David H. Brooks, a university graduate with an accounting degree and the former CEO of DHBIndustries, Inc., was charged in October 2007 with accounting and securities fraud for failing toreport the company’s inventory at the lower of cost or market. From 2001 to 2005, DHB purchasedlarge quantities of a material called Zylon and used it in making bulletproof vests that were sold tothe U.S. military and local law enforcement agencies. During this same period, DHB learned thatZylon deteriorated rapidly when exposed to light, heat, and body perspiration. DHB knew that oneof its competitors, Second Chance Body Armor, had stopped using Zylon in its vests and, eventually, discontinued its business because customer demand for its Zylon-based vests had evaporated.DHB did not write down its own inventory of Zylon and Zylon-based vests because it had a largecontract to supply the U.S. military with bulletproof vests. In its financial statements for the yearended December 31, 2004, DHB reported inventories of $86 million, sales of $90 million, netincome of $8.3 million, but no inventory write-down. Yet, only eight months later, DHB admittedit should have written down its inventory by $18 million.Required:1. Show the impact of the inventory write-down on the accounting equation, and also show thejournal entry that should have been recorded on December 31, 2004.2. Calculate ( a ) the Inventory balance that should have been reported on December 31, 2004,and ( b ) the amount of Net Income that should have been reported for the year ended December 31, 2004. (Assume the inventory write-down does not affect income tax.)3. DHB’s share price reached an all-time high ($20–$22 per share) in November and December2004, but then the company’s CEO, CFO, and other executives began selling their shares inthe company. Within a few weeks, they had cashed in over $200 million of stock. In August2005, after DHB announced its inventory would have to be written down, the stock price fellto less than $5 per share. If you were an attorney representing DHB’s investors, what evidencewould you present to assert that a fraud had occurred? If you were an attorney defendingDHB, what counterarguments would you make?
David H. Brooks, a university graduate with an accounting degree and the former CEO of DHB
Industries, Inc., was charged in October 2007 with accounting and securities fraud for failing to
report the company’s inventory at the lower of cost or market. From 2001 to 2005, DHB purchased
large quantities of a material called Zylon and used it in making bulletproof vests that were sold to
the U.S. military and local law enforcement agencies. During this same period, DHB learned that
Zylon deteriorated rapidly when exposed to light, heat, and body perspiration. DHB knew that one
of its competitors, Second Chance Body Armor, had stopped using Zylon in its vests and, eventually, discontinued its business because customer demand for its Zylon-based vests had evaporated.
DHB did not write down its own inventory of Zylon and Zylon-based vests because it had a large
contract to supply the U.S. military with bulletproof vests. In its financial statements for the year
ended December 31, 2004, DHB reported inventories of $86 million, sales of $90 million, net
income of $8.3 million, but no inventory write-down. Yet, only eight months later, DHB admitted
it should have written down its inventory by $18 million.
Required:
1. Show the impact of the inventory write-down on the
journal entry that should have been recorded on December 31, 2004.
2. Calculate ( a ) the Inventory balance that should have been reported on December 31, 2004,
and ( b ) the amount of Net Income that should have been reported for the year ended December 31, 2004. (Assume the inventory write-down does not affect income tax.)
3. DHB’s share price reached an all-time high ($20–$22 per share) in November and December
2004, but then the company’s CEO, CFO, and other executives began selling their shares in
the company. Within a few weeks, they had cashed in over $200 million of stock. In August
2005, after DHB announced its inventory would have to be written down, the stock price fell
to less than $5 per share. If you were an attorney representing DHB’s investors, what evidence
would you present to assert that a fraud had occurred? If you were an attorney defending
DHB, what counterarguments would you make?
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