CASE 1.10
DHB INDUSTRIES, INC.
Synopsis
David Brooks founded DHB Industries in the early 1990s. Throughout its existence, the
principal operating unit of DHB was its Point Blank subsidiary that manufactured bullet-resistant
operating results from 2003 through 2005 had been the product of a massive accounting fraud.
Brooks and his two subordinates had routinely and blatantly altered DHB’s accounting records to
achieve the earnings targets that he had established for the company. The primary account
manipulated by the co-conspirators was DHB’s inventory.
A major problem faced by the conspirators was concealing their misdeeds from the company’s
independent auditors. Accomplishing that objective was made easier by the fact that between 2001
and 2005 the company had four different accounting firms serve as its independent auditors.
Frequent clashes between management and the company’s auditors were responsible for the almost
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DHB Industries, Inc.—Key Facts
1. David Brooks was sanctioned in 1992 by the SEC for failing to establish proper internal control
procedures for a brokerage firm owned and operated by his brother.
2. A few months before being sanctioned by the SEC, Brooks organized a small company that
would ultimately be named DHB Industries, Inc.
4. DHB’s sales of protective vests increased dramatically in the early 2000’s due to the 9/11
terrorist attacks and the Second Gulf War.
5. Despite record revenues and earnings, DHB’s net operating cash flows were very weak; in
6. Brooks ruled DHB with a dictatorial and intimidating management style; the company’s
8. At the conclusion of the fiscal 2005 audit, DHB’s auditors refused to issue an opinion on the
company’s financial statements in time for DHB to meet the SEC filing deadline.
9. Following Brooks’ dismissal as DHB’s CEO and chairman of the board, a year-long forensic
11. Law enforcement authorities filed a seventeen-count federal indictment against Brooks in late
2007 that included, among other charges, allegations of corporate fraud, insider trading, and
conspiracy.
12. In late 2011, Brooks was found guilty by a federal jury of all seventeen charges filed against
him, while DHB’s former COO was found guilty of fourteen similar charges; DHB’s former CFO
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Instructional Objectives
1. To illustrate the lengths to which dishonest executives will go to misrepresent their company’s
reported financial data.
3. To identify fraud risk factors.
4. To provide students an opportunity to apply the materiality construct.
Suggestions for Use
One method I use in covering large cases is to require students, in groups of three or four, to
complete a case template. After the students have met in their groups and completed the templates
(one per group), we then reconvene and discuss the case by going over the completed templates. I
use a variety of templates for this purpose. Listed next are the narrative items included in one such
template:
1. Identify the three most important facts of this case.
2. Identify three other facts or circumstances regarding this case that you would have liked to
have known.
Suggested Solutions to Case Questions
1. Before responding to this question, you may want to have your students discuss some of the
general benchmarks that are used in making materiality decisions, such as, five percent of net
income or one percent of net assets or net revenues. Of course, the authoritative professional
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Listed next are examples of differences in DHB’s original and restated 2004 financial statements
that I would consider to be material (the balance sheet items are listed first followed by the income
statement items):
•The $47 million difference in “Inventories”
•The $18.5 million difference in the current asset “Deferred Income Tax Assets”
•The $6.5 million difference in the current liability “Notes Payable” (granted, this was a
classification difference since this figure was included as a long-term liability in the original
financial statements)
Although this case question does not require students to explain the specific factors or
circumstances that accounted for the material differences between the original and restated 2004
DHB financial statements, you may want to provide them with an overview of some of the major
sources of those differences. The 2006 Form 10-K for DHB, which was issued in late 2007, presents
a detailed analysis of the company’s restated financial statements for 2003 and 2004 in a footnote
•The failure of DHB to apply the lower of cost or market rule to inventories in preparing the
original financial statements.
•Purchase rebates were recorded as revenues rather than as reductions to cost of goods sold in
the original financial statements.
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•”During the years ended December 31, 2004 and 2003, withholding taxes for bonuses paid and
the exercise of stock options and warrants were not withheld and paid to the taxing authorities
as required. The Company has now recorded liabilities for its potential obligations for federal
2. AU Section 316, “Consideration of Fraud in a Financial Statement Audit,” of the PCAOB’s
Interim Standards has a lengthy appendix that identifies “Examples of Fraud Risk Factors.” These
risk factors are sorted by the three components or “angles” of the fraud triangle:
incentives/pressures, opportunities, and attitudes/rationalizations. Listed next are fraud risk factors
included in the appendix to AU Section 316. (Note: A comparable list of fraud risk factors is
included in the AICPA Professional Standards at AU-C Section 240.A75.)
Incentives/pressures:
•High degree of competition
Opportunities:
•Significant related-party transactions
Attitudes/rationalizations:
•Ineffective communication, implementation or support, or enforcement of the entity’s values or
ethical standards by management
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Which of these fraud risk factors should have been of primary concern to DHB’s auditors?
There is certainly room for considerable debate when it comes to this question. At the top of my list
I would include, in no particular order, the following items, each one of which had very significant
implications for the integrity of DHB’s financial statements and, in turn, for DHB’s auditors.
.
•Domination of management by a single person or a small group
3. Note: in effect, the only evidence that DHB’s auditors collected regarding the existence of the
$7 million of vest components was a management representation that those items existed. Of course,
this “evidence” was subsequently revealed to be patently false by another member of management,
namely, David Brooks. As pointed out in the case, the controversy over the $7 million of “missing”
vest components was a factor that contributed to DHB’s auditors refusing to issue an audit opinion
Paragraph 29 of AS No. 15 addresses those circumstances in which auditors have doubts
regarding the overall integrity of certain audit evidence. “If audit evidence obtained from one source
is inconsistent with that obtained from another, or if the auditor has doubts about the reliability of
information to be used as audit evidence, the auditor should perform the audit procedures necessary
4. Note: AU Section 334, “Related Parties,” within the PCAOB’s Interim Standards discusses
that agency’s auditing standards for related parties and related-party transactions. AU-C Section
550, “Related Parties,” includes the AICPA’s auditing standards for related parties and related-party
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transactions. These two sets of standards are very similar.
There are two key issues an auditor should consider when a client has engaged in material
related-party transactions: 1) whether economic substance, rather than legal form, was the
determining factor in the accounting for such transactions, and 2) whether such transactions have
been disclosed adequately in the client’s financial statements as required by U.S. GAAP. The latter
of these issues does not present any major problems for the auditor since GAAP are very explicit
regarding the disclosures necessary for related-party transactions. Determining whether the
economic substance of a related-party transaction has prevailed over its legal form is generally a
more difficult issue for the auditor to resolve. Professional auditing standards discuss the procedures
that an auditor should consider applying to material related-party transactions. Listed below are
examples of such procedures.
5. The Sarbanes-Oxley Act of 2002 dramatically changed the nature of internal control reporting
responsibilities. For the first time, that federal statute mandated that the management of public
companies report on the effectiveness of their organizations’ internal controls. These reports must
indicate whether a company’s internal controls have been properly implemented and whether they
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financial reporting is to express an opinion on the effectiveness of the company’s internal control
over financial reporting” This paragraph goes on to indicate that “a company’s internal control
cannot be considered effective if one or more material weaknesses exist.” As a result of this latter
premise, “the auditor must plan and perform the audit to obtain reasonable assurance about whether
•“The auditor must communicate, in writing, to management and the audit committee all
material weaknesses identified during the audit.”
•“If the auditor concludes that the oversight of the company’s external financial reporting and
internal control over financial reporting by the company’s audit committee is ineffective, the
auditor must communicate that conclusion in writing to the board of directors.”
•“The auditor also should consider whether there are any deficiencies, or combinations of
6. Empirical research has demonstrated that there is somewhat of a “learning curve” effect in
independent audits. That is, auditors generally become more proficient in detecting material errors
in a client’s financial statements the longer their “tenure” with that client. Frequent auditor changes
undercut the learning curve effect and thus tend to diminish the overall quality of a given company’s
independent audit services.
one that shared its view regarding the issue in dispute.
AU Section 315, “Communications between Predecessor and Successor Auditors,” of the
PCAOB’s Interim Standards discusses the communications that should take place between a former
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and replacement audit team. These communications are intended to help ensure that successor
7. Clearly, auditors should not be subject to verbal abuse, intimidation, or other types of
harassment by client management or employees. If lower-level auditors are the target of abusive
treatment by client management or employees, they should immediately contact their immediate
8. “Yes,” the SEC does have a responsibility to protect the investing public from self-interested
corporate executives. According to the SEC’s website, its mission “is to protect investors, maintain
9. The Sarbanes-Oxley Act revolutionized the audit committee function for public companies.
SOX effectively mandates that every SEC registrant establish an audit committee. If a registrant
does not have an audit committee, then the board of directors, as a whole, must provide the
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•The audit committee must retain and supervise the given company’s independent auditors and,
in doing so, determine that the audit engagement team is competent to conduct the audit.
•The audit committee must ensure that the company’s auditors are independent.
•The audit committee must approve all professional services provided to the company by its
independent auditors and ensure that auditors do not provide to the company any of the
specifically prohibited services identified by SOX, such as bookkeeping services.
Note: PCAOB Auditing Standard No. 16, “Communications with Audit Committees,” requires
auditors of SEC registrants to discuss a wide range of matters with a client’s audit committee.
These matters include the terms of the audit engagement, the overall audit strategy, the quality of the
company’s financial reporting, among others. Because the PCAOB has no jurisdiction over audit
committees, all of the mandates include in AS No. 16 are directed toward auditors.