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Headphone Maker Hears the Sound of Accounting Fraud

January 8, 2010

On Christmas Eve, Koss Corp. fired its vice president of finance for allegedly embezzling up to $31 million over a period of five years from the headphone company, and on New Year's Eve it dismissed its auditor too.

The case could have ramifications in the debate over Sarbanes-Oxley Section 404 compliance, and whether the rules should apply to smaller public companies, according to an interesting account on If Koss had better internal controls in place, it might have discovered the fraud sooner.

The company finally dismissed Sujata Sachdeva, who served as the company’s principal accounting officer, only after federal prosecutors charged her with embezzlement. Sachdeva allegedly spent $4.5 million of Koss’s money on shopping sprees around Milwaukee buying up jewelry, fur coats, and fashions. Koss only learned of the embezzlement after American Express informed the company of several expensive wire transfers that Sachdeva made from the company’s bank account to her personal Amex account.When it checked her office, it found some of the items still in their shopping bags with the expensive price tags attached.

The company fired its outside auditor, Grant Thornton, on New Year’s Eve, but the firm noted in its defense that Koss’s level of revenues did not subject the company to Sarbanes-Oxley 404 internal control audits, and the headphone maker never engaged Grant Thornton to conduct an audit of its internal controls.

The SEC has delayed implementation of the SOX 404(b) requirements for smaller public companies several times, but in October it said that companies with a float below $75 million would need to begin complying with the auditor sign-off requirements. However, the financial regulatory reform legislation passed by the House last month contained a provision permanently exempting small companies from the requirements, which many have complained are expensive and onerous.

Proponents of SOX 404(b), however, are still hoping that the provision does not get included in the Senate version of the bill, which is still in the works and very much in play. That's especially true now, with Senate Banking Committee chairman Christopher Dodd’s recently announced retirement prompting fresh speculation on which provisions will be included or not included in the final legislation, particularly the creation of a Consumer Financial Protection Agency. The SOX 404 exemption provision may not get as much attention as the Consumer Financial Protection Agency part of the legislation, but it’s one that many accounting firms will be watching closely. The Koss case could give proponents of SOX 404 fresh ammunition to argue their case.

Comments (3)
To the above 2 comments:

As an auditor myself I have to say that 404(a) to 404(z) is less relevant than how many times they changed the water in the fish tank at Koss's headquarters (or whether or not they had a fish tank).

Why? Because over most of the past 5 years, Koss's market cap was under 100 million, and annual gross revenues under 50 million. A $31 million should have been detected when Grant Thornton's auditor reached the parking lot. It's called materiality (the very same excuse they will probably be using as a defense!)

An audit is designed to detect misstatements due to fraud. There's no need to test a fire prevention system if the whole damn building is on fire! Can someone explain a dumb auditor like myself how on earth would 404 requirements have helped detect the Koss fraud when the so-called "audit" didn't?

Clearly, someone was sleeping at the wheel, and it was Ms. Sachdeva. I think she would wholeheartedly agree with me.
Posted by babuey | Monday, July 05 2010 at 3:20PM ET
First: It's very difficult to detect internal fraud, even with good internal controls, when you have collusion between several people, as was the case with Koss.
Second: Senior management should have been familiar enough with the company's financials to have detected a change, and investigated the change (whether good or bad) to determine the reason(s) for any changes. In other words, senior management (besides the CFO) should be reviewing the company's financials paying attention to and asking for explanations for changes in sales volumes, cost of sales, gross margins, bank and investment account balances, cash flows, lines of credit, etc.
Third: The outside auditor, whether or not the company is subject to SB 404, should have done the same basic analysis of the company's financials, and asked the same basic questions that senior management should have been asking. Based on my experience as a CFO of several manufacturing companies, smart auditors routinely do that.
Conclusion: It seems to me that to a certain extent, that although fraud is hard to detect fraud when you have several people colluding, I suspect senior management and the outside auditors were not paying as close attention to the company's financials as they should have been.
Posted by Douglas A. Shearer, CPA | Friday, July 02 2010 at 11:17AM ET
I believe this whole thing could have been avoided if an effective 404(a) was done by a competent and objective party, in accordance with the SEC Interpretive Guidance. The SEC Interpretive Guidance specifically says, "Management's evaluation of the risk of misstatement should include consideration of the vulnerability of the entity to fraudulent activity."

Some fraud is not possible to detect, but this fraud clearly should have been detected in a properly executed SOX 404(a) assessment AND in a proper application of SAS 99 by the outside auditors. It was clearly "in scope" and it should have been identified through inquiry.

So one might ask, was the fraud portion of the SOX 404(a) assessment performed by a competent and objective party?

Or a bigger question is, was the SOX 404(a) management assessment in fact done at all?

Bob Benoit
President and Director of SOX Research
Lord & Benoit, LLC
Posted by BobBenoitsky | Sunday, January 10 2010 at 8:20PM ET
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