KOSS CORPORATION AND THE SACHDEVA SCANDAL

During the fall of 2009, Koss Corporation, a Wisconsin based designer, manufacturer and marketer of stereophonic headphones, revealed that its Vice President of Finance (Sujata Sue Sachdeva) had defrauded the company of approximately $31 million over a period of at least five years. Grant Thornton LLP was the companys auditor, and the firm issued unqualified audit opinions for the entire period in which they worked for Koss.

According to reports, Sachdevas theft accelerated over a period of years as follows:

FY 2005:$2,195,477

FY 2006:$2,227,669

FY 2007:$3,160,310

FY 2008:$5,040,968

FY 2009:$8,485,937

Q1FY 2010:$5,326,305

Q2FY 2010:$4,917,005

To give you a sense of the magnitude of the fraud, annual revenues for Koss Corporation are in the range of $40-$45 million annually, and previously reported pre-tax income for fiscal years 2007 and through Q1 2010 was as follows:

FY 2007:$8,344,715

FY 2008:$7,410,569

FY 2009:$2,887,730

FY 2010:$928,491

How could Sachdeva have stolen so much money and fooled so many people over a long period? It is thought that Sachdeva hid the theft in the companys cost of goods sold accounts, and that weak internal controls and poor corporate governance and oversight enabled her to conceal the theft from corporate officials. Certainly, there must have been questions raised about the companys deteriorating financial condition. But any number of excuses could have been used by Sachdeva to explain the missing money. For example, she might have blamed higher cost of goods sold on a change in suppliers or rising raw materials prices. Further, the company had no internal audit unit, nor was it required to have its auditor evaluate its internal control system (Koss is a non-accelerated public filer not yet subject to the requirements concerning internal control audit in SOX). Another contributing factor in Sachdevas ability to conceal her theft was that top-management of Koss had a high degree of trust in her, and did not monitor the accounts that she controlled at the company.

Sachdevas total compensation for fiscal year 2009 was $173,734. But according to published reports, Sachdeva was known for her unusually lavish lifestyle and shopping sprees. It is reported that she spent $225,000 at a single Houston, Texas, jewelry store. Another report describes a $1.4 million shopping at Valentina Boutique in Mequon, Wisconsin. People familiar with her spending habits assumed that she used family money and that her husbands job as a prominent pediatrician funded her extravagant lifestyle. The fraud was ultimately uncovered because American Express became concerned when it realized that Sachdeva was paying for large balances on her personal account with wire transfers from a Koss Corporation account. American express then notified the FBI and relayed it concerns.

Upon learning of the fraud, Koss Corporation executives fired Sachdeva, along with the companys audit firm, Grant Thornton LLP. Koss Corporation is attempting to recover its monetary losses through the recovery and sale of merchandise that was purchased by Sachdeva as part of the unauthorized transactions and through insurance proceeds and possible claims against third parties (including Grant Thornton LLP). Law enforcement authorities notified Koss Corporation that at least 22,000 items including high-end womens clothing, shoes, handbags and jewelry have been recovered to date. Sachdeva stored the bulk of the items she purchased in rented storage units in order to conceal the items from her husband.

Methods of Misappropriating Cash`

Sachdeva circumvented the internal controls of the company to get cash by authorizing issuance of more than 500 cashiers cheques to pay for her personal expenses. She also fraudulently authorized and directed numerous wire transfer including wiring company funds to American Express to pay for personal purchases on her credit card. Form 2008 through December 2009, Sachdeva fraudulently authorized more than 200 bank wire transfers totaling $16million to American Express.

Other means of fraudulently misappropriating cash for personal use by Sachdeva, as described by SEC, included the misuse of petty cash. She issued cheques payable to petty cash and had Koss employees negotiate and return the money to her, which she then used to pay for her personal expenses. She also converted unused travelers cheques that the company had purchased for use by its employees travelling on company-related business and fraudulently used them for herself.

Of course Sachdeva could not have embezzled these monies and covered up all by herself. She had the help of Julie Mulvaney, a senior accountant, who though did not receive any of the benefits of the massive embezzlements materially participated in the cover-up of the fraud. Mulvaney maintained a red book containing numerous false journal entries to the companys accounting books and records. She wrote the false journal entries in the red book and then entered them in the companys accounting books and records. By means of those entries, Mulvaney purported to adjust or reclassify the amount of company cash without supporting documentation or any legitimate explanation.

Mulvaney also prepared falsified accounting books and records and maintained them in a series of coloured folders, called the rainbow files. The rainbow files consisted of seven folders covering fiscal years 1995-2000 (green folder), 2004 (orange), 2005 (blue), 2005 (orange), 2006 (blue), 2007 (yellow), and 2008 (green). The rainbow files included more than 100 fraudulent transactions on the companys books and records. The rainbow files also reflected a scheme to conceal the receipt of funds by the company through a debit/credit wipe (DC Wipe). A DC Wipe made it appear that a certain transaction (e.g., a sale to a customer and the receipt of funds by the company) never took place.

For example, in December 2007, Koss received funds totalling more than $100,000 from an overseas customer. Mulvaney falsified the books and records to make it appear that the company never received the funds. In an attempt to avoid detection, she reduced five separate sales accounts by different amounts that collectively totalled the exact amount instead of reducing a single sales account by the whole amount.

The fraudulent accounting cover-up also involved the companys sales over the Internet and at its retail outlet. From fiscal year 2006 through the time the fraud was discovered during the second quarter of fiscal year 2010 (December 2009), Sachdeva and Mulvaney didnt record in Kosss books any sales made over the Internet or at the companys retail outlet, totalling $1.8 million.

The Role of the External Auditors

Few weeks prior to scheduled visits from the external auditors, Grant Thornton, Sachdeva would review the companys cash position. She would presume the difference between the cash in the companys bank accounts and the related ledger accounts was because of her theft of company funds. In a panic, Sachdeva would then call Mulvaney into her office and show her the numbers. Mulvaney would respond by saying, Let me look at everything and get back to you, and dont worry, and then apparently make the journal entries that no one questioned.

How is it possible that Grant Thornton did not discover such a massive defalcation? Well, Sachdeva noted, in a court disposition, that the auditing firm threw green auditors at the company every year as Grant Thornton considered Koss a well-run company and a good training ground for its new auditors. These auditors did not question the amounts of money flowing in and out of the company. Koss filed a lawsuit against the auditing firm. It alleged that Grant Thornton failed to properly perform audits of the companys financial statements and failed to properly assess the companys internal controls, thereby allowing the embezzlement to continue and the damage to the company to escalate. The lawsuit claims specifically that Grant Thornton repeatedly assured Kosss management and its board that the companys internal controls were effective and that Koss could rely on those same internal controls and Grant Thorntons work.

Information about the Companys Audit Committee

A brief profile about the companys audit committee members are provided as follows:

Thomas L. Doerr, 65, has been a director of the company since 1987. In 1972, Mr Doerr co-founded Leeson Electric Corporation and served as its president and chief executive officer until 1982. The company manufactures industrial electric motors. In 1983, Mr Doerr incorporated Doerr Corporation as a holding company for the purpose of acquiring established companies involved in distributing products to industrial and commercial markets. Currently, Mr Doerr serves as President of Doerr Corporation. Mr. Doerr owns no stock in Koss Corporation, and received $24,000 in cash compensation during 2009 to serve on the audit committee.

Lawrence S. Mattson, 77, has been a director of the company since 1978. Mr Mattson is the retired president of Oster Company, a division of Sunbeam Corporation, which manufactures and sells portable household appliances. Mr. Mattson is the designated audit committee financial expert. Mr Mattson owns no stock in Koss Corporation, and received $23,000 in cash compensation during 2009 to serve on the audit committee.

Theodore H. Nixon, 57, has been a director of the company since 2006. Since 1992, Mr Nixon has been the chief executive officer of D. D. Williamson, which is a manufacturer of caramel coloring use in the food and beverage industries. Mr Nixon joined D. D. Williamson in 1974 and was promoted to President and Chief Operating Officer in 1982. Mr Nixon is also a director of the non-profit Center for Quality of Management. Mr Nixon owns 2,480 shares of common stock of the company (less than 1% of outstanding shares), and received $21,000 in cash compensation during 2009 to serve on the audit committee.

John J. Stollenwerk, 69, has been a director of the company since 1986. Mr Stollenwerk is the Chairman of the Allen-Edmonds Shoe Corporation, an international manufacturer and retailer of high-quality footwear. He is also a director of Allen-Edmonds Shoe Corporation, Badger Meter, Inc., US Bancorp, and Northwestern Mutual Life Insurance Company. Mr Stollenwerk owns 13,551 shares of common stock of the company (less than 1% of outstanding shares), and received $23,000 in cash compensation during 2009 to serve on the audit committee.

The audit committee met three times during the fiscal year ended June 30, 2009. The independent accountants (Grant Thornton LLP) were present at two of these meetings to discuss their scope and the results of their audit. Koss claims that each member of the audit committee is independent.

The proxy statement describes the responsibilities of the audit committee as follows: the audit committee among other things, monitors the integrity of the financial reporting process, systems of internal controls, and financial statements and reports of the company; appoints, compensates, retains and oversees the Companys independent auditors, including reviewing the qualifications, performance and independence of the independent auditors; reviews and pre-approves all audit, attest and review services and permitted non-audit services; oversees the audit work performed by the companys internal accounting staff; and oversees the companys compliance with legal and regulatory requirements. The Audit Committee meets twice a year with the companys independent accountants to discuss the results of their examinations, their evaluations of the companys internal controls, and overall quality of the companys financial reporting.

After considering the case above, answer the following questions. You should support your answers with issues from the case where necessary:

a) Identify the weaknesses in the audit committee governance structure and suggest ways that could improve it.

b) The issues from the case suggest that Koss Corporation had week internal controls. What controls could the company have used to prevent misappropriation of cash including inappropriate use of corporate credit cards?

c) Was it wrong for Grant Thornton to have used green auditors (i.e. auditors who had just completed school with little or no experience) for such an engagement? Explain. What could Grant Thornton have done to ensure that such green auditors performed the work in accordance with the firms quality control procedures?

d) Sachdevas level of oversight as an executive allowed her to conceal the fraud effectively. This could also be attributed to the fact that top management had a high degree of trust in her and did not monitor the accounts she controlled. What was Grant Thorntons responsibility to uncover such fraud? What was management and the audit committees responsibility to notice that something looked amiss in the financial statement?