SEC – Government Contracts Firm Settle Internal Controls Action

Internal controls has been at the center of a number of Commission enforcement actions in recent months. Its most recent action in this area focuses on a firm that recognized revenue in a manner that was inconsistent with its own policies. Ultimately the firm discovered the issue, corrected its filings and self-reported. In the Matter of L3 Technologies, Inc., Adm. Proc. File No. 3-17769 (January 11, 2017).

L3 is a prime contractor for various foreign and U.S. government agencies, including the Department of Defense. Its shares are traded on the NYSE. The firm contacted to maintain a fleet of about 100 fixed-wing C-12 airplanes for the U.S. Army at bases in the United States and around the world. The contract was initially handled through a subsidiary and later through its Army Sustainment Division. The contract had a five year term beginning in June 2010.

In mid-2013 the firm realized it might lose money on the contract that year. At the same time the firm concluded that it has not billed the Army for all of the work. L3 then developed a “Revenue Recovery Initiative” – a plan to determine the amount of unbilled work which would then be billed to the Army. By November of 2013 the company determined that there was $50 million in unbilled work. While the Army was billed for that amount, by year end there was no agreement on payment because of the complexity of the work.

The VP of Finance for the Army Sustainment Division, under pressure from superiors, had employees generate about 69 invoices for work performed but unbilled. The invoices were not delivered to the Army. By recognizing the revenue of $17.9 million represented by the invoices the Division was just able to meet its target for management bonuses.

Recognizing the revenue from the 69 invoices was not consistent with L2’s revenue recognition policy. That policy required that: there be persuasive evidence of an arrangement; the services have been provided; the price be fixed or determinable; and collectability be reasonably assured. Here collectability was not reasonably assured since the invoices had not been delivered. Nevertheless, the revenue was recognized. Steps were taken to evade the internal controls and deceive the auditors.

When the invoices were created a report was forwarded to the internal ethics department. An investigation failed to uncover the scheme largely because of a lack of understanding of firm procedures.

By June 2014, however, the invoices were discovered. An internal investigation using outside advisers was launched. On July 31, 2014 a press release reporting the preliminary unaudited financial results for the second quarter of 2014 stated that the firm was conducting a review of an accounting matter. The release also stated that the firm expected to incur a pre-tax charge against operating income for periods prior to 2014.

In October 2014 L3 filed a Form 10-K/A for the fiscal year ended December 31, 2013 and a Form 10-Q/A for the first quarter of 2014. Those filings amended the disclosures following the internal review, admitting the company had not maintained an effective control environment in one segment with respect to revenue, that there had been an intentional override related to certain transactions and that personnel did not perform reviews of certain employee concerns regarding violations of accounting policies. The amended filings also disclosed that the review concluded that the accounting treatment for certain sales-type lease transactions in another segment of the company required correction. The correction was made.

In its Form 10-K for 2015 the firm stated that it had undertaken certain steps to remediate the material weakness of internal controls. Those steps had been tested and found effective. The firm self-reported. The Order alleges violations of Exchange Act Sections 13(b)(2)(A) and 13(b)(2)(B).

To resolve the proceeding the company consented to the entry of a cease and desist order based on the Sections cited in the Order. Respondent will also pay a penalty of $1.6 million.

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