Lessons Galore in New SEC Internal Control Case

The SEC fined defense contractor L-3 Technologies $1.6 million this week for poor accounting controls. The penalty might be small money, but we don’t often see a “pure” books-and-records enforcement action, so compliance officers would do well to examine the lessons learned here.

The failures happened as part of a contract L-3 had with the Defense Department to provide support for roughly 100 fixed-aircraft. The contract ran from 2010 to 2015. By sometime in mid-2013, senior executives in that L-3 division (the Army Sustainment Division, or ASD) realized that they had bid too low on the work, and the company wouldn’t make enough money that year.

Said ASD executives then devised a “Revenue Recovery Initiative”—am I the only one who winces at the name of that plan?—where they reviewed work L-3 had supposedly provided, but not yet billed to the U.S. Army. By November 2013, the division had determined that it found $50 million in services L-3 had provided, but not yet invoiced.

Army accountants balked at those new billables, and a standoff ensued. By December, L-3 executives were looking for some way to book that revenue before year-end so they could meet bonus performance targets. The VP of finance for ASD then directed employees to draft 69 invoices, worth a total of $17.9 million, but not send them to the Army since the contract was still in dispute.

As a matter of Generally Accepted Accounting Principles, pre-booking invoices is a big no-no. Even if ASD expected to recoup that $17.9 million eventually—which was by no means certain—GAAP does have a four-part test to determine whether revenue can be recognized. One part is whether the goods or services have in fact been delivered; another is whether the company is reasonably sure it will be able to collect the money. Right there, ASD flunked.

Enter the Ethics & Investigation

The good news is that as L-3 executives concocted this scheme, someone in that division alerted the company’s ethics & compliance function. The bad news is that the investigators didn’t understand L-3’s billing processes and misunderstood statements witnesses made to them. As a result, the investigation didn’t get escalated to the audit committee until summer 2014.

Right away, what comes to my mind is Principle 4 of the COSO internal control framework: “demonstrate commitment to a competent workforce.” Whether the failure there was hiring a finance executive who would propose misconduct, or using investigators who missed the misconduct, I’m not sure.

Things went downhill from there. When L-3’s audit committee did become aware of the problem in summer 2014, it disclosed an investigation into accounting matters and reported the matter to the SEC. Ultimately the board admitted to a material weakness in its internal control over financial reporting, and had to issue amended financial statements for all of 2013 and first-quarter 2014.

When all was done, L-3 took a pre-tax charge of $169 million for the period, because it had found other improprieties beyond the ASD debacle itself. The misconduct by the afore-mentioned ASD executives accounted for $15.4 million of that pre-tax charge.

What Good Remediation Looks Like

The SEC did praise L-3 for the actions it took in 2014 to clean up the ASD mess. In its 2015 annual report, L-3 outlined what some of those steps were:

• Firing executives in the ASD and several other divisions were trouble was found;
• Creating and filling a controller position for the Aerospace Segment, which includes the troubled business units;
• “Designating senior level employees to oversee and manage” investigations into accounting irregularities, which you can interpret as you will; and
• Naming a new corporate ethics officer.

I’m not clear whether the ethics officer was a newly created position, or whether L-3 fired someone. The company is large, and has numerous people working in corporate ethics. If anyone knows the scoop and wants to share, I promise to keep your name out of it.

The fundamental lesson here is all about that Principle 4 of the COSO framework: Does your company make a commitment to hiring competent staff?

After all, L-3’s corporate culture worked fairly well here: when staff within the ASD saw the funny numbers, they reported it to the company’s ethics team. Nobody can blame them for a preliminary investigation that flopped because L-3’s investigations team couldn’t follow the accounting.

Once the audit committee did understand what was afoot, it self-disclosed to regulators and launched an investigation with outside advisers who did knew how to unravel l’affaire des invoices. They got to the bottom of things within a matter of months.

What failed was L-3’s commitment to hire competent staff: both operations executives who would behave ethically in difficult circumstances, and investigators who would know when accounting procedures don’t pass the smell test.

Now L-3 has better people on the job. It was an expensive lesson in workforce development to learn.