury type automobiles, a Cadillac and a Buick Riviera. Is that true?