In 2005, Congress authorized a demonstration project for use of Recovery Audit Contractors (RAC) in Section 306 of the Medicare Prescription Drug, Improvement, and Modernization Act of 2003. In general, the Department of Health and Human Services (HHS) was directed to demonstrate the use of RACs in identifying and correcting overpayments and underpayments under the Medicare program. The project was to cover at least two states with three contractors and last for no more than three years. The project initially covered three states—Florida, New York and California—and was eventually expanded to also include Massachusetts, South Carolina and Arizona.

In section 302 of the Tax Relief and Health Care Act of 2006, Congress required HHS to enter contracts with RACs in all states by no later than January 1, 2010, making the demonstration project permanent.

Medicare Overpayments & Underpayments

The purpose of the RAC contracts is to identify underpayments and overpayments and recoup overpayments under Part A or B of the Medicare program. RACs are paid on a contingent basis for detecting and correcting improper payments. Correcting includes both collecting overpayments from providers and refunding underpayments to providers.

The RAC review process is similar to that used by existing Medicare claims processing contractors. The RACs have performed two types of reviews:  automated reviews and complex medical reviews. The automated reviews were designed to identify the “low-hanging fruit” and used data mining techniques to identify multiple units billed, missing modifiers and payments for discontinued HCPC/CPT codes. The complex medical reviews reviewed the medical record or other documentation. They have caused payment denials mainly due to lack of medical necessity and missing records or documentation.

As of March 27, 2008, RACs had succeeded in correcting more than $1.03 billion in improper Medicare payments. Approximately 96 percent were overpayments collected from providers. Most of these overpayments (85 percent) were collected from inpatient hospital providers.

Impact on Health Care Providers

Until January 2010, unless providers were located in one of the demonstration states, they were not subject to a RAC audit nor had they received notice of a RAC audit. However, some providers have established reserves. They did so by recording a liability (or reduction of a receivable) in a due to or from third-party payer account and a related contractual allowance for uncollectible payments (contra revenue) for the possibility of a RAC audit and the potential for repayment of Medicare overpayments. We will hereafter refer to this activity collectively as an allowance.

Accounting Implications

Accounting Standards Codification (ASC) Topic No. 954-605 addresses revenue recognition for health care entities. Highlights of 954-605-25-2 through 25-6 include:

• Revenue usually is recorded when the service is provided and gross service revenue is recorded on an accrual basis at the provider’s established rates, regardless of expectation of collection
• Provisions for contractual adjustments and discounts are recognized on an accrual basis and deducted from gross service revenue to determine net service revenue
• Amounts realizable from third-party payers for health care services are usually less than the provider’s full established rates for those services
• Estimates of contractual adjustments, other adjustments and the allowance for uncollectible accounts shall be reported in the period during which the services are provided even through the actual amounts may become known at a later date

ASC Topic No. 954-310 addresses receivables for health care entities. Similar to the revenue recognition guidance discussed above, this section states that contractual adjustments, discounts and an allowance for uncollectible accounts shall be recorded in the period during which services are provided. This is to measure the receivables for health care services initially at net realizable value.

Based on the above accounting guidance, providers may wonder whether it is appropriate to record an estimated allowance for overpayments or uncollectible payments for RAC audits. The answer is no, unless the provider is able to provide sufficient appropriate evidence based on its own experience and assumptions as discussed further below.

AICPA Statement of Position 00-1 (SOP 00-1), Auditing Health Care Third-Party Revenues and Related Receivables, is the primary source of authoritative auditing literature for the remainder of this discussion. Its provisions are based on and consistent with the relevant ASC sections and clarify the provider-specific evidence requirement.

The SOP states in part, “Management is responsible for assuring that revenues are not recognized until their realization is reasonably assured. As a result, management makes a reasonable estimate of amounts that ultimately will be realized, considering—among other things—adjustments associated with regulatory reviews, audits, billing reviews, investigations or other proceedings. Estimates that are significant to management’s assertions about revenue include the provision for third-party payer contractual adjustments and allowances.”

Management may estimate an allowance for a potential RAC audit, subject to the considerations discussed further below, to avoid recording revenue that is not reasonably assured of being realized. As discussed in paragraphs 16-17 of SOP 00-1, the measurement of estimates is inherently uncertain and depends on the outcome of future events. That information related to the outcome of a future RAC audit does not exist does not necessarily lead to a conclusion that the evidential matter supporting management’s assertions is not sufficient to support management’s estimates.

In other words, management may make an estimate based on specific evidential matter supporting the necessity for and amount of the accrual. Par. 28 of SOP 00-1 states in part, “The fact that an entity currently is not subject to a governmental investigation does not mean that a recorded valuation allowance for potential billing adjustments is not warranted. Nor do these emerging industry trends necessarily indicate that an accrual for a specific entity is warranted.”

Therefore, while an allowance may be warranted for providers not yet subject to a RAC audit, it must be based on evidence other than the industry trends that have emerged as a result of the RAC demonstration project, i.e., the actual experience of providers in the demonstration states. A general allowance should not be recorded, but a specific allowance supported by provider-specific billing may be appropriate.

The bottom line is an accrual based on an estimated percentage of Medicare revenues consistent with the results of the demonstration project is not sufficient appropriate evidence. Instead, a provider’s estimates must be based on its own experience and assumptions, such as:

• The results of an internal billing/coding, medical records or other review
• The results of external billing/coding, medical records or other review
• The results of other internal analysis

Other Related Matters

Providers who identify potential overpayments should seek immediate assistance from legal counsel and compliance experts to determine what, if any, notice to give to third parties or additional action to take.

Conclusion

If it is appropriate to record an allowance for RAC audits based on appropriate, provider-specific evidence, then the allowance would be considered an accounting estimate and subsequent changes in the recorded allowance would be accounted for as a change in accounting estimate. The allowance should be recorded as a component of amounts due from or to third-party payers on the balance sheet and a deduction in arriving at net patient service revenue shown on the statement of operations (or statement of revenues, expenses and changes in net assets).

Contact your BKD advisor with any questions regarding RAC audits and related accounting considerations.