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Name: Michelle Diaz

Acct. 723: Advanced Auditing Theory and Practice


Professor: Arthur Digman
Date: 05/25/2017

Case 1.10 DHB Industries, Inc.

Questions:

1. The material differences between the original and the restated financial statements for
DHB are the following:

Inventory: was highly inflated by a lot, as wee can see that the original statements
present inventory within the $30,000, however, in the ones presented, inventory is
highly increased to $84,000. This is important since the companys main source of
income deals with sale of its inventory.
The deferred income tax assets had increased $18 million originally, but not
represented as really low amounts or no amounts at all.
There are accounts receivable from an additional related party, which was not
disclosed to SEC.
The liability section, where some items are excluded notes payable, employment
tax without obligation and more importantly items long-term liabilities are used to
cover up some of the expenses that were made.
In the stockholders equity section, retained earnings are presented but in reality
there was a retained deficit.
Net sales, cost of good sold and gross profits were altered to make the company
more profitable.
Taxes are also being withheld or not being represented in the financial statements
at the end the fiscal year.

All of these key items that were highly overstated or modified to present a company with
great earnings, by excluding certain items (liabilities). These material differences are
important because assets are being reported that dont exist or dont belong to the
company, inventory was highly overstated in order to reach the 27% increase in earning
that was expected by the professional stock analysts and these differences should have
been taken into account and analyzed with greater detail.

2. According to AS 2401, there are three conditions that have to be present when the
fraud occurs, which this is represented the fraud triangle. The fraud risk factors posed by
DHB for its independent auditors are:

Pressure on the individual or the intent to commit fraud


o Brooks principal goal was to ensure that DHB consistently reported gross
profit margins of 27% or more and increased earnings, in order to meet the
expectations of professional analysts. This pressure to maintain the
company at this level was enough incentive and burden to commit the
fraud.
Opportunity to commit fraud
o The opportunities that Brook had to commit this fraud were many:
Internal control- there was a huge lack of internal control within
the company, especially since Brook exercised absolute control
over every aspect of DHBs business.
The governance and the lack of culture within the company
allowed Brook have control over DHBs board of directors and the
decisions made within the company, since this board consisted of
friends and neighbors of him. This allowed the company to have an
ineffective board of directors, which could have prevented or be
able to detect this fraud.
Related party transactions with the TAP Company, which was
privately owned company, where Brooks wife was the CEO. This
aspect was never disclosed in the Form 10-K to SEC.
Brooks personality and attitude that he had with other people. He
used threats of physical harm to enforce his policies and directives.
This allowed people to grow a certain fear towards him, which
made it easy for him to have more control and power over the
company in general.
The ability to rationalize the crime:
o The lack of internal control, the values and ethical standards that needed to
be implemented by management. There was no base of professional
conduct or policies that detailed the performance and expectation of
conduct that the company needed. This allowed Brooks to act in the way
he did with major authority.
o Involvement in the accounting department, and the accounting estimates.
The influence he had over his subordinates, due to the close relationship
he had with them.
o Pass violations with the law that Brook had.
o The relationship between the company and the past independent auditors.

In my opinion, the ones that should have the audits primary concern are:
The lack of internal control. Without internal control, one person can be the
dominant person of all the company and its activities, which is easier to commit
any type of fraud.
The related party transactions with TAP, especially since it wasnt disclosed at all
with SEC and should be a red flag for the auditors.
Its important to take in consideration the relationship that independent auditors
have with the company, and in this case, having many auditors resign can be an
alerting factor to the reasons why.
3. According to AS 1105, the objective of the auditor is to plan and perform the audit to
obtain appropriate audit evidence that is sufficient to support the opinion expressed in the
auditor's report. This means that the audit evidence obtained to support the assertions
made by management should be sufficient and appropriate to support what is stated in the
financial statements, however, in this case, there was a lack of evidence due to a natural
disaster. Auditors, according to this PCAOB, when in doubt of any audit evidence or if
there isnt enough evidence to support the assertions, the auditor should perform the
audit procedures necessary to resolve the matter and should determine the effect, if any,
on other aspects of the audit. It may be difficult even after performing the audit
procedures, to obtain any evidence, especially in this case where no evidence can exist.
The auditors may need to disclose this information in the audit report.

4. According to AS 2410: Related Parties: The auditor should perform procedures to


obtain an understanding of the company's relationships and transactions with its related
parties that might reasonably be expected to affect the risks of material misstatement of
the financial statements in conjunction with performing risk assessment procedures in
accordance with AS 2110, Identifying and Assessing Risks of Material Misstatement.
The procedures performed to obtain an understanding of the company's relationships and
transactions with its related parties include:

Obtaining an understanding of the company's process


o This means that the auditors should identify the transactions between these
parties, verifying their authorization and accounting and disclosing this
information in the financial statements.
Performing inquiries
o The auditing firm should obtain information from management regarding
every possible detail of the related parties.
Communicating with the audit engagement team and other auditors
o The auditors should inform to its engagement team all important
information found and acquired from management about the related
parties.

These transactions should be disclosed in the financial statements or determined to be a


significant risk, then the auditor should do the following procedures or steps:

Read and evaluate that information and the audit evidence relating to the
transaction are consistent with the inquiries and information provided by
management
Determine if the transaction was authorized and is in accordance with the
companys policies in regard with related parties.
Determine any exceptions made
Evaluate the financial capacity of the related parties
Perform other necessary procedures to determine the risks of material
misstatement
5. The internal control reporting responsibilities:

Management (Sec Section 404 of the Independent Auditors of Public


Sarbanes- Oxley Act) Companies (AS 2201)
Reports on internal control in their Its objective is to express an
annual reports opinion on the effectiveness of the
The internal control report must companys internal control over
include: financial reporting
- statement of managements If material weaknesses exist, the
assessment of the effectiveness of auditor should plan and perform the
the companys internal control audit to obtain appropriate evidence
- statement identifying the to obtain reasonable assurance
framework used by management to about the existence of these
evaluate the effectiveness material weaknesses.
- statement that includes the Recognize control framework to
auditing firm has issued an perform the audit of internal control
attestation report on the companys
internal control.

The main objective of management is to provide an effective internal control for its
company to be efficient and well managed. On the other hand, the auditors responsibility
is to express and opinion on the internal control by measuring their effectiveness and
function within the company.

6. The potential consequences that frequent changes in auditors have for the quality of a
given entitys independent audits are many. First, with a new auditing firm, the company
has to start all over with creating a relationship with the auditors and vice versa. If an
auditing firm had been maintained for several years, then the firm would know very well
its clients and will be easier to detect any changes within the company due to the years
working together. The relationship between these two parties is important because it
allows better working relationship. If there are frequent changes in auditors then this
relationship will start from scratch. Second, the cost of having to change auditors which
not only involve the financial situation but also the time of the company and of the
auditing firm, which has to be filed to SEC with the 8-K form. Third, these changes could
lead to bad relationships among parties, which are reported to SEC and could have a
negative affect on either of the parties, depending on the situation.

According to AS 2610, when there is a change in independent auditors, it is important for


the Successor auditor to communicate with the predecessor auditor to obtain information
about its client before accepting the engagement (with authorization of the client).
Within the information or inquiry, the successor should ask about:
The integrity of management
Any disagreement and the reason behind them
The reasons why there was a change in auditors
Legal situations the company may be in
Revision of the predecessors working papers (consent from client)
All this work and time that is dedicated to obtaining a new auditor each time can be very
costly to a company. For this reason, its better to maintain one independent auditor that
knows the company well and has built a strong relationship with where there are no
problems among them and the working relationship will flow easily, everything being
handled professionally.

7. I personally think that no one should experience any treatment or attitude that David
Brooks had with certain of the companys independent auditors. For this reason, the
auditors should report any of this type of behavior to their superiors and confront the
matter directly to the person acting inappropriate. Confrontation may be difficult at times
because we may never know how the other person may react, especially in this situation
where Brooks has a really bad temper and acts impulsively. For this reason, a more
secure and safe way to act on this problem is to report to higher authorities than can take
the direct action.

8. SEC does have the responsibility to protect the investing public from self-interested
corporate executives as state in the U.S Securities and Exchange Commission website, in
the What We Do section, the mission of the U.S. Securities and Exchange
Commission is to protect investors, maintain fair, orderly, and efficient markets, and
facilitate capital formation. For this reason, SEC requires that these public companies
provide fair financial and other information to the public so that the investors have
enough knowledge and information about the company and decide whether to put their
investment.

According to AS 1001, The objective of the ordinary audit of financial statements by the
independent auditor is the expression of an opinion on the fairness with which they
present, in all material respects, financial position, results of operations, and its cash
flows in conformity with generally accepted accounting principles. With the opinion
letter given by the auditors about the company, this allows investors to have a more
secure reliance on its investments. Auditors by performing their audits and opinion
letters, allow a more secure a fair ground of investments for the general public.

9. The primary responsibilities of a public companys audit committee are:

Make sure the company complies with legal and regulatory requirements and the
standards
Must ensure that the companys auditors are independent
Monitor the performance of the companys internal and external auditors
Establish effective procedures and controls within the company
An audit committee is important because it helps maintain a well balance relationship
with the independent auditors and allows the job of the auditing firm to be accomplished
more easily.