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 accounting equation, and also show 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?