How difficult would it be to understate revenue?,What would be the effect on Koss's value if revenues were understated?

CASE 6.3 Koss Corporation and Unauthorized Financial Transactions visions to hospital patients. Several years later he teamed up with a friend, Martin In 1953, John C. Koss founded the Koss Corporation and began renting tele. Lange, to develop audio products. In 1958, they began building a model 390 stereo phonograph (record player and a model SP-3 stereophone in Mr. Koss's basement. The phonograph offered few advantages over existing products, but the SP-3, the world's first stereo headphone, was an immediate success. the Beatles were photographed using the Pro4. In 1969, a Pro4 was installed on Air became the recording industry standard. Music sensations such as Tony Bennett and In 1962, Koss introduced the Pro4 stereophone, an even higher-quality headset that Force One. By 1983, Koss employed more than 850 people in locations throughout Michael J. Koss, became president and CEO.2 the world. In 1991, John C. Koss retired from active management, and his oldest son, Unauthorized Financial Transactions On December 21, 2009, Lisa Cohen, managing general partner of Barrington Capital LLC, a small Barrington, Illinois, hedge fund, noticed an announcement that Koss Corporation had requested a halt in the trading of its shares until it could learn ately downloaded Koss's press release (Exhibit 1). Aside from the notice about the extent and effect of unauthorized financial transactions. Ms. Cohen immedi- unauthorized transactions, a halt in trading, and the fact that Koss's CFO was on release contained only a standard disclaimer about forward-looking statements. Ms. Cohen next downloaded Koss's 2009 proxy statement (excerpts in Exhibit 2) and learned that Koss was still controlled by the founding family. John C. Koss Site the founder, and his son, Michael, were board members, along with four executives from medium-size Midwest manufacturing firms. Koss appeared to be a highly sta- ble firm in terms of board membership and executive leadership . Three nonfamily directors had been on the board for between 22 and 31 years, the fourth joined in 2006. Nonfamily executives had been with the firm for between 9 and 18 years. Ms. Cohen had an associate download Koss's annual financial statements for the ended June 30, 2005 through 2009 (Exhibits 3 and 4), and the three months ended years September 30, 2009 (Exhibit 5 and 6). The following day, December 22, 2009, the Milwaukee Journal Sentinel quoted a fed- eral criminal complaint charging Koss's CFO, Sujata Sachdeva, with spending hundreds of thousands of dollars at high-end clothing stores. The complaint alleged that the spending came to light when American Express contacted Koss CEO Michael J. Koss and informed him the CFO was paying down her balances with large wire transfers from a Koss bank account. According to the complaint, spending included $1,358,322 1. Koss corporate history, Koss museum. http://www.koss.com/koss/kossweb.nsf/kmuseum?openform 2 Ibid 474 SECTION SIX VALUATION at Valentina, $670,000 at Au Courant, and $649,000 at Zita, three clothing boutiques north of Milwaukee. The article mentioned a possible $4.5 million embezzlement, a 3 very large amount for a firm with 2009 revenue of only $38.2 million Ms. Cohen's first thought was that cash was overstated, but a quick glance at Koss's September 30, 2009, balance sheet (Exhibit 5) showed that overstated cash was not a major problem. She assumed the unauthorized transactions must have reduced cash on Koss's balance sheet. The cash withdrawals would have been offset with some combination of debits that (1) overstated asset accounts, (2) increased expense accounts, (3) increased loss accounts, (4) increased owners' equity- other comprehensive losses, (5) decreased revenues, or (6) understated liabilities. Other comprehensive income did not appear on Koss's balance sheets, and Koss's 2009 10-K did not mention other comprehensive income, so Ms. Cohen ruled out item 4. Koss's income statements also showed no losses, so Ms. Cohen assumed Koss had overstated asset accounts, understated liability accounts, offset the cash withdrawals by increasing expenses or reducing revenues, or some combination of those problems. Given that investors often over- or underreact to this type of news, Ms. Cohen assumed she might have an opportunity to either short Koss's stock or place a large buy order when trading resumed. Two days later, December 24, 2009, Koss issued a press release stating that unauthorized transactions since 2006 might exceed $20 million, but those losses might be offset by insurance or asset recoveries (Exhibit 7A). At that point, Ms. Cohen decided on a target price for when Koss resumed trading. If the stock traded at 20% above her target price, she would short the shares; if it traded at 20% below her target price, she would buy shares. On January 4, 2010, Koss issued a press release stating that unauthorized transactions since 2005 may have exceeded $31 million (Exhibit 7B), which gave Ms. Cohen even more confidence in her decision and led to a change in her target price. On January 11, 2010, trading resumed. The price quickly dropped from about $5.50 per share ($81.2 million market value) when trading was suspended to about $4.10 per share ($60.5 million market value). Trading volume was about 110,000 shares on that day; within three days Ms. Cohen established her investment position and then waited for price changes or additional news. On January 15, 2010, The Business Journal of Milwaukee published an interview with Valentina's owner:4 "You find yourself dumbfounded," Valentina owner Tony Chirchirillo said of the news. "We never expected anything like this."... She seemed to be "a very nice person" who placed special orders for designer gowns and garments that cost between $2,000 and $8,000, he said. Chirchirillo said he and his wife, Cheryl, and daughter, Gina Frakes, who run the store, assumed "she came from money" and that her job at Koss, plus her husband Ramesh Sachdeva's position as a prominent pediatrician, provided the spending money. The Chirchirillos are now planning the future of the business with the "devastating" loss of their biggest customer. ... It threw everything upside down," Chirchirillo said. 3. Romell, Rick, "American Express alerted Koss about executive's spending spree," Milwaukee Wisconsin Journal Sentinel, December 22, 2009. http://www.jsonline.com/business/79905827.html. 4. Kirchen, Rich, "Fall from grace: Most shocked by Sachdeva's embezzlement on Journal of Milwaukee, January 15, 2010 httn mil ct PORATION AND UNAUTHORIZED FINANCIMI. TRANSACTW 475 The Milwaukee division of the FBI issued a January 20, 2010. press release announcing wire fraud. The press release included the following additional information that a grand jury returned an indictment charging Sujata Sachdeva with six counts of with the proceeds of Sachdeva's fraud should she be convicted in this matter. Among The indictment also seeks the forfeiture of property alleged to have been purchased this property is her residence located in Mequon, Wisconsin, a 2007 Mercedes Benz, and clothing, jewelry, art objects, and household items seized from Sachdeva's home and two storage units she maintained in Milwaukee. In addition, the indictment seeks the forfeiture of various items of clothing, jewelry, art objects, and other items currently in the possession of five merchants in the Milwaukee area, as well as a hand-carved door and a vacation ownership interest in a resort property. That same day the Milwaukee Journal Sentinel article reported that a mental plea Stephen E. Kravit, a well-known Milwaukee criminal defense attorney and former federal prosecutor who is not connected to the case, said the short length of the indictment is an indication that prosecutors expect Sachdeva to try to work out a plea was likely:6 agreement rather than go to trial. "Normally, the prosecutors would have laid out way more charges if they expected it to go to trial," Kravit said. A plea agreement would put Sachdeva in a more favorable position for sentencing, he said. Asked whether he would seek a plea bargain, Hart (Michael F. Hart , Mrs. Sachdeva's defense attorney) said only, These are early stages of an ongoing process." The "unusual behaviors" Hart cited Wednesday include Sachdeva's apparent practice of buying expensive clothing and then leaving it at the shops or placing it in storage. A federal search warrant made public this week detailed a huge cache of goods including 461 boxes of shoes, 34 fur coats and 65 racks of clothingallegedly stored by Sachdeva in rented space in the Third Ward. Merchants also have acknowledged that they stored paid-for clothing for Sachdeva. "It is unusual to say the least to buy items of clothing and never pick them up from the store," Hart said. Does that sound like rational behavior to you?" In a January 29, 2010, court hearing, Mrs. Sachdeva pleaded not guilty to accusations that she embezzled $31 million. According to the Journal Sentinel? Sachdeva's husband, pediatrician and Children's Hospital of Wisconsin executive Ramesh Sachdeva, also was present Friday, sitting in the third row at the back of the small courtroom. After the hearing, he shook hands with two FBI agents and Jacobs (prosecutor, Assistant U.S. Attorney Matt Jacobs) and said, "Thank you."... Jacobs said later that he believed it was simple courtesy that prompted Ramesh Sach- deva to thank the prosecutor and the FBI agents. " Jacobs "I think he's appreciative that we're treating his wife in a professional way, said. 5. Department of Justice Press Release, U.S. Attorney's Office, Eastern District of Wisconsin, January 20, 2010. http://milwaukee.fbi.gov/dojpressrel/pressrel10/mw012010.htm. 6. Hajewski, Doris, and Rick Romell, "Mental plea in Koss case likely," Journal Sentinel, January 20, 2010. http://www.jsonline.com/business/82194642.html. 7. Hajewski, Doris , and Rick Romell , "Former Koss executive pleads not guilty to embezzlement," Journal Sentinel, March 30, 2010. http://www.jsonline.com/business/83040142.html. SECTION SIX VALUATION On February 16, 2010, Koss issued a press release (Exhibit 7C) announcing Form 10-Q for the six months ended December 31, 2009, did not contain financi statements. The press release stated that "the absence of such unauthorized transa tions Atalso mentioned class action law suits against various Koss executives and directo Although the 10-Q omitted financial statements, it did mention that law officials ha Seized more than 25,000 items and released preliminary estimates of the amounts the unauthorized transactions since 2005: FY 2006: FY 2007: FY 2008: FY 2009: Q1 FY 2010: FY 2005: $2,195,477 $2,227,669 $3,160,310 $5,040,968 $8,485,937 $5,326,305 $4,917,005 On February 24, 2010, Koss issued a press release (Exhibit 7D) stating that a law = had been filed against Michael Koss, John Koss Sr., the other Koss directors, Su Sachdeva, Grant Thornton LLP, and Koss Corporation (as a nominal defenda By the end of March Koss's stock price increased to $5.86 per share, for a man valuation of $86.5 million. Q1 FY 2010: Required 1. Why was Ms. Cohen not concerned that cash was overstated? 2. Which asset accounts might be overstated? How difficult would it be to overs them? What would be the effect on Koss's value if assets were overstated? 3. Which liability accounts might be understated? How difficult would it be to understate them? What would be the effect on Koss's value if liabilities were understated? 4. Which expense accounts might be overstated? How difficult would it be to overstate them? What would be the effect on Koss's value if expenses were overstated? 5. How difficult would it be to understate revenues? What would be the effect Koss's value if revenues were understated? 6. Of the possible errors (asset or expense overstatements, liability or revenue understatements), which is the most likely error? Which is least likely? Why? 7. What is the likely effect of the pending lawsuits on Koss Corporation's value Explain. 8. Did the alleged embezzlement likely start in 2005, or earlier? Explain. 9. Was stability in Koss's management and board a strength or weakness in ter of corporate governance? Explain. 10. Evaluate Koss's compensation structure for its executives and its board. Did compensation structure influence corporate governance? Explain. Koss CORPORATION ANDS UNAUTHORIZED PISANIA TRANSACTIONS CASE 6.3 477 NEWS RELEASE 4129 NORTH PORT WASHINGTON AVENUE, MILWAUKEE, WI 53212 / 414 964-5000) WWW.KOSS.COM EXHIBIT 1 Knas CORPORATION, SEC FORM 8-K FILING. DECEMBER 21. 2009 FOR IMMEDIATE RELEASE December 21, 2009 CONTACT: Michael J. Koss President & CEO (414) 964-5000 mikoss@koss.com Trading of Koss Corporation Stock Halts Milwaukee, Wisconsin: Koss Corporation (NASDAQ SYMBOL: KOSS), the U.S. based high-fidelity stereophone leader, requested today that NASDAQ immediately halt trading of its securities after discovering information regarding certain unauthorized transactions. The Board of Directors appointed a special committee of independent directors to lead an internal investigation involving the unauthorized transactions and determine the effect, if any, on Koss' financial statements. NASDAQ halted trading of Koss Corporation stock today. Law enforcement is also assisting Koss Corporation with this matter. Sujata Sachdeva, Vice President of Finance and Secretary of Koss Corporation, was placed on unpaid administrative leave pending the results of this investigation. Koss Corporation markets a complete line of high-fidelity stereophones, speaker-phones, computer headsets, telecommunications headsets, active noise canceling stereophones, wireless stereophones, and compact disc recordings of American Symphony Orchestras on the Koss Classics label. This press release contains forward-looking statements. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as may," "will," "should," "forecasts," "expects," "plans," "anticipates," "believes," "estimates," "predicts," "potential," or "continue" or the negative of such terms and other comparable terminology. These statements are only predictions. Actual events or results may differ materially. In evaluating forward-looking statements, you should specifically consider various factors that may cause actual results to vary from those contained in the forward-looking statements, such as general economic conditions, in particular, consumer demand for the Company's and its customers' products, competitive and technological developments, foreign currency fluctuations, and costs of operations. Shareholders, potential investors and other readers are urged to consider these factors carefully in evaluating the forward-looking statements and are cautioned not to place undue reliance on such forward-looking statements. The forward-looking statements made herein are only made as of the date of this press release and the Company undertakes no obligation to publicly update such forward-looking statements to reflect subsequent events or circumstances. In addition, such uncertainties and other operational matters are discussed further in the Company's quarterly and annual filings with the Securities and Exchange Commission