Fraud Files: Koss Says Numbers Will Improve After Theft Uncovered

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In the company's most recent 10-Q filed with the Securities and Exchange Commission, Koss Corp. (KOSS) stated the obvious: Now that their fraud troubles are over, they expect better financial results.

I suppose it's hard to argue with them. Indeed, if the person accused of stealing $31 million from the firm is no longer employed there, the company's numbers should certainly improve.

The company plans to restate the numbers from at least fiscal 2008, 2009 and 2010. There is no word about restating periods prior to that, although the company has indicated that the alleged theft began in fiscal 2005.Koss management is still sticking by their estimate of $31 million in losses from an alleged embezzlement by their Vice President of Finance, Sue Sachdeva. There is no official word on exactly how she supposedly carried out and covered up the fraud, just the report that it was discovered when American Express contacted the company about large payments from the company's bank account to Sachdeva's personal credit card.

More interesting than the obvious financial improvement as a result of stopping a fraud-in-progress is the assertion that Koss management appears to be making about the state of its internal controls while the alleged fraud was occurring. The 10-Q states:
The Company maintains a system of disclosure controls and procedures that were designed to and believed to provide reasonable assurance that information, which is required to be timely disclosed, is accumulated and communicated to management in a timely fashion. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. It is possible for even the best control system to be circumvented by those with the intent, knowledge and opportunity to do so.

And it goes on to state:
Although numerous actions were taken beginning in late December 2009 following the discovery of the unauthorized transactions, including changes relating to the Company's banking procedures and certain other internal policies and procedures, as well as the other actions described in the Explanatory Note, the Company implemented no formal changes in the Company's internal control over financial reporting during the Company's most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.

I find both of these sections of the 10-Q troubling. In the first part I've quoted, it appears that management is suggesting Koss had good internal controls that were simply circumvented by a clever executive. Does management really expect the investing public to believe the company had good controls and they just 'accidentally' fell victim to a $31 million theft?

The second section I've quoted is even more disturbing. The company says some changes were made to procedures following the discovery of the alleged embezzlement, but there were "no formal changes in the Company's internal control over financial reporting."

So the public should pretend that Koss's controls were good to begin with an no formal changes were in order? I'm not buying it.

I've written several times how easy it may have been for an executive to get away with a theft of this magnitude from Koss based on an uninvolved executive team and a manager with too much autonomy. Even though we still don't know for sure how the fraud was executed and concealed, many outside observers agree that someone had to be asleep at the wheel for this to happen at Koss.

And I'm certainly not buying the idea that no "formal" changes were necessary to internal controls at Koss. How can any executive in their right mind fall victim to a massive fraud like this one (based on the dollar figure of theft compared to annual sales) and not believe some substantial changes are in order?

Shame on Baker Tilly, the new auditors at Koss. The SEC requires an auditor review prior to filing a 10-Q. How could Baker Tilly review the above statements and allow Koss to file such nonsense with the SEC?

The executives at Koss should be throwing themselves at the feet of their investors, begging for mercy and promising to do better. They should be taking a hard look at the policies in procedures in place at the company, and they should make wholesale changes to them to prevent something like this from happening again. If management is not willing to do this on their own, the auditors need to step up and demand changes or they should resign. Let's get out of the land of make believe and into reality, where a publicly traded company has experienced a massive fraud and should be motivated to make substantial changes for the good of the investing public.

Tracy L. Coenen, CPA, MBA, CFE, CFF is a fraud examiner and forensic accountant who investigates corporate fraud and consumers scams, and is the author of Essentials of Corporate Fraud and Expert Fraud Investigation: A Step-by-Step Guide.
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