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Defense and aerospace operator L-3 Communications Holdings Inc.’s lower-than-expected second quarter earnings and possible misconduct in maintenance of accounts have taken a toll on its share price. L-3 Communications lost 12.27% yesterday to close at $104.96 per share.  The aftermarket trade indicates L-3 Communications shares will continue to slide.

What were the accounting irregularities?

During the second quarter release, the company announced that they have unearthed an accounting misconduct at its Aerospace Systems segment. The company is being assisted by outside accounting and legal advisors to solve this problem.

The accounting problems pertained to a Department of Defense contract running from Dec 2010 through Jan 2015. That contract has averaged annual sales of approximately $150 million. It related to cost overruns on the program that were inappropriately deferred while net sales were overstated in the accounts.

Steps Taken by the Company

L-3 Communications decided to incur a pre-tax charge of $84 million and reduce net sales by $43 million over 2011-2014.  The company incurred a post-tax charge of 21 cents per share in the reported quarter. The company also lowered its estimated operating income from the Aerospace Systems segment by nearly $35 million for the second half of 2014.

In addition, the company fired four employees while one resigned.

What the law firms will try to find out?

Concealment and manipulation of financial information and presenting a rosier picture to the investors is a serious allegation. Shareholders have every right to be in the know, as they have a stake in the company and any fall in the share price affects them financially.

This alleged misconduct has brought in a group of shareholder rights law firms who will try to probe whether the problem runs deeper than what has been apparently revealed. The objective of these law firms will be to protect the interest of the investors of L-3 Communications.

Investigation will throw light on the persons involved in the fraud and how the accounts were manipulated over the years.

Our View

Though the company said that it has isolated the problem and adjusted current as well as previous year accounts, it also admitted the gravity of the misconduct of its employees.

We note that L-3 Communications has been a consistent performer clocking earnings beats over the last few years. However, the probe will reveal the company’s true accounting details and the real picture when compared to market projections.

Zacks Rank

L-3 Communications currently holds a Zacks Rank #2 (Buy). Other operators in the aerospace and defense space, which look well placed at current levels, include The Boeing Company , Northrop Grumman Corporation and General Dynamics Corp. . All these stocks carry the same Zacks Rank as L-3 Communications.

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