Koss's $20 Million Embezzlement Should Be a Wake-Up Call to Execs

Although 2009 will go down in history as a year in which an appalling number of Ponzi schemes were exposed, it should not be forgotten that other white collar crimes can be just as devastating to companies. Corporate embezzlement, for instance. Stereophonic headphone maker Koss Corp. appears to have suffered the largest employee theft in 2009, if the company's internal investigation is correct. The U.S. Attorney's office in Milwaukee filed a criminal complaint against the company's Vice President of Finance Sujata "Sue" Sachdeva in connection with an alleged $4.5 million shopping spree, but the Milwaukee Journal Sentinel reports the alleged "unauthorized transactions" could total $20 million. Koss fired Sachdeva in December.%%DynaPub-Enhancement class="enhancement contentType-HTML Content fragmentId-1 payloadId-61603 alignment-right size-small"%% Even more amazing than the size of the alleged theft itself is how it was discovered and how long it took to discover it. The alleged fraud came to light recently after American Express notified Koss of large transfers from its bank account to pay Sachdeva's personal credit cards, according to the complaint. The alleged fraud was initially estimated at $4.5 million, but within a couple of days the estimate grew to $20 million over four years, an average of over $400,000 per month being wired to American Express.

That's a staggering figure, especially when you consider that the company had net sales of only $38 million in fiscal 2009 and $47 million in fiscal 2008. Net profits in fiscal 2009 were only about $2 million. How does a company of this size not notice losses averaging $5 million per year, more than 10% of net sales?

The signs were apparently there. Sachdeva earned an average of $190,000 in total annual compensation in fiscal 2008 and 2009. Yet allegedly she spent millions at Milwaukee area boutiques, and the federal criminal complaint against her says there were "several large piles" of clothing with tags attached sitting in her office at Koss. Several individual price tags were in excess of $2,000.

Who allegedly found all that clothing in Sachdeva's office, and when? CEO Michael Koss, after American Express gave him the heads up.

What strikes me as odd is the fact that Koss hadn't seen these apparently unconcealed piles of couture before. I would consider finding so much clothing in an office unusual and noteworthy; does the fact that he'd never noticed it mean that Koss never went into Sachdeva's office before he received the call from American Express? Koss did not respond to a request seeking comment on the situation.

The Art Of The Long Con

How does a top finance executive get away with embezzlement? No matter how good a company's controls may be, the finance chief has the ability to override them, and can exert pressure on subordinates to turn a blind eye or actively participate in the fraud. That's why all executives and company board members should be actively involved in monitoring their company's finances.

Something should have given away that there was a problem years ago at Koss. According to the complaint, this was no relatively minor fraud: We're talking about an alleged theft which exceeded 10% of the company's annual revenue for four years running, and dwarfed the annual profits of the company.

How could an alleged fraud like this have been hidden? There are a few possibilities:

1. The money could be stolen, but the books not updated to reflect that, so the theft is unrecorded. This doesn't appear to be the case at Koss: Sachdeva apparently told the FBI that she doctored the company's bank balance on the books to cover the alleged theft.

2. In falsifying the bank account on the books, an entry has to be made to at least one other account in order for the books to balance. The alleged theft could be booked as an accounts receivable. This way, the total assets remain neutral (cash has been decreased by the theft, but accounts receivable have been inflated by an equal amount). This is a good method because it keeps the assets in a neutral position. It is a bad method because it creates fake accounts receivable, which start aging and will eventually have to be removed from the accounting system.

3. Liabilities could be reduced to offset the cash that has been funneled out of the company. This sounds attractive because it seems to do something good -- it apparently reduces the total the company owes to other parties. But the problem is that it's a phony reduction of the liabilities, and all the legitimate vendors will eventually want to get paid what they are owed. This, too, will require some future ledger legerdemain to conceal the effects of the original entry covering up the alleged theft.

4. The alleged theft could be booked to one or more expense accounts to hide the theft. This is the easiest and most attractive option. It is easiest because it will not require any future accounting entries to clean up the mess left by the original cover-up. It's attractive because, if done correctly, there is a reasonable chance of it going unnoticed -- especially if other executives aren't paying close attention.

The best way to cover up a theft using this method is to break up the total amount that must be concealed into multiple small entries to a variety of expense accounts. The smaller each entry, the less likely it is to be detected as unusual. The most common account for this type of concealment would be cost of goods sold, as this is a line item that can easily vary in any industry, and the fraudster relies on everyone's acceptance that variances are normal and not suspicious.

Catch Me If You're Careful

Some observers might wonder why the company's auditors, Grant Thornton, didn't detect the alleged fraud, or blame them for not doing so. That's a difficult case to make. A traditional financial statement audit is designed to do two specific things: determine if the accounting rules have been properly applied to the company's financial statements, and run a basic check of the math. Those audits are not designed to detect fraud -- and therefore they almost never do detect it.

I'd say that the responsibility in this case lies with Koss's executives and board of directors. They should have been more carefully monitoring the finances and should have detected the unusual variances in their company's numbers. And they should have had controls in place to detect the type of wire transfers Sachdeva was allegedly making -- from a company bank account to a personal credit card account.

There should also be a mechanism in place for employees to report wrongdoing to the board of directors. The criminal complaint states that Sachdeva's assistant made the wire transfers to American Express. It is unclear whether that employee was actively involved in the alleged fraud, or whether she was an unwitting participant. Either way, the fact that at least one other Koss employee was involved, according to the complaint, means that management had an opportunity to discover the fraud much earlier, and might have if additional controls had been in place.

It will be interesting to see what Koss says about the way this alleged embezzlement was carried out and concealed. This case should be a wake-up call for all companies: Do not let your top finance executives operate in a vacuum. Other executives need to be actively involved in the finance function so that thefts don't go unnoticed for years.

The prosecution and defense of this case will be interesting as well. Sachdeva has been charged with only wire fraud for now, but I wouldn't be surprised if additional charges are added by the Feds. (View the criminal complaint here.)

It's unclear whether Sachdeva has any assets that could be used for restitution, but Koss might be able to recover at least some money by returning the unused clothing to the boutiques. Sachdeva's attorney declined to comment on the matter or the issue of restitution, saying it was too early in the prosecution for him to say anything.

Tracy L. Coenen, CPA, MBA, CFE 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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