On February 28, 2011, the SEC charged DHBIndustries Inc. (DHB), a major supplier of body armour to the U.S.military and law enforcement agencies, with engaging in a massive accounting fraud. The SEC alsocharged three of the company's former outside directors and audit committee members for their complicity in the fraud. The SEC complaint also alleged thatthe directors' actions allowed DHB's David Brooks, Dawn Schlegeland Sandra Hatfieldto divert corporate funds to a controlled entityfor personal gain.Hatfield and Brooks were convicted in September 2010 on various chargesarising out of a $200 million fraud.
1.Using fraud theory, analyse and explain the fraud committed by David Brooks.(10marks)
2.Research and critically discuss whetherthe fraud committed by Brooks could have risked the collapse of DHB Industries Inc. in 2004. Justify your opinion, stating any assumptions. (12marks)
3.(a) Analyse the Balance Sheets and Income Statement (Statement of Operations) for the 2004 and2003financial years using the following methods to detect red flags which suggest the likelihood of financial statement fraud:(i)Ratio analysis using 5 appropriate ratios(ii)M Score 5 variable model(b) Discuss the red flags, if any, which you have detected in part 3(a) above.((5 + 10marks) + 5marks= 20marks)
4.Using fraud prevention theory, critically discuss:(a) how members of the audit committee failed to prevent the fraud at DHB, and(b) whatstrategies could have been implemented by DHB to prevent the fraud.(2 x 6 marks= 12marks)
FOR THE YEARS ENDED DECEMBER 31, (In thousands, except share and per share data) ASSETS 2004 2003 2002 Current assets Cash and cash equivalents $447 $441 $393 Accounts receivable, less allowance for doubtful of $702 and $852, respectively 47,560 33,707 22904 Accounts receivable - related party Inventories 85,973 54,753 33,360 Deferred income tax assets 483 372 3,319 Prepaid expenses and other current assets 1,220 1,518 971 Total current assets 142,266 90,791 60,947 Property and equipment, net 2,632 1,819 1,620 Other assets: Other investment 942 Deferred income tax assets Deposits and other assets 593 437 1,402 Total other assets 818 2.809 Total assets $145, 857 $93,428 65,371 LIABILITIES AND STOCKHOLDERS' EQUITY Accounts payable $8,014 $9,465 $5,368 Accrued expenses and other current liabilities 8,350 5,635 2,454 Note payable - bank 6,000 Income taxes payable 14 ,816 6,869 otal current liabilities 37,180 23,969 7,822 Long Term Liabilities Notes payable-bank 25,634 22,012 24,354 Notes payable-stockholder 1,500 Term loan payable 4,500 Other liabilities 1.086 502 350 Total liabilities 68,400 46,483 34,026 Stockholders' equity 77,457 46,945 Total liabilities and stockholders' equity $145,857 $93,428 65,371 CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, (In thousands, except share and per share data) 200 2003 200 Net Income $30,435 $15,172 $15,980 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation Amortization of deferred financing costs 978 560 463 125 Provision for doubtful accounts 39 Write-off of other investment Change in minority interest due to sale of subsidiary stock Minority interest in consolidated subsidiary 224 200 Stock issued for services 165 Issuance of stock warrants to outside consultant -267 646 Deferred income tax expense (benefit) 3,912 -4,462 Changes in operating assets and liabilities: Accounts receivable -10,585 -11,929 Accounts receivable-related party -6,583 Inventories 31,220 -21,393 Prepaid expenses and other current assets Deposits and other assets 298 -547 106 Accounts payable -1,451 4,097 OEG'L- Income taxes payabl 7,947 6,869 Accrued expenses and other current liabilities 2, 715 -61 Other liabilities 152 350 Net cash provided by (used in) operating activities -10,095 2,595 -15,145 CASH FLOWS FROM INVESTING ACTIVITIES Proceeds from sale of property and equipment 302 Purchases of property and equipment -1,791 -741 -367 Net cash used in investing activities -1,791 -741 -65 CASH FLOWS FROM FINANCING ACTIVITIES Dividends paid on preferred stock (related party) -360 -360 -345 Proceeds of notes payable - bank 253,768 154,889 92,378 Payments of notes payable - bank 252, 146 155,231 -76,466 Payments of note payable- stockholder 1,500 Proceeds from the issuance of long term debt 12,500 5 500 ssuance costs of term loan payable -83 -32 Principal payments on term loan payable 2,000 .20 2004 200 2002 Net sales (including related party sales of $6,559, $15,109 and 12 respectively) $340,075 $230,011 $130,347 Cost of goods sold (including related party purchases of $17,627, $29,243,and $8,387, respe , respectively) 166,670 92,621 94 135 63 ,341 37,726 Selling, general and administrative expenses 23.903 Income before other income (expense) 49,571 26.016 13,823 Other income (expense) Interest expense -1,374 1,344 -1,645 Write down of other investment -904 Gain on sale of subsidiary stock 1450 Other income (including insurance settlement of $1,009 in 2003) 35 1,059 130 Total other income (expense) - 1,339 261 -1,515 Income before income tax (benefit) expense 18,232 26,277 12 ,308 Income taxes (benefit) expense: Current taxes 17,840 7,186 77 Deferred tax expense (benefit) -267 3,912 -3,749 Total income tax (benefit) expense Income before minority interest of subsidiary 30,659 15,179 Less minority interest of subsidiary -7 - Net income 15,172 15,980 Dividend - preferred stock (related party) - 360 -345 Income available to common stockholders 530%IS $14,812 Basic earnings per common share 50.73 $0.36 $0.42 ed earnings per common shar $0.67 SO.34 30 37
