Fraud is more difficult to uncover and often goes undetected for a longer period of time...

        

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Fraud is more difficult to uncover and often goes undetected for a longer period of time when there is collusion among the perpetrators. Koss Corporation, a manufacturer of headphones located in Milwaukee, and their auditors found this aut the hard way when the company was notified by American Express that their vice president of finance, secretary, and principal accounting officer had been wiring funds from Koss Corporation's account into her personal American Express account to fund her lavish lifestyle. Kass Carporation's principal accounting officer, Sujata ("Sue") Sachdeva, embezzled approximately $31 million over 5 years. Koss' Vice President-Finance and Secretary, Sujata Sachdeva, earned total compensation of approximately $200,000 per year for fiscal years 2008 and 2009 (SEC 2009a). Ms. Sachdeva, her husband-an attorney, Ph.D., and M.D. at Children's Hospital of Wisconsin-and their children reportedly enjoyed a lavish lifestyle including numerous trips abroad, private schools for the children, and a house worth nearly $800,000 in the Milwaukee suburbs. While in her 20s, Ms. Sachdeva worked in New York for the brokerage firm of Smith Barney and the now-defunct international accounting firm of Arthur Andersen. Ms. Sachdeva was partrayed as an active fundraiser in the nonprofit community-reportedly raising approximately $1.5 million annually for charitable causes. She was also portrayed as an impeccable dresser with an impressive wardrobe (Hajewski and Romell 2010a). Internal Control Assertions Under Sarbanes-Oxley The Kass Corporation case relates to the financialstatement audit opinions rendered by Koss' independent audit firm, Grant Thornton LLP, and senior management's attestation as to the effectiveness of internal control over financial reporting (ICFR) follawing the passage of the Sarbanes-Oxley Act of 2002 (SOX). Section 404 of SOx requires the CEO and CFO of U.S. registrants, and their external auditor, to separately report on and attest to the effectiveness of ICFR. However, the SEC repeatedly extended the deadline for auditor attestation on the effectiveness of ICFR for nonaccelerated filers (public companies with a market capitalization of less than $75 million, such as Koss). Koss relied on the SEC's extensions related to the required auditor attestation and never engaged Grant Thornton to opine on the effectiveness of Koss' ICFR. In an interview, Michael J. Koss said the new costs associated with SOX were galling to his family, who "pride themselves on being good stewards of their company. However, the Association of Certified Fraud Examiners (ACFE) released an updated Global Fraud Study in 2010. The ACFE has long believed smaller companies (similar to Koss Corporation) are particularly susceptible to fraud given their relatively limited resources. For small businesses, comparing those with fewer than 100 employees and thase with 100 or more (Koss had 72 employees at June 30, 2009; see SEC 2009b), the 15 most frequent anti-fraudcontrols cited for the smallest organizations included external audit of financial atatementa (W1), management'a certification of financiala ( 3), and an external audit of ICFR (# 6) (ACFE 2010). These findings lend credence to the notion that external financial statement and ICFR audits, coupled with management certifications, are viewed to be deterrents to fraud. The fallowing are excerpts from management's attestation on ICFR (signed by Michael J. Koss, CEO and CFO), and Grant Thornton's financial statement audit opinion, respectively, for the company's fiscal year ended June 30, 2009: Kass Attestation (in part): Management's Annual Report on Internal Controls over Financial Reporting: The Company's management, including its Chief Executive Officer/Chief Financial Officer, is responsible for establishing and maintaining adequate internal control of financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(F)) and designing such internal control to provide reasonable assurances regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Management conducted its evaluation of the effectiveness of its internal control over financial reporting based on the framework in "Internal Control-Integrated Framework" issued by the Committee af Sponsoring Organizations of the Treadway Commission ("COSO") as of June 2009. Based on this assessment, the Company's management, including its ChiefExecutive Officer/Chief Financial Officer, believes that as of June 30, 2009, the Company's internal control over financial reporting was effective based on the criteria set forth by coso in "Internal Control-integrated Framework." However, because of the inherent limitations in all control systems, no evaluation of controls can pravide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. This annual report does not include anattestation report of the Company's registered public accounting firmregarding internal control over financial reporting. Management's report was not subject to attestation by the Company's registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management's reportin this Form 10-K. (emphasis added) Grant Thornton's Financial Statement Audit Opinion Scope Paragraph (in part): The Company is not required tohave, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an apinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express nosuch opinion (emphasis added) (SEC 2009b). There are a number of characteristics unique to Koss Corporation in addition to the Company's independent auditor not being required to perform an audit of Koss' ICFR as specified by Section 404 of SOX. Though public, approximately 73 percent of the Company's shares are held by members of the founding family, including John C. Koss, Michael J. Koss, and John Koss, Jr. Note that as joint CEO and CFO, Michael J. Koss was the only member of senior management required to opine on the effectiveness of the Company's ICFR. The only other required signatory on the Form 10-K (beyond directors) was the Company's Vice President of Finance, Principal Accounting Officer, and Secretary-Sujata Sachdeva. Ms. Sachdeva was not required to separately issue an opinion on Koss' internal controls as she was not the Company's CFO, but rather designated as the Principal Accounting Officer. Embezzlement And Financial Statement Fraud At Koss On December 21, 2009, Koss Corporation filed a Form 8-K with the SEC reporting "other events" involving Koss Carporation. The 8-K filing indicated Koss requested the NASDAQ stock exchange to halt trading of its common stock due to the discovery of information regarding certain unauthorized transactions. The company also indicated it had placed Ms. Sachdeva on unpaid administrative leave (SEC 2009c). Holiday celebrations were likely tempered for certain personnel of Grant Thornton LLP, Koss' independent auditor. On ecember 31, 2009, Kass, upon a recommendation from the Company's Audit Committee, dismissed Grant Thornton. In an 8-K filing dated January 4, 2010, the company reported it had dismissed Grant Thornton and expanded its cautionary disclosure of nonreliance on previously issued financial statements, audit reports, and interim reviews, stating, in part: The Company's Audit Committee, on the recommendation of its advisors and management, expanded the scope of the Company's previously disclosed internal investigation of unauthorized financial transactions by Sujata Sachdeva, the Company's former Vice President of Finance and Secretary, to include fiscal years 2005 through the present. The Company has now concluded that its previously issued financial statements on Forms 10-K for the fiscal years ended June 30, 2005 through 2009 and on Form 10-Q for the three months ended September 30, 2009 should no longer be relied upon due to the unauthorized financial transactions. An internal investigation under the supervision of an independent committee of the Board of Directors with the assistance of independent counsel and forensic accountants is continuing. Preliminary estimates indicate that the amount of unauthorized transactions since fiscal year 200S through the present has exceeded $31 million, but at this point the Company and its advisors cannot assess the potential impact an its financial statements or identify the extent that specific fiscal periods may be affected. Nor can the Company and its advisors yet assess the extent of the possible offsets through insurance, asset recoveries and other mechanisms related to the unauthorized transactions. As promptly as possible, the Company plans to restate its financial statements for applicable periods as further investigation indicates. (item 4.02(a) of Kass Corporation's 8-K filed january 4, 2010) (SEC 2010a). On January 6, 2010, Koss filed an amended 8-K with the SEC to include Grant Thornton's required response to the Company's characterization of the auditor dismissal. Grant Thornton responded, in part, as follows: We have read Item 4.01 of Form 8-K of Kass Corporation dated January 4, 2010, and agree with the statements concerning our Firm contained therein. We have no basis to agree or disagree with the statements and conclusions in Item 4.02(a), some of which were not disclosed to Grant Thornton LLP prior to receipt of this filing (SEC 2010b). On lanuary 18, 2010, a Koss press release announced the hiring of a new Executive Vice President, CFO, and Principal Accounting Officer (Michael J. Koss had previously resigned as the company's CFO following news of the alleged embezzlement). The newly hired afficer has a degree in accounting, an M.B.A., and is a licensed CPA with extensive manufacturing experience (SEC 2010c). Safeguards Against Fraud and Embezzlement Theoretically, there are a number of lines of defense against fraud and embezzlement such as those alleged against Ms. Sachdeva. These include the requirement for the CEO and CFO (both Michael J. Koss in this circumstance) to separately attest as to the effectiveness of a Company's ICFR, oversight of those charged with corporate governance (including the board of directors with an independent audit committee), inside whistleblowers, anonymous tipsters, and the independent auditor's opinion as to the effectiveness of ICFR. Recall, Grant Thornton was not engaged to issue such an opinion. Koss Corporation's board of directors in 2009 was comprised of six individuals, including John and MichaelJ. Koss. Excluding one new member in 2006, the remaining five board members had an average tenure of 32 years (AccountingWEB 2010). Ironically, none of these potential safety nets detected the alleged fraud, but rather an independent, outside (not the auditor) third party. According to the criminal complaint, "neither Koss' auditors nor its executives uncovered the alleged fraud. Rather, American Express alerted the company's CEO, Michael Koss, to several large wire transfers made from a Koss bank account to pay Sachdeva's personal credit card. The purchases in question included $382,400 at two jewelry stores and $1.4 million at one clothing boutique" (Johnson 2010). In February 2010, Koss sued American Express, alleging that the credit card company violated the requirements of the Bank Secrecy Act requiring companies such as American Express to have programs to detect and report activity that may suggest the existence of financial crimes. The suit alleges that American Express was aware as early as February of 2008 that Ms. Sachdeva was paying her personal credit card bill with Kass funds, but did nothing to stop the fraud until December of 2009 (Hajewski 2010a). In the criminal complaint, Sachdeva told FBI agents she had authorized an assistant to make the wire transfers, which she later concealed by falsifying the balance in Koss' bank account. The complaint does not explain how she allegedly made these changes or why they were not detected sooner. Her attorney declined comment on the case (lohnsan 2010). A federal search warrant reveals FBI agents seized 461 boxes of shoes, 34 fur coats, and 65 racks of clothing stored in rented space and at area merchants (Hajewski and Romell 2010b). The U.S. Marshals Service was reported to inventory some 22,000 items seized by the FBI (Hajewski and Romell 2010c). The items are scheduled to be auctioned online with net proceeds remitted to Kass (Hajewski 2010b). Ms. Sachdeva's attorney attempted to block the release of her medical records to the court. As a condition of Sachdeva's release on bail, the court had ordered a mental health evaluation be done by Pre-Trial Services. According to the criminal indictment, Sachdeva spent the money on luxury clothing, jewelry, trips, renovations to her home, and services for herself and her family. In a letter to the court, her attorney said sensitive information in Sachdeva's medical records would be "directiy relevant" to her defense, adding, "We do not believe it is either necessary or appropriate that Pre-Trial Services be in possession of these records." It was previously reported that her attorney planned to raise the issue of mental state in Ms. Sachdeva's defense (Hajewski 2010c). Ms. Sachdeva pled nat guilty to accusations that she embezzled $31 million from Kass. The case is believed to be one of the largest embezzlements in Wisconsin history, and the largest in the U.S. for 2009 (Van de Kamp Nohl 2010). Ms. Sachdeva's attorney said, "As this case proceeds, we intend to show that Ms. Sachdeva's mental and emotional health played a significant role in her conduct." Asked whether that was the basis for her not-guilty plea, he declined additional comment. Later, her attorney issued a statement reiterating his remarks and added, "This is the beginning of an ongoing process, and our focus will be on the arguments we make in court. However, the issues of Ms. Sachdeva's mental and emotional health are essential to this case." Sachdeva also was ordered by the court to refrain from using alcohal and to submit to periodic drug and alcohol testing (Hajewski and Romell 2010c). In April 2010, the Koss case was assigned a preliminary hearing date of June 15, 2010. On June 15, 2010, federal prosecutors indicated they were working toward a plea agreement with Mc. Sachdeva and did not anticipate the case would go to trial (Hajewski 2010b). On June 24, 2010, Koss Corporation filed suit against both Ms. Sachdeva and Koss' former independent auditor, Grant Thorntan, alleging fraud, negligence, and breach of fiduciary duty. The suit seeks more than $30 million in damages (Hajewski 2010d). Epilogue On June 30, 2010, Koss restated its previously audited financial statements for fiscal years 2009 and 2008. The impacts of the unauthorized transactions were treated as a theft loss in a separate operating expense line item totaling $8.5 million and $S.1 million for the fiscal years ended June 30, 2009 and 2008, respectively, and a reduction in opening retained earnings of $3.3 million (SEC 2010d). For fiscal 2009 (2008), net sales were originally understated by $3.5 ($2.1) million, and cost of goods sold averstated by $1.7 ($1.0) million. Substantial balance sheet adjustments at June 30, 2009, included a reduction in accounts receivable of $4.0 million, a reduction in inventories of $1.1 million, capitalization of $1.7 million in product software development casts, recognition of $2.9 million in cash surrender value of life insurance, an increase in accounts payable and accrued liabilities of $2.2 million, and an increase in long-term liabilities of $1.2 million (SEC 2010d). On July 27, 2010, Ms. Sachdeva pled guilty to all six counts of felony fraud against her. Under the plea agreement, Ms. Sachdeva agreed to pay approximately $34 million in restitution to Koss. The plea deal specifies a minimum of five years in prison though federal prosecutors may recommend a longer sentence. Sentencing was scheduled for November 17, 2010 (Hajewski 2010e). Directions for PART A: 1. Is this fraud an example of asset misappropriation or fraudulent financial reporting? 2. Ms. Sachdeva came from a wealthy family, so the theft was not necessary for her to live comfortably. What incentive and attitude/rationalization do you believe drove Ms. Sachdeva to embezzle? Would there have been behavioral red flags that should have alerted auditors to the fraud? 3. There are differences in the ability af an ICFR audit to detect fraud, the ability of a financial statement audit to detect fraud, the ability of a fraud/forensic accountant to detect fraud, and the ability of senior management to detect fraud. With those differences in mind, provide at least four suggestions for improving the ability of financial statement auditors to prevent or detect fraud. This may include the composition of the auditor's brainstorming team, management's evaluation of ICFR, etc. 4. Make a list of at least four factors leading to the Koss embezzlement and fraud not being detected by senior management and/or the independent auditor. For your list, rank order the factors (with "1" being the most contributing factor). Defend your top factor, including why you believe it was the most contributing factor, and why you believe it autweighs the others. Fraud is more difficult to uncover and often goes undetected for a longer period of time when there is collusion among the perpetrators. Koss Corporation, a manufacturer of headphones located in Milwaukee, and their auditors found this aut the hard way when the company was notified by American Express that their vice president of finance, secretary, and principal accounting officer had been wiring funds from Koss Corporation's account into her personal American Express account to fund her lavish lifestyle. Kass Carporation's principal accounting officer, Sujata ("Sue") Sachdeva, embezzled approximately $31 million over 5 years. Koss' Vice President-Finance and Secretary, Sujata Sachdeva, earned total compensation of approximately $200,000 per year for fiscal years 2008 and 2009 (SEC 2009a). Ms. Sachdeva, her husband-an attorney, Ph.D., and M.D. at Children's Hospital of Wisconsin-and their children reportedly enjoyed a lavish lifestyle including numerous trips abroad, private schools for the children, and a house worth nearly $800,000 in the Milwaukee suburbs. While in her 20s, Ms. Sachdeva worked in New York for the brokerage firm of Smith Barney and the now-defunct international accounting firm of Arthur Andersen. Ms. Sachdeva was partrayed as an active fundraiser in the nonprofit community-reportedly raising approximately $1.5 million annually for charitable causes. She was also portrayed as an impeccable dresser with an impressive wardrobe (Hajewski and Romell 2010a). Internal Control Assertions Under Sarbanes-Oxley The Kass Corporation case relates to the financialstatement audit opinions rendered by Koss' independent audit firm, Grant Thornton LLP, and senior management's attestation as to the effectiveness of internal control over financial reporting (ICFR) follawing the passage of the Sarbanes-Oxley Act of 2002 (SOX). Section 404 of SOx requires the CEO and CFO of U.S. registrants, and their external auditor, to separately report on and attest to the effectiveness of ICFR. However, the SEC repeatedly extended the deadline for auditor attestation on the effectiveness of ICFR for nonaccelerated filers (public companies with a market capitalization of less than $75 million, such as Koss). Koss relied on the SEC's extensions related to the required auditor attestation and never engaged Grant Thornton to opine on the effectiveness of Koss' ICFR. In an interview, Michael J. Koss said the new costs associated with SOX were galling to his family, who "pride themselves on being good stewards of their company. However, the Association of Certified Fraud Examiners (ACFE) released an updated Global Fraud Study in 2010. The ACFE has long believed smaller companies (similar to Koss Corporation) are particularly susceptible to fraud given their relatively limited resources. For small businesses, comparing those with fewer than 100 employees and thase with 100 or more (Koss had 72 employees at June 30, 2009; see SEC 2009b), the 15 most frequent anti-fraudcontrols cited for the smallest organizations included external audit of financial atatementa (W1), management'a certification of financiala ( 3), and an external audit of ICFR (# 6) (ACFE 2010). These findings lend credence to the notion that external financial statement and ICFR audits, coupled with management certifications, are viewed to be deterrents to fraud. The fallowing are excerpts from management's attestation on ICFR (signed by Michael J. Koss, CEO and CFO), and Grant Thornton's financial statement audit opinion, respectively, for the company's fiscal year ended June 30, 2009: Kass Attestation (in part): Management's Annual Report on Internal Controls over Financial Reporting: The Company's management, including its Chief Executive Officer/Chief Financial Officer, is responsible for establishing and maintaining adequate internal control of financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(F)) and designing such internal control to provide reasonable assurances regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Management conducted its evaluation of the effectiveness of its internal control over financial reporting based on the framework in "Internal Control-Integrated Framework" issued by the Committee af Sponsoring Organizations of the Treadway Commission ("COSO") as of June 2009. Based on this assessment, the Company's management, including its ChiefExecutive Officer/Chief Financial Officer, believes that as of June 30, 2009, the Company's internal control over financial reporting was effective based on the criteria set forth by coso in "Internal Control-integrated Framework." However, because of the inherent limitations in all control systems, no evaluation of controls can pravide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. This annual report does not include anattestation report of the Company's registered public accounting firmregarding internal control over financial reporting. Management's report was not subject to attestation by the Company's registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management's reportin this Form 10-K. (emphasis added) Grant Thornton's Financial Statement Audit Opinion Scope Paragraph (in part): The Company is not required tohave, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an apinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express nosuch opinion (emphasis added) (SEC 2009b). There are a number of characteristics unique to Koss Corporation in addition to the Company's independent auditor not being required to perform an audit of Koss' ICFR as specified by Section 404 of SOX. Though public, approximately 73 percent of the Company's shares are held by members of the founding family, including John C. Koss, Michael J. Koss, and John Koss, Jr. Note that as joint CEO and CFO, Michael J. Koss was the only member of senior management required to opine on the effectiveness of the Company's ICFR. The only other required signatory on the Form 10-K (beyond directors) was the Company's Vice President of Finance, Principal Accounting Officer, and Secretary-Sujata Sachdeva. Ms. Sachdeva was not required to separately issue an opinion on Koss' internal controls as she was not the Company's CFO, but rather designated as the Principal Accounting Officer. Embezzlement And Financial Statement Fraud At Koss On December 21, 2009, Koss Corporation filed a Form 8-K with the SEC reporting "other events" involving Koss Carporation. The 8-K filing indicated Koss requested the NASDAQ stock exchange to halt trading of its common stock due to the discovery of information regarding certain unauthorized transactions. The company also indicated it had placed Ms. Sachdeva on unpaid administrative leave (SEC 2009c). Holiday celebrations were likely tempered for certain personnel of Grant Thornton LLP, Koss' independent auditor. On ecember 31, 2009, Kass, upon a recommendation from the Company's Audit Committee, dismissed Grant Thornton. In an 8-K filing dated January 4, 2010, the company reported it had dismissed Grant Thornton and expanded its cautionary disclosure of nonreliance on previously issued financial statements, audit reports, and interim reviews, stating, in part: The Company's Audit Committee, on the recommendation of its advisors and management, expanded the scope of the Company's previously disclosed internal investigation of unauthorized financial transactions by Sujata Sachdeva, the Company's former Vice President of Finance and Secretary, to include fiscal years 2005 through the present. The Company has now concluded that its previously issued financial statements on Forms 10-K for the fiscal years ended June 30, 2005 through 2009 and on Form 10-Q for the three months ended September 30, 2009 should no longer be relied upon due to the unauthorized financial transactions. An internal investigation under the supervision of an independent committee of the Board of Directors with the assistance of independent counsel and forensic accountants is continuing. Preliminary estimates indicate that the amount of unauthorized transactions since fiscal year 200S through the present has exceeded $31 million, but at this point the Company and its advisors cannot assess the potential impact an its financial statements or identify the extent that specific fiscal periods may be affected. Nor can the Company and its advisors yet assess the extent of the possible offsets through insurance, asset recoveries and other mechanisms related to the unauthorized transactions. As promptly as possible, the Company plans to restate its financial statements for applicable periods as further investigation indicates. (item 4.02(a) of Kass Corporation's 8-K filed january 4, 2010) (SEC 2010a). On January 6, 2010, Koss filed an amended 8-K with the SEC to include Grant Thornton's required response to the Company's characterization of the auditor dismissal. Grant Thornton responded, in part, as follows: We have read Item 4.01 of Form 8-K of Kass Corporation dated January 4, 2010, and agree with the statements concerning our Firm contained therein. We have no basis to agree or disagree with the statements and conclusions in Item 4.02(a), some of which were not disclosed to Grant Thornton LLP prior to receipt of this filing (SEC 2010b). On lanuary 18, 2010, a Koss press release announced the hiring of a new Executive Vice President, CFO, and Principal Accounting Officer (Michael J. Koss had previously resigned as the company's CFO following news of the alleged embezzlement). The newly hired afficer has a degree in accounting, an M.B.A., and is a licensed CPA with extensive manufacturing experience (SEC 2010c). Safeguards Against Fraud and Embezzlement Theoretically, there are a number of lines of defense against fraud and embezzlement such as those alleged against Ms. Sachdeva. These include the requirement for the CEO and CFO (both Michael J. Koss in this circumstance) to separately attest as to the effectiveness of a Company's ICFR, oversight of those charged with corporate governance (including the board of directors with an independent audit committee), inside whistleblowers, anonymous tipsters, and the independent auditor's opinion as to the effectiveness of ICFR. Recall, Grant Thornton was not engaged to issue such an opinion. Koss Corporation's board of directors in 2009 was comprised of six individuals, including John and MichaelJ. Koss. Excluding one new member in 2006, the remaining five board members had an average tenure of 32 years (AccountingWEB 2010). Ironically, none of these potential safety nets detected the alleged fraud, but rather an independent, outside (not the auditor) third party. According to the criminal complaint, "neither Koss' auditors nor its executives uncovered the alleged fraud. Rather, American Express alerted the company's CEO, Michael Koss, to several large wire transfers made from a Koss bank account to pay Sachdeva's personal credit card. The purchases in question included $382,400 at two jewelry stores and $1.4 million at one clothing boutique" (Johnson 2010). In February 2010, Koss sued American Express, alleging that the credit card company violated the requirements of the Bank Secrecy Act requiring companies such as American Express to have programs to detect and report activity that may suggest the existence of financial crimes. The suit alleges that American Express was aware as early as February of 2008 that Ms. Sachdeva was paying her personal credit card bill with Kass funds, but did nothing to stop the fraud until December of 2009 (Hajewski 2010a). In the criminal complaint, Sachdeva told FBI agents she had authorized an assistant to make the wire transfers, which she later concealed by falsifying the balance in Koss' bank account. The complaint does not explain how she allegedly made these changes or why they were not detected sooner. Her attorney declined comment on the case (lohnsan 2010). A federal search warrant reveals FBI agents seized 461 boxes of shoes, 34 fur coats, and 65 racks of clothing stored in rented space and at area merchants (Hajewski and Romell 2010b). The U.S. Marshals Service was reported to inventory some 22,000 items seized by the FBI (Hajewski and Romell 2010c). The items are scheduled to be auctioned online with net proceeds remitted to Kass (Hajewski 2010b). Ms. Sachdeva's attorney attempted to block the release of her medical records to the court. As a condition of Sachdeva's release on bail, the court had ordered a mental health evaluation be done by Pre-Trial Services. According to the criminal indictment, Sachdeva spent the money on luxury clothing, jewelry, trips, renovations to her home, and services for herself and her family. In a letter to the court, her attorney said sensitive information in Sachdeva's medical records would be "directiy relevant" to her defense, adding, "We do not believe it is either necessary or appropriate that Pre-Trial Services be in possession of these records." It was previously reported that her attorney planned to raise the issue of mental state in Ms. Sachdeva's defense (Hajewski 2010c). Ms. Sachdeva pled nat guilty to accusations that she embezzled $31 million from Kass. The case is believed to be one of the largest embezzlements in Wisconsin history, and the largest in the U.S. for 2009 (Van de Kamp Nohl 2010). Ms. Sachdeva's attorney said, "As this case proceeds, we intend to show that Ms. Sachdeva's mental and emotional health played a significant role in her conduct." Asked whether that was the basis for her not-guilty plea, he declined additional comment. Later, her attorney issued a statement reiterating his remarks and added, "This is the beginning of an ongoing process, and our focus will be on the arguments we make in court. However, the issues of Ms. Sachdeva's mental and emotional health are essential to this case." Sachdeva also was ordered by the court to refrain from using alcohal and to submit to periodic drug and alcohol testing (Hajewski and Romell 2010c). In April 2010, the Koss case was assigned a preliminary hearing date of June 15, 2010. On June 15, 2010, federal prosecutors indicated they were working toward a plea agreement with Mc. Sachdeva and did not anticipate the case would go to trial (Hajewski 2010b). On June 24, 2010, Koss Corporation filed suit against both Ms. Sachdeva and Koss' former independent auditor, Grant Thorntan, alleging fraud, negligence, and breach of fiduciary duty. The suit seeks more than $30 million in damages (Hajewski 2010d). Epilogue On June 30, 2010, Koss restated its previously audited financial statements for fiscal years 2009 and 2008. The impacts of the unauthorized transactions were treated as a theft loss in a separate operating expense line item totaling $8.5 million and $S.1 million for the fiscal years ended June 30, 2009 and 2008, respectively, and a reduction in opening retained earnings of $3.3 million (SEC 2010d). For fiscal 2009 (2008), net sales were originally understated by $3.5 ($2.1) million, and cost of goods sold averstated by $1.7 ($1.0) million. Substantial balance sheet adjustments at June 30, 2009, included a reduction in accounts receivable of $4.0 million, a reduction in inventories of $1.1 million, capitalization of $1.7 million in product software development casts, recognition of $2.9 million in cash surrender value of life insurance, an increase in accounts payable and accrued liabilities of $2.2 million, and an increase in long-term liabilities of $1.2 million (SEC 2010d). On July 27, 2010, Ms. Sachdeva pled guilty to all six counts of felony fraud against her. Under the plea agreement, Ms. Sachdeva agreed to pay approximately $34 million in restitution to Koss. The plea deal specifies a minimum of five years in prison though federal prosecutors may recommend a longer sentence. Sentencing was scheduled for November 17, 2010 (Hajewski 2010e). Directions for PART A: 1. Is this fraud an example of asset misappropriation or fraudulent financial reporting? 2. Ms. Sachdeva came from a wealthy family, so the theft was not necessary for her to live comfortably. What incentive and attitude/rationalization do you believe drove Ms. Sachdeva to embezzle? Would there have been behavioral red flags that should have alerted auditors to the fraud? 3. There are differences in the ability af an ICFR audit to detect fraud, the ability of a financial statement audit to detect fraud, the ability of a fraud/forensic accountant to detect fraud, and the ability of senior management to detect fraud. With those differences in mind, provide at least four suggestions for improving the ability of financial statement auditors to prevent or detect fraud. This may include the composition of the auditor's brainstorming team, management's evaluation of ICFR, etc. 4. Make a list of at least four factors leading to the Koss embezzlement and fraud not being detected by senior management and/or the independent auditor. For your list, rank order the factors (with "1" being the most contributing factor). Defend your top factor, including why you believe it was the most contributing factor, and why you believe it autweighs the others. Fraud is more difficult to uncover and often goes undetected for a longer period of time when there is collusion among the perpetrators. Koss Corporation, a manufacturer of headphones located in Milwaukee, and their auditors found this aut the hard way when the company was notified by American Express that their vice president of finance, secretary, and principal accounting officer had been wiring funds from Koss Corporation's account into her personal American Express account to fund her lavish lifestyle. Kass Carporation's principal accounting officer, Sujata ("Sue") Sachdeva, embezzled approximately $31 million over 5 years. Koss' Vice President-Finance and Secretary, Sujata Sachdeva, earned total compensation of approximately $200,000 per year for fiscal years 2008 and 2009 (SEC 2009a). Ms. Sachdeva, her husband-an attorney, Ph.D., and M.D. at Children's Hospital of Wisconsin-and their children reportedly enjoyed a lavish lifestyle including numerous trips abroad, private schools for the children, and a house worth nearly $800,000 in the Milwaukee suburbs. While in her 20s, Ms. Sachdeva worked in New York for the brokerage firm of Smith Barney and the now-defunct international accounting firm of Arthur Andersen. Ms. Sachdeva was partrayed as an active fundraiser in the nonprofit community-reportedly raising approximately $1.5 million annually for charitable causes. She was also portrayed as an impeccable dresser with an impressive wardrobe (Hajewski and Romell 2010a). Internal Control Assertions Under Sarbanes-Oxley The Kass Corporation case relates to the financialstatement audit opinions rendered by Koss' independent audit firm, Grant Thornton LLP, and senior management's attestation as to the effectiveness of internal control over financial reporting (ICFR) follawing the passage of the Sarbanes-Oxley Act of 2002 (SOX). Section 404 of SOx requires the CEO and CFO of U.S. registrants, and their external auditor, to separately report on and attest to the effectiveness of ICFR. However, the SEC repeatedly extended the deadline for auditor attestation on the effectiveness of ICFR for nonaccelerated filers (public companies with a market capitalization of less than $75 million, such as Koss). Koss relied on the SEC's extensions related to the required auditor attestation and never engaged Grant Thornton to opine on the effectiveness of Koss' ICFR. In an interview, Michael J. Koss said the new costs associated with SOX were galling to his family, who "pride themselves on being good stewards of their company. However, the Association of Certified Fraud Examiners (ACFE) released an updated Global Fraud Study in 2010. The ACFE has long believed smaller companies (similar to Koss Corporation) are particularly susceptible to fraud given their relatively limited resources. For small businesses, comparing those with fewer than 100 employees and thase with 100 or more (Koss had 72 employees at June 30, 2009; see SEC 2009b), the 15 most frequent anti-fraudcontrols cited for the smallest organizations included external audit of financial atatementa (W1), management'a certification of financiala ( 3), and an external audit of ICFR (# 6) (ACFE 2010). These findings lend credence to the notion that external financial statement and ICFR audits, coupled with management certifications, are viewed to be deterrents to fraud. The fallowing are excerpts from management's attestation on ICFR (signed by Michael J. Koss, CEO and CFO), and Grant Thornton's financial statement audit opinion, respectively, for the company's fiscal year ended June 30, 2009: Kass Attestation (in part): Management's Annual Report on Internal Controls over Financial Reporting: The Company's management, including its Chief Executive Officer/Chief Financial Officer, is responsible for establishing and maintaining adequate internal control of financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(F)) and designing such internal control to provide reasonable assurances regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Management conducted its evaluation of the effectiveness of its internal control over financial reporting based on the framework in "Internal Control-Integrated Framework" issued by the Committee af Sponsoring Organizations of the Treadway Commission ("COSO") as of June 2009. Based on this assessment, the Company's management, including its ChiefExecutive Officer/Chief Financial Officer, believes that as of June 30, 2009, the Company's internal control over financial reporting was effective based on the criteria set forth by coso in "Internal Control-integrated Framework." However, because of the inherent limitations in all control systems, no evaluation of controls can pravide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. This annual report does not include anattestation report of the Company's registered public accounting firmregarding internal control over financial reporting. Management's report was not subject to attestation by the Company's registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management's reportin this Form 10-K. (emphasis added) Grant Thornton's Financial Statement Audit Opinion Scope Paragraph (in part): The Company is not required tohave, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an apinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express nosuch opinion (emphasis added) (SEC 2009b). There are a number of characteristics unique to Koss Corporation in addition to the Company's independent auditor not being required to perform an audit of Koss' ICFR as specified by Section 404 of SOX. Though public, approximately 73 percent of the Company's shares are held by members of the founding family, including John C. Koss, Michael J. Koss, and John Koss, Jr. Note that as joint CEO and CFO, Michael J. Koss was the only member of senior management required to opine on the effectiveness of the Company's ICFR. The only other required signatory on the Form 10-K (beyond directors) was the Company's Vice President of Finance, Principal Accounting Officer, and Secretary-Sujata Sachdeva. Ms. Sachdeva was not required to separately issue an opinion on Koss' internal controls as she was not the Company's CFO, but rather designated as the Principal Accounting Officer. Embezzlement And Financial Statement Fraud At Koss On December 21, 2009, Koss Corporation filed a Form 8-K with the SEC reporting "other events" involving Koss Carporation. The 8-K filing indicated Koss requested the NASDAQ stock exchange to halt trading of its common stock due to the discovery of information regarding certain unauthorized transactions. The company also indicated it had placed Ms. Sachdeva on unpaid administrative leave (SEC 2009c). Holiday celebrations were likely tempered for certain personnel of Grant Thornton LLP, Koss' independent auditor. On ecember 31, 2009, Kass, upon a recommendation from the Company's Audit Committee, dismissed Grant Thornton. In an 8-K filing dated January 4, 2010, the company reported it had dismissed Grant Thornton and expanded its cautionary disclosure of nonreliance on previously issued financial statements, audit reports, and interim reviews, stating, in part: The Company's Audit Committee, on the recommendation of its advisors and management, expanded the scope of the Company's previously disclosed internal investigation of unauthorized financial transactions by Sujata Sachdeva, the Company's former Vice President of Finance and Secretary, to include fiscal years 2005 through the present. The Company has now concluded that its previously issued financial statements on Forms 10-K for the fiscal years ended June 30, 2005 through 2009 and on Form 10-Q for the three months ended September 30, 2009 should no longer be relied upon due to the unauthorized financial transactions. An internal investigation under the supervision of an independent committee of the Board of Directors with the assistance of independent counsel and forensic accountants is continuing. Preliminary estimates indicate that the amount of unauthorized transactions since fiscal year 200S through the present has exceeded $31 million, but at this point the Company and its advisors cannot assess the potential impact an its financial statements or identify the extent that specific fiscal periods may be affected. Nor can the Company and its advisors yet assess the extent of the possible offsets through insurance, asset recoveries and other mechanisms related to the unauthorized transactions. As promptly as possible, the Company plans to restate its financial statements for applicable periods as further investigation indicates. (item 4.02(a) of Kass Corporation's 8-K filed january 4, 2010) (SEC 2010a). On January 6, 2010, Koss filed an amended 8-K with the SEC to include Grant Thornton's required response to the Company's characterization of the auditor dismissal. Grant Thornton responded, in part, as follows: We have read Item 4.01 of Form 8-K of Kass Corporation dated January 4, 2010, and agree with the statements concerning our Firm contained therein. We have no basis to agree or disagree with the statements and conclusions in Item 4.02(a), some of which were not disclosed to Grant Thornton LLP prior to receipt of this filing (SEC 2010b). On lanuary 18, 2010, a Koss press release announced the hiring of a new Executive Vice President, CFO, and Principal Accounting Officer (Michael J. Koss had previously resigned as the company's CFO following news of the alleged embezzlement). The newly hired afficer has a degree in accounting, an M.B.A., and is a licensed CPA with extensive manufacturing experience (SEC 2010c). Safeguards Against Fraud and Embezzlement Theoretically, there are a number of lines of defense against fraud and embezzlement such as those alleged against Ms. Sachdeva. These include the requirement for the CEO and CFO (both Michael J. Koss in this circumstance) to separately attest as to the effectiveness of a Company's ICFR, oversight of those charged with corporate governance (including the board of directors with an independent audit committee), inside whistleblowers, anonymous tipsters, and the independent auditor's opinion as to the effectiveness of ICFR. Recall, Grant Thornton was not engaged to issue such an opinion. Koss Corporation's board of directors in 2009 was comprised of six individuals, including John and MichaelJ. Koss. Excluding one new member in 2006, the remaining five board members had an average tenure of 32 years (AccountingWEB 2010). Ironically, none of these potential safety nets detected the alleged fraud, but rather an independent, outside (not the auditor) third party. According to the criminal complaint, "neither Koss' auditors nor its executives uncovered the alleged fraud. Rather, American Express alerted the company's CEO, Michael Koss, to several large wire transfers made from a Koss bank account to pay Sachdeva's personal credit card. The purchases in question included $382,400 at two jewelry stores and $1.4 million at one clothing boutique" (Johnson 2010). In February 2010, Koss sued American Express, alleging that the credit card company violated the requirements of the Bank Secrecy Act requiring companies such as American Express to have programs to detect and report activity that may suggest the existence of financial crimes. The suit alleges that American Express was aware as early as February of 2008 that Ms. Sachdeva was paying her personal credit card bill with Kass funds, but did nothing to stop the fraud until December of 2009 (Hajewski 2010a). In the criminal complaint, Sachdeva told FBI agents she had authorized an assistant to make the wire transfers, which she later concealed by falsifying the balance in Koss' bank account. The complaint does not explain how she allegedly made these changes or why they were not detected sooner. Her attorney declined comment on the case (lohnsan 2010). A federal search warrant reveals FBI agents seized 461 boxes of shoes, 34 fur coats, and 65 racks of clothing stored in rented space and at area merchants (Hajewski and Romell 2010b). The U.S. Marshals Service was reported to inventory some 22,000 items seized by the FBI (Hajewski and Romell 2010c). The items are scheduled to be auctioned online with net proceeds remitted to Kass (Hajewski 2010b). Ms. Sachdeva's attorney attempted to block the release of her medical records to the court. As a condition of Sachdeva's release on bail, the court had ordered a mental health evaluation be done by Pre-Trial Services. According to the criminal indictment, Sachdeva spent the money on luxury clothing, jewelry, trips, renovations to her home, and services for herself and her family. In a letter to the court, her attorney said sensitive information in Sachdeva's medical records would be "directiy relevant" to her defense, adding, "We do not believe it is either necessary or appropriate that Pre-Trial Services be in possession of these records." It was previously reported that her attorney planned to raise the issue of mental state in Ms. Sachdeva's defense (Hajewski 2010c). Ms. Sachdeva pled nat guilty to accusations that she embezzled $31 million from Kass. The case is believed to be one of the largest embezzlements in Wisconsin history, and the largest in the U.S. for 2009 (Van de Kamp Nohl 2010). Ms. Sachdeva's attorney said, "As this case proceeds, we intend to show that Ms. Sachdeva's mental and emotional health played a significant role in her conduct." Asked whether that was the basis for her not-guilty plea, he declined additional comment. Later, her attorney issued a statement reiterating his remarks and added, "This is the beginning of an ongoing process, and our focus will be on the arguments we make in court. However, the issues of Ms. Sachdeva's mental and emotional health are essential to this case." Sachdeva also was ordered by the court to refrain from using alcohal and to submit to periodic drug and alcohol testing (Hajewski and Romell 2010c). In April 2010, the Koss case was assigned a preliminary hearing date of June 15, 2010. On June 15, 2010, federal prosecutors indicated they were working toward a plea agreement with Mc. Sachdeva and did not anticipate the case would go to trial (Hajewski 2010b). On June 24, 2010, Koss Corporation filed suit against both Ms. Sachdeva and Koss' former independent auditor, Grant Thorntan, alleging fraud, negligence, and breach of fiduciary duty. The suit seeks more than $30 million in damages (Hajewski 2010d). Epilogue On June 30, 2010, Koss restated its previously audited financial statements for fiscal years 2009 and 2008. The impacts of the unauthorized transactions were treated as a theft loss in a separate operating expense line item totaling $8.5 million and $S.1 million for the fiscal years ended June 30, 2009 and 2008, respectively, and a reduction in opening retained earnings of $3.3 million (SEC 2010d). For fiscal 2009 (2008), net sales were originally understated by $3.5 ($2.1) million, and cost of goods sold averstated by $1.7 ($1.0) million. Substantial balance sheet adjustments at June 30, 2009, included a reduction in accounts receivable of $4.0 million, a reduction in inventories of $1.1 million, capitalization of $1.7 million in product software development casts, recognition of $2.9 million in cash surrender value of life insurance, an increase in accounts payable and accrued liabilities of $2.2 million, and an increase in long-term liabilities of $1.2 million (SEC 2010d). On July 27, 2010, Ms. Sachdeva pled guilty to all six counts of felony fraud against her. Under the plea agreement, Ms. Sachdeva agreed to pay approximately $34 million in restitution to Koss. The plea deal specifies a minimum of five years in prison though federal prosecutors may recommend a longer sentence. Sentencing was scheduled for November 17, 2010 (Hajewski 2010e). Directions for PART A: 1. Is this fraud an example of asset misappropriation or fraudulent financial reporting? 2. Ms. Sachdeva came from a wealthy family, so the theft was not necessary for her to live comfortably. What incentive and attitude/rationalization do you believe drove Ms. Sachdeva to embezzle? Would there have been behavioral red flags that should have alerted auditors to the fraud? 3. There are differences in the ability af an ICFR audit to detect fraud, the ability of a financial statement audit to detect fraud, the ability of a fraud/forensic accountant to detect fraud, and the ability of senior management to detect fraud. With those differences in mind, provide at least four suggestions for improving the ability of financial statement auditors to prevent or detect fraud. This may include the composition of the auditor's brainstorming team, management's evaluation of ICFR, etc. 4. Make a list of at least four factors leading to the Koss embezzlement and fraud not being detected by senior management and/or the independent auditor. For your list, rank order the factors (with "1" being the most contributing factor). Defend your top factor, including why you believe it was the most contributing factor, and why you believe it autweighs the others. Fraud is more difficult to uncover and often goes undetected for a longer period of time when there is collusion among the perpetrators. Koss Corporation, a manufacturer of headphones located in Milwaukee, and their auditors found this aut the hard way when the company was notified by American Express that their vice president of finance, secretary, and principal accounting officer had been wiring funds from Koss Corporation's account into her personal American Express account to fund her lavish lifestyle. Kass Carporation's principal accounting officer, Sujata ("Sue") Sachdeva, embezzled approximately $31 million over 5 years. Koss' Vice President-Finance and Secretary, Sujata Sachdeva, earned total compensation of approximately $200,000 per year for fiscal years 2008 and 2009 (SEC 2009a). Ms. Sachdeva, her husband-an attorney, Ph.D., and M.D. at Children's Hospital of Wisconsin-and their children reportedly enjoyed a lavish lifestyle including numerous trips abroad, private schools for the children, and a house worth nearly $800,000 in the Milwaukee suburbs. While in her 20s, Ms. Sachdeva worked in New York for the brokerage firm of Smith Barney and the now-defunct international accounting firm of Arthur Andersen. Ms. Sachdeva was partrayed as an active fundraiser in the nonprofit community-reportedly raising approximately $1.5 million annually for charitable causes. She was also portrayed as an impeccable dresser with an impressive wardrobe (Hajewski and Romell 2010a). Internal Control Assertions Under Sarbanes-Oxley The Kass Corporation case relates to the financialstatement audit opinions rendered by Koss' independent audit firm, Grant Thornton LLP, and senior management's attestation as to the effectiveness of internal control over financial reporting (ICFR) follawing the passage of the Sarbanes-Oxley Act of 2002 (SOX). Section 404 of SOx requires the CEO and CFO of U.S. registrants, and their external auditor, to separately report on and attest to the effectiveness of ICFR. However, the SEC repeatedly extended the deadline for auditor attestation on the effectiveness of ICFR for nonaccelerated filers (public companies with a market capitalization of less than $75 million, such as Koss). Koss relied on the SEC's extensions related to the required auditor attestation and never engaged Grant Thornton to opine on the effectiveness of Koss' ICFR. In an interview, Michael J. Koss said the new costs associated with SOX were galling to his family, who "pride themselves on being good stewards of their company. However, the Association of Certified Fraud Examiners (ACFE) released an updated Global Fraud Study in 2010. The ACFE has long believed smaller companies (similar to Koss Corporation) are particularly susceptible to fraud given their relatively limited resources. For small businesses, comparing those with fewer than 100 employees and thase with 100 or more (Koss had 72 employees at June 30, 2009; see SEC 2009b), the 15 most frequent anti-fraudcontrols cited for the smallest organizations included external audit of financial atatementa (W1), management'a certification of financiala ( 3), and an external audit of ICFR (# 6) (ACFE 2010). These findings lend credence to the notion that external financial statement and ICFR audits, coupled with management certifications, are viewed to be deterrents to fraud. The fallowing are excerpts from management's attestation on ICFR (signed by Michael J. Koss, CEO and CFO), and Grant Thornton's financial statement audit opinion, respectively, for the company's fiscal year ended June 30, 2009: Kass Attestation (in part): Management's Annual Report on Internal Controls over Financial Reporting: The Company's management, including its Chief Executive Officer/Chief Financial Officer, is responsible for establishing and maintaining adequate internal control of financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(F)) and designing such internal control to provide reasonable assurances regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Management conducted its evaluation of the effectiveness of its internal control over financial reporting based on the framework in "Internal Control-Integrated Framework" issued by the Committee af Sponsoring Organizations of the Treadway Commission ("COSO") as of June 2009. Based on this assessment, the Company's management, including its ChiefExecutive Officer/Chief Financial Officer, believes that as of June 30, 2009, the Company's internal control over financial reporting was effective based on the criteria set forth by coso in "Internal Control-integrated Framework." However, because of the inherent limitations in all control systems, no evaluation of controls can pravide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. This annual report does not include anattestation report of the Company's registered public accounting firmregarding internal control over financial reporting. Management's report was not subject to attestation by the Company's registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management's reportin this Form 10-K. (emphasis added) Grant Thornton's Financial Statement Audit Opinion Scope Paragraph (in part): The Company is not required tohave, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an apinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express nosuch opinion (emphasis added) (SEC 2009b). There are a number of characteristics unique to Koss Corporation in addition to the Company's independent auditor not being required to perform an audit of Koss' ICFR as specified by Section 404 of SOX. Though public, approximately 73 percent of the Company's shares are held by members of the founding family, including John C. Koss, Michael J. Koss, and John Koss, Jr. Note that as joint CEO and CFO, Michael J. Koss was the only member of senior management required to opine on the effectiveness of the Company's ICFR. The only other required signatory on the Form 10-K (beyond directors) was the Company's Vice President of Finance, Principal Accounting Officer, and Secretary-Sujata Sachdeva. Ms. Sachdeva was not required to separately issue an opinion on Koss' internal controls as she was not the Company's CFO, but rather designated as the Principal Accounting Officer. Embezzlement And Financial Statement Fraud At Koss On December 21, 2009, Koss Corporation filed a Form 8-K with the SEC reporting "other events" involving Koss Carporation. The 8-K filing indicated Koss requested the NASDAQ stock exchange to halt trading of its common stock due to the discovery of information regarding certain unauthorized transactions. The company also indicated it had placed Ms. Sachdeva on unpaid administrative leave (SEC 2009c). Holiday celebrations were likely tempered for certain personnel of Grant Thornton LLP, Koss' independent auditor. On ecember 31, 2009, Kass, upon a recommendation from the Company's Audit Committee, dismissed Grant Thornton. In an 8-K filing dated January 4, 2010, the company reported it had dismissed Grant Thornton and expanded its cautionary disclosure of nonreliance on previously issued financial statements, audit reports, and interim reviews, stating, in part: The Company's Audit Committee, on the recommendation of its advisors and management, expanded the scope of the Company's previously disclosed internal investigation of unauthorized financial transactions by Sujata Sachdeva, the Company's former Vice President of Finance and Secretary, to include fiscal years 2005 through the present. The Company has now concluded that its previously issued financial statements on Forms 10-K for the fiscal years ended June 30, 2005 through 2009 and on Form 10-Q for the three months ended September 30, 2009 should no longer be relied upon due to the unauthorized financial transactions. An internal investigation under the supervision of an independent committee of the Board of Directors with the assistance of independent counsel and forensic accountants is continuing. Preliminary estimates indicate that the amount of unauthorized transactions since fiscal year 200S through the present has exceeded $31 million, but at this point the Company and its advisors cannot assess the potential impact an its financial statements or identify the extent that specific fiscal periods may be affected. Nor can the Company and its advisors yet assess the extent of the possible offsets through insurance, asset recoveries and other mechanisms related to the unauthorized transactions. As promptly as possible, the Company plans to restate its financial statements for applicable periods as further investigation indicates. (item 4.02(a) of Kass Corporation's 8-K filed january 4, 2010) (SEC 2010a). On January 6, 2010, Koss filed an amended 8-K with the SEC to include Grant Thornton's required response to the Company's characterization of the auditor dismissal. Grant Thornton responded, in part, as follows: We have read Item 4.01 of Form 8-K of Kass Corporation dated January 4, 2010, and agree with the statements concerning our Firm contained therein. We have no basis to agree or disagree with the statements and conclusions in Item 4.02(a), some of which were not disclosed to Grant Thornton LLP prior to receipt of this filing (SEC 2010b). On lanuary 18, 2010, a Koss press release announced the hiring of a new Executive Vice President, CFO, and Principal Accounting Officer (Michael J. Koss had previously resigned as the company's CFO following news of the alleged embezzlement). The newly hired afficer has a degree in accounting, an M.B.A., and is a licensed CPA with extensive manufacturing experience (SEC 2010c). Safeguards Against Fraud and Embezzlement Theoretically, there are a number of lines of defense against fraud and embezzlement such as those alleged against Ms. Sachdeva. These include the requirement for the CEO and CFO (both Michael J. Koss in this circumstance) to separately attest as to the effectiveness of a Company's ICFR, oversight of those charged with corporate governance (including the board of directors with an independent audit committee), inside whistleblowers, anonymous tipsters, and the independent auditor's opinion as to the effectiveness of ICFR. Recall, Grant Thornton was not engaged to issue such an opinion. Koss Corporation's board of directors in 2009 was comprised of six individuals, including John and MichaelJ. Koss. Excluding one new member in 2006, the remaining five board members had an average tenure of 32 years (AccountingWEB 2010). Ironically, none of these potential safety nets detected the alleged fraud, but rather an independent, outside (not the auditor) third party. According to the criminal complaint, "neither Koss' auditors nor its executives uncovered the alleged fraud. Rather, American Express alerted the company's CEO, Michael Koss, to several large wire transfers made from a Koss bank account to pay Sachdeva's personal credit card. The purchases in question included $382,400 at two jewelry stores and $1.4 million at one clothing boutique" (Johnson 2010). In February 2010, Koss sued American Express, alleging that the credit card company violated the requirements of the Bank Secrecy Act requiring companies such as American Express to have programs to detect and report activity that may suggest the existence of financial crimes. The suit alleges that American Express was aware as early as February of 2008 that Ms. Sachdeva was paying her personal credit card bill with Kass funds, but did nothing to stop the fraud until December of 2009 (Hajewski 2010a). In the criminal complaint, Sachdeva told FBI agents she had authorized an assistant to make the wire transfers, which she later concealed by falsifying the balance in Koss' bank account. The complaint does not explain how she allegedly made these changes or why they were not detected sooner. Her attorney declined comment on the case (lohnsan 2010). A federal search warrant reveals FBI agents seized 461 boxes of shoes, 34 fur coats, and 65 racks of clothing stored in rented space and at area merchants (Hajewski and Romell 2010b). The U.S. Marshals Service was reported to inventory some 22,000 items seized by the FBI (Hajewski and Romell 2010c). The items are scheduled to be auctioned online with net proceeds remitted to Kass (Hajewski 2010b). Ms. Sachdeva's attorney attempted to block the release of her medical records to the court. As a condition of Sachdeva's release on bail, the court had ordered a mental health evaluation be done by Pre-Trial Services. According to the criminal indictment, Sachdeva spent the money on luxury clothing, jewelry, trips, renovations to her home, and services for herself and her family. In a letter to the court, her attorney said sensitive information in Sachdeva's medical records would be "directiy relevant" to her defense, adding, "We do not believe it is either necessary or appropriate that Pre-Trial Services be in possession of these records." It was previously reported that her attorney planned to raise the issue of mental state in Ms. Sachdeva's defense (Hajewski 2010c). Ms. Sachdeva pled nat guilty to accusations that she embezzled $31 million from Kass. The case is believed to be one of the largest embezzlements in Wisconsin history, and the largest in the U.S. for 2009 (Van de Kamp Nohl 2010). Ms. Sachdeva's attorney said, "As this case proceeds, we intend to show that Ms. Sachdeva's mental and emotional health played a significant role in her conduct." Asked whether that was the basis for her not-guilty plea, he declined additional comment. Later, her attorney issued a statement reiterating his remarks and added, "This is the beginning of an ongoing process, and our focus will be on the arguments we make in court. However, the issues of Ms. Sachdeva's mental and emotional health are essential to this case." Sachdeva also was ordered by the court to refrain from using alcohal and to submit to periodic drug and alcohol testing (Hajewski and Romell 2010c). In April 2010, the Koss case was assigned a preliminary hearing date of June 15, 2010. On June 15, 2010, federal prosecutors indicated they were working toward a plea agreement with Mc. Sachdeva and did not anticipate the case would go to trial (Hajewski 2010b). On June 24, 2010, Koss Corporation filed suit against both Ms. Sachdeva and Koss' former independent auditor, Grant Thorntan, alleging fraud, negligence, and breach of fiduciary duty. The suit seeks more than $30 million in damages (Hajewski 2010d). Epilogue On June 30, 2010, Koss restated its previously audited financial statements for fiscal years 2009 and 2008. The impacts of the unauthorized transactions were treated as a theft loss in a separate operating expense line item totaling $8.5 million and $S.1 million for the fiscal years ended June 30, 2009 and 2008, respectively, and a reduction in opening retained earnings of $3.3 million (SEC 2010d). For fiscal 2009 (2008), net sales were originally understated by $3.5 ($2.1) million, and cost of goods sold averstated by $1.7 ($1.0) million. Substantial balance sheet adjustments at June 30, 2009, included a reduction in accounts receivable of $4.0 million, a reduction in inventories of $1.1 million, capitalization of $1.7 million in product software development casts, recognition of $2.9 million in cash surrender value of life insurance, an increase in accounts payable and accrued liabilities of $2.2 million, and an increase in long-term liabilities of $1.2 million (SEC 2010d). On July 27, 2010, Ms. Sachdeva pled guilty to all six counts of felony fraud against her. Under the plea agreement, Ms. Sachdeva agreed to pay approximately $34 million in restitution to Koss. The plea deal specifies a minimum of five years in prison though federal prosecutors may recommend a longer sentence. Sentencing was scheduled for November 17, 2010 (Hajewski 2010e). Directions for PART A: 1. Is this fraud an example of asset misappropriation or fraudulent financial reporting? 2. Ms. Sachdeva came from a wealthy family, so the theft was not necessary for her to live comfortably. What incentive and attitude/rationalization do you believe drove Ms. Sachdeva to embezzle? Would there have been behavioral red flags that should have alerted auditors to the fraud? 3. There are differences in the ability af an ICFR audit to detect fraud, the ability of a financial statement audit to detect fraud, the ability of a fraud/forensic accountant to detect fraud, and the ability of senior management to detect fraud. With those differences in mind, provide at least four suggestions for improving the ability of financial statement auditors to prevent or detect fraud. This may include the composition of the auditor's brainstorming team, management's evaluation of ICFR, etc. 4. Make a list of at least four factors leading to the Koss embezzlement and fraud not being detected by senior management and/or the independent auditor. For your list, rank order the factors (with "1" being the most contributing factor). Defend your top factor, including why you believe it was the most contributing factor, and why you believe it autweighs the others. Fraud is more difficult to uncover and often goes undetected for a longer period of time when there is collusion among the perpetrators. Koss Corporation, a manufacturer of headphones located in Milwaukee, and their auditors found this aut the hard way when the company was notified by American Express that their vice president of finance, secretary, and principal accounting officer had been wiring funds from Koss Corporation's account into her personal American Express account to fund her lavish lifestyle. Kass Carporation's principal accounting officer, Sujata ("Sue") Sachdeva, embezzled approximately $31 million over 5 years. Koss' Vice President-Finance and Secretary, Sujata Sachdeva, earned total compensation of approximately $200,000 per year for fiscal years 2008 and 2009 (SEC 2009a). Ms. Sachdeva, her husband-an attorney, Ph.D., and M.D. at Children's Hospital of Wisconsin-and their children reportedly enjoyed a lavish lifestyle including numerous trips abroad, private schools for the children, and a house worth nearly $800,000 in the Milwaukee suburbs. While in her 20s, Ms. Sachdeva worked in New York for the brokerage firm of Smith Barney and the now-defunct international accounting firm of Arthur Andersen. Ms. Sachdeva was partrayed as an active fundraiser in the nonprofit community-reportedly raising approximately $1.5 million annually for charitable causes. She was also portrayed as an impeccable dresser with an impressive wardrobe (Hajewski and Romell 2010a). Internal Control Assertions Under Sarbanes-Oxley The Kass Corporation case relates to the financialstatement audit opinions rendered by Koss' independent audit firm, Grant Thornton LLP, and senior management's attestation as to the effectiveness of internal control over financial reporting (ICFR) follawing the passage of the Sarbanes-Oxley Act of 2002 (SOX). Section 404 of SOx requires the CEO and CFO of U.S. registrants, and their external auditor, to separately report on and attest to the effectiveness of ICFR. However, the SEC repeatedly extended the deadline for auditor attestation on the effectiveness of ICFR for nonaccelerated filers (public companies with a market capitalization of less than $75 million, such as Koss). Koss relied on the SEC's extensions related to the required auditor attestation and never engaged Grant Thornton to opine on the effectiveness of Koss' ICFR. In an interview, Michael J. Koss said the new costs associated with SOX were galling to his family, who "pride themselves on being good stewards of their company. However, the Association of Certified Fraud Examiners (ACFE) released an updated Global Fraud Study in 2010. The ACFE has long believed smaller companies (similar to Koss Corporation) are particularly susceptible to fraud given their relatively limited resources. For small businesses, comparing those with fewer than 100 employees and thase with 100 or more (Koss had 72 employees at June 30, 2009; see SEC 2009b), the 15 most frequent anti-fraudcontrols cited for the smallest organizations included external audit of financial atatementa (W1), management'a certification of financiala ( 3), and an external audit of ICFR (# 6) (ACFE 2010). These findings lend credence to the notion that external financial statement and ICFR audits, coupled with management certifications, are viewed to be deterrents to fraud. The fallowing are excerpts from management's attestation on ICFR (signed by Michael J. Koss, CEO and CFO), and Grant Thornton's financial statement audit opinion, respectively, for the company's fiscal year ended June 30, 2009: Kass Attestation (in part): Management's Annual Report on Internal Controls over Financial Reporting: The Company's management, including its Chief Executive Officer/Chief Financial Officer, is responsible for establishing and maintaining adequate internal control of financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(F)) and designing such internal control to provide reasonable assurances regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Management conducted its evaluation of the effectiveness of its internal control over financial reporting based on the framework in "Internal Control-Integrated Framework" issued by the Committee af Sponsoring Organizations of the Treadway Commission ("COSO") as of June 2009. Based on this assessment, the Company's management, including its ChiefExecutive Officer/Chief Financial Officer, believes that as of June 30, 2009, the Company's internal control over financial reporting was effective based on the criteria set forth by coso in "Internal Control-integrated Framework." However, because of the inherent limitations in all control systems, no evaluation of controls can pravide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. This annual report does not include anattestation report of the Company's registered public accounting firmregarding internal control over financial reporting. Management's report was not subject to attestation by the Company's registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management's reportin this Form 10-K. (emphasis added) Grant Thornton's Financial Statement Audit Opinion Scope Paragraph (in part): The Company is not required tohave, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an apinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express nosuch opinion (emphasis added) (SEC 2009b). There are a number of characteristics unique to Koss Corporation in addition to the Company's independent auditor not being required to perform an audit of Koss' ICFR as specified by Section 404 of SOX. Though public, approximately 73 percent of the Company's shares are held by members of the founding family, including John C. Koss, Michael J. Koss, and John Koss, Jr. Note that as joint CEO and CFO, Michael J. Koss was the only member of senior management required to opine on the effectiveness of the Company's ICFR. The only other required signatory on the Form 10-K (beyond directors) was the Company's Vice President of Finance, Principal Accounting Officer, and Secretary-Sujata Sachdeva. Ms. Sachdeva was not required to separately issue an opinion on Koss' internal controls as she was not the Company's CFO, but rather designated as the Principal Accounting Officer. Embezzlement And Financial Statement Fraud At Koss On December 21, 2009, Koss Corporation filed a Form 8-K with the SEC reporting "other events" involving Koss Carporation. The 8-K filing indicated Koss requested the NASDAQ stock exchange to halt trading of its common stock due to the discovery of information regarding certain unauthorized transactions. The company also indicated it had placed Ms. Sachdeva on unpaid administrative leave (SEC 2009c). Holiday celebrations were likely tempered for certain personnel of Grant Thornton LLP, Koss' independent auditor. On ecember 31, 2009, Kass, upon a recommendation from the Company's Audit Committee, dismissed Grant Thornton. In an 8-K filing dated January 4, 2010, the company reported it had dismissed Grant Thornton and expanded its cautionary disclosure of nonreliance on previously issued financial statements, audit reports, and interim reviews, stating, in part: The Company's Audit Committee, on the recommendation of its advisors and management, expanded the scope of the Company's previously disclosed internal investigation of unauthorized financial transactions by Sujata Sachdeva, the Company's former Vice President of Finance and Secretary, to include fiscal years 2005 through the present. The Company has now concluded that its previously issued financial statements on Forms 10-K for the fiscal years ended June 30, 2005 through 2009 and on Form 10-Q for the three months ended September 30, 2009 should no longer be relied upon due to the unauthorized financial transactions. An internal investigation under the supervision of an independent committee of the Board of Directors with the assistance of independent counsel and forensic accountants is continuing. Preliminary estimates indicate that the amount of unauthorized transactions since fiscal year 200S through the present has exceeded $31 million, but at this point the Company and its advisors cannot assess the potential impact an its financial statements or identify the extent that specific fiscal periods may be affected. Nor can the Company and its advisors yet assess the extent of the possible offsets through insurance, asset recoveries and other mechanisms related to the unauthorized transactions. As promptly as possible, the Company plans to restate its financial statements for applicable periods as further investigation indicates. (item 4.02(a) of Kass Corporation's 8-K filed january 4, 2010) (SEC 2010a). On January 6, 2010, Koss filed an amended 8-K with the SEC to include Grant Thornton's required response to the Company's characterization of the auditor dismissal. Grant Thornton responded, in part, as follows: We have read Item 4.01 of Form 8-K of Kass Corporation dated January 4, 2010, and agree with the statements concerning our Firm contained therein. We have no basis to agree or disagree with the statements and conclusions in Item 4.02(a), some of which were not disclosed to Grant Thornton LLP prior to receipt of this filing (SEC 2010b). On lanuary 18, 2010, a Koss press release announced the hiring of a new Executive Vice President, CFO, and Principal Accounting Officer (Michael J. Koss had previously resigned as the company's CFO following news of the alleged embezzlement). The newly hired afficer has a degree in accounting, an M.B.A., and is a licensed CPA with extensive manufacturing experience (SEC 2010c). Safeguards Against Fraud and Embezzlement Theoretically, there are a number of lines of defense against fraud and embezzlement such as those alleged against Ms. Sachdeva. These include the requirement for the CEO and CFO (both Michael J. Koss in this circumstance) to separately attest as to the effectiveness of a Company's ICFR, oversight of those charged with corporate governance (including the board of directors with an independent audit committee), inside whistleblowers, anonymous tipsters, and the independent auditor's opinion as to the effectiveness of ICFR. Recall, Grant Thornton was not engaged to issue such an opinion. Koss Corporation's board of directors in 2009 was comprised of six individuals, including John and MichaelJ. Koss. Excluding one new member in 2006, the remaining five board members had an average tenure of 32 years (AccountingWEB 2010). Ironically, none of these potential safety nets detected the alleged fraud, but rather an independent, outside (not the auditor) third party. According to the criminal complaint, "neither Koss' auditors nor its executives uncovered the alleged fraud. Rather, American Express alerted the company's CEO, Michael Koss, to several large wire transfers made from a Koss bank account to pay Sachdeva's personal credit card. The purchases in question included $382,400 at two jewelry stores and $1.4 million at one clothing boutique" (Johnson 2010). In February 2010, Koss sued American Express, alleging that the credit card company violated the requirements of the Bank Secrecy Act requiring companies such as American Express to have programs to detect and report activity that may suggest the existence of financial crimes. The suit alleges that American Express was aware as early as February of 2008 that Ms. Sachdeva was paying her personal credit card bill with Kass funds, but did nothing to stop the fraud until December of 2009 (Hajewski 2010a). In the criminal complaint, Sachdeva told FBI agents she had authorized an assistant to make the wire transfers, which she later concealed by falsifying the balance in Koss' bank account. The complaint does not explain how she allegedly made these changes or why they were not detected sooner. Her attorney declined comment on the case (lohnsan 2010). A federal search warrant reveals FBI agents seized 461 boxes of shoes, 34 fur coats, and 65 racks of clothing stored in rented space and at area merchants (Hajewski and Romell 2010b). The U.S. Marshals Service was reported to inventory some 22,000 items seized by the FBI (Hajewski and Romell 2010c). The items are scheduled to be auctioned online with net proceeds remitted to Kass (Hajewski 2010b). Ms. Sachdeva's attorney attempted to block the release of her medical records to the court. As a condition of Sachdeva's release on bail, the court had ordered a mental health evaluation be done by Pre-Trial Services. According to the criminal indictment, Sachdeva spent the money on luxury clothing, jewelry, trips, renovations to her home, and services for herself and her family. In a letter to the court, her attorney said sensitive information in Sachdeva's medical records would be "directiy relevant" to her defense, adding, "We do not believe it is either necessary or appropriate that Pre-Trial Services be in possession of these records." It was previously reported that her attorney planned to raise the issue of mental state in Ms. Sachdeva's defense (Hajewski 2010c). Ms. Sachdeva pled nat guilty to accusations that she embezzled $31 million from Kass. The case is believed to be one of the largest embezzlements in Wisconsin history, and the largest in the U.S. for 2009 (Van de Kamp Nohl 2010). Ms. Sachdeva's attorney said, "As this case proceeds, we intend to show that Ms. Sachdeva's mental and emotional health played a significant role in her conduct." Asked whether that was the basis for her not-guilty plea, he declined additional comment. Later, her attorney issued a statement reiterating his remarks and added, "This is the beginning of an ongoing process, and our focus will be on the arguments we make in court. However, the issues of Ms. Sachdeva's mental and emotional health are essential to this case." Sachdeva also was ordered by the court to refrain from using alcohal and to submit to periodic drug and alcohol testing (Hajewski and Romell 2010c). In April 2010, the Koss case was assigned a preliminary hearing date of June 15, 2010. On June 15, 2010, federal prosecutors indicated they were working toward a plea agreement with Mc. Sachdeva and did not anticipate the case would go to trial (Hajewski 2010b). On June 24, 2010, Koss Corporation filed suit against both Ms. Sachdeva and Koss' former independent auditor, Grant Thorntan, alleging fraud, negligence, and breach of fiduciary duty. The suit seeks more than $30 million in damages (Hajewski 2010d). Epilogue On June 30, 2010, Koss restated its previously audited financial statements for fiscal years 2009 and 2008. The impacts of the unauthorized transactions were treated as a theft loss in a separate operating expense line item totaling $8.5 million and $S.1 million for the fiscal years ended June 30, 2009 and 2008, respectively, and a reduction in opening retained earnings of $3.3 million (SEC 2010d). For fiscal 2009 (2008), net sales were originally understated by $3.5 ($2.1) million, and cost of goods sold averstated by $1.7 ($1.0) million. Substantial balance sheet adjustments at June 30, 2009, included a reduction in accounts receivable of $4.0 million, a reduction in inventories of $1.1 million, capitalization of $1.7 million in product software development casts, recognition of $2.9 million in cash surrender value of life insurance, an increase in accounts payable and accrued liabilities of $2.2 million, and an increase in long-term liabilities of $1.2 million (SEC 2010d). On July 27, 2010, Ms. Sachdeva pled guilty to all six counts of felony fraud against her. Under the plea agreement, Ms. Sachdeva agreed to pay approximately $34 million in restitution to Koss. The plea deal specifies a minimum of five years in prison though federal prosecutors may recommend a longer sentence. Sentencing was scheduled for November 17, 2010 (Hajewski 2010e). Directions for PART A: 1. Is this fraud an example of asset misappropriation or fraudulent financial reporting? 2. Ms. Sachdeva came from a wealthy family, so the theft was not necessary for her to live comfortably. What incentive and attitude/rationalization do you believe drove Ms. Sachdeva to embezzle? Would there have been behavioral red flags that should have alerted auditors to the fraud? 3. There are differences in the ability af an ICFR audit to detect fraud, the ability of a financial statement audit to detect fraud, the ability of a fraud/forensic accountant to detect fraud, and the ability of senior management to detect fraud. With those differences in mind, provide at least four suggestions for improving the ability of financial statement auditors to prevent or detect fraud. This may include the composition of the auditor's brainstorming team, management's evaluation of ICFR, etc. 4. Make a list of at least four factors leading to the Koss embezzlement and fraud not being detected by senior management and/or the independent auditor. For your list, rank order the factors (with "1" being the most contributing factor). Defend your top factor, including why you believe it was the most contributing factor, and why you believe it autweighs the others. Fraud is more difficult to uncover and often goes undetected for a longer period of time when there is collusion among the perpetrators. Koss Corporation, a manufacturer of headphones located in Milwaukee, and their auditors found this aut the hard way when the company was notified by American Express that their vice president of finance, secretary, and principal accounting officer had been wiring funds from Koss Corporation's account into her personal American Express account to fund her lavish lifestyle. Kass Carporation's principal accounting officer, Sujata ("Sue") Sachdeva, embezzled approximately $31 million over 5 years. Koss' Vice President-Finance and Secretary, Sujata Sachdeva, earned total compensation of approximately $200,000 per year for fiscal years 2008 and 2009 (SEC 2009a). Ms. Sachdeva, her husband-an attorney, Ph.D., and M.D. at Children's Hospital of Wisconsin-and their children reportedly enjoyed a lavish lifestyle including numerous trips abroad, private schools for the children, and a house worth nearly $800,000 in the Milwaukee suburbs. While in her 20s, Ms. Sachdeva worked in New York for the brokerage firm of Smith Barney and the now-defunct international accounting firm of Arthur Andersen. Ms. Sachdeva was partrayed as an active fundraiser in the nonprofit community-reportedly raising approximately $1.5 million annually for charitable causes. She was also portrayed as an impeccable dresser with an impressive wardrobe (Hajewski and Romell 2010a). Internal Control Assertions Under Sarbanes-Oxley The Kass Corporation case relates to the financialstatement audit opinions rendered by Koss' independent audit firm, Grant Thornton LLP, and senior management's attestation as to the effectiveness of internal control over financial reporting (ICFR) follawing the passage of the Sarbanes-Oxley Act of 2002 (SOX). Section 404 of SOx requires the CEO and CFO of U.S. registrants, and their external auditor, to separately report on and attest to the effectiveness of ICFR. However, the SEC repeatedly extended the deadline for auditor attestation on the effectiveness of ICFR for nonaccelerated filers (public companies with a market capitalization of less than $75 million, such as Koss). Koss relied on the SEC's extensions related to the required auditor attestation and never engaged Grant Thornton to opine on the effectiveness of Koss' ICFR. In an interview, Michael J. Koss said the new costs associated with SOX were galling to his family, who "pride themselves on being good stewards of their company. However, the Association of Certified Fraud Examiners (ACFE) released an updated Global Fraud Study in 2010. The ACFE has long believed smaller companies (similar to Koss Corporation) are particularly susceptible to fraud given their relatively limited resources. For small businesses, comparing those with fewer than 100 employees and thase with 100 or more (Koss had 72 employees at June 30, 2009; see SEC 2009b), the 15 most frequent anti-fraudcontrols cited for the smallest organizations included external audit of financial atatementa (W1), management'a certification of financiala ( 3), and an external audit of ICFR (# 6) (ACFE 2010). These findings lend credence to the notion that external financial statement and ICFR audits, coupled with management certifications, are viewed to be deterrents to fraud. The fallowing are excerpts from management's attestation on ICFR (signed by Michael J. Koss, CEO and CFO), and Grant Thornton's financial statement audit opinion, respectively, for the company's fiscal year ended June 30, 2009: Kass Attestation (in part): Management's Annual Report on Internal Controls over Financial Reporting: The Company's management, including its Chief Executive Officer/Chief Financial Officer, is responsible for establishing and maintaining adequate internal control of financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(F)) and designing such internal control to provide reasonable assurances regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Management conducted its evaluation of the effectiveness of its internal control over financial reporting based on the framework in "Internal Control-Integrated Framework" issued by the Committee af Sponsoring Organizations of the Treadway Commission ("COSO") as of June 2009. Based on this assessment, the Company's management, including its ChiefExecutive Officer/Chief Financial Officer, believes that as of June 30, 2009, the Company's internal control over financial reporting was effective based on the criteria set forth by coso in "Internal Control-integrated Framework." However, because of the inherent limitations in all control systems, no evaluation of controls can pravide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. This annual report does not include anattestation report of the Company's registered public accounting firmregarding internal control over financial reporting. Management's report was not subject to attestation by the Company's registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management's reportin this Form 10-K. (emphasis added) Grant Thornton's Financial Statement Audit Opinion Scope Paragraph (in part): The Company is not required tohave, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an apinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express nosuch opinion (emphasis added) (SEC 2009b). There are a number of characteristics unique to Koss Corporation in addition to the Company's independent auditor not being required to perform an audit of Koss' ICFR as specified by Section 404 of SOX. Though public, approximately 73 percent of the Company's shares are held by members of the founding family, including John C. Koss, Michael J. Koss, and John Koss, Jr. Note that as joint CEO and CFO, Michael J. Koss was the only member of senior management required to opine on the effectiveness of the Company's ICFR. The only other required signatory on the Form 10-K (beyond directors) was the Company's Vice President of Finance, Principal Accounting Officer, and Secretary-Sujata Sachdeva. Ms. Sachdeva was not required to separately issue an opinion on Koss' internal controls as she was not the Company's CFO, but rather designated as the Principal Accounting Officer. Embezzlement And Financial Statement Fraud At Koss On December 21, 2009, Koss Corporation filed a Form 8-K with the SEC reporting "other events" involving Koss Carporation. The 8-K filing indicated Koss requested the NASDAQ stock exchange to halt trading of its common stock due to the discovery of information regarding certain unauthorized transactions. The company also indicated it had placed Ms. Sachdeva on unpaid administrative leave (SEC 2009c). Holiday celebrations were likely tempered for certain personnel of Grant Thornton LLP, Koss' independent auditor. On ecember 31, 2009, Kass, upon a recommendation from the Company's Audit Committee, dismissed Grant Thornton. In an 8-K filing dated January 4, 2010, the company reported it had dismissed Grant Thornton and expanded its cautionary disclosure of nonreliance on previously issued financial statements, audit reports, and interim reviews, stating, in part: The Company's Audit Committee, on the recommendation of its advisors and management, expanded the scope of the Company's previously disclosed internal investigation of unauthorized financial transactions by Sujata Sachdeva, the Company's former Vice President of Finance and Secretary, to include fiscal years 2005 through the present. The Company has now concluded that its previously issued financial statements on Forms 10-K for the fiscal years ended June 30, 2005 through 2009 and on Form 10-Q for the three months ended September 30, 2009 should no longer be relied upon due to the unauthorized financial transactions. An internal investigation under the supervision of an independent committee of the Board of Directors with the assistance of independent counsel and forensic accountants is continuing. Preliminary estimates indicate that the amount of unauthorized transactions since fiscal year 200S through the present has exceeded $31 million, but at this point the Company and its advisors cannot assess the potential impact an its financial statements or identify the extent that specific fiscal periods may be affected. Nor can the Company and its advisors yet assess the extent of the possible offsets through insurance, asset recoveries and other mechanisms related to the unauthorized transactions. As promptly as possible, the Company plans to restate its financial statements for applicable periods as further investigation indicates. (item 4.02(a) of Kass Corporation's 8-K filed january 4, 2010) (SEC 2010a). On January 6, 2010, Koss filed an amended 8-K with the SEC to include Grant Thornton's required response to the Company's characterization of the auditor dismissal. Grant Thornton responded, in part, as follows: We have read Item 4.01 of Form 8-K of Kass Corporation dated January 4, 2010, and agree with the statements concerning our Firm contained therein. We have no basis to agree or disagree with the statements and conclusions in Item 4.02(a), some of which were not disclosed to Grant Thornton LLP prior to receipt of this filing (SEC 2010b). On lanuary 18, 2010, a Koss press release announced the hiring of a new Executive Vice President, CFO, and Principal Accounting Officer (Michael J. Koss had previously resigned as the company's CFO following news of the alleged embezzlement). The newly hired afficer has a degree in accounting, an M.B.A., and is a licensed CPA with extensive manufacturing experience (SEC 2010c). Safeguards Against Fraud and Embezzlement Theoretically, there are a number of lines of defense against fraud and embezzlement such as those alleged against Ms. Sachdeva. These include the requirement for the CEO and CFO (both Michael J. Koss in this circumstance) to separately attest as to the effectiveness of a Company's ICFR, oversight of those charged with corporate governance (including the board of directors with an independent audit committee), inside whistleblowers, anonymous tipsters, and the independent auditor's opinion as to the effectiveness of ICFR. Recall, Grant Thornton was not engaged to issue such an opinion. Koss Corporation's board of directors in 2009 was comprised of six individuals, including John and MichaelJ. Koss. Excluding one new member in 2006, the remaining five board members had an average tenure of 32 years (AccountingWEB 2010). Ironically, none of these potential safety nets detected the alleged fraud, but rather an independent, outside (not the auditor) third party. According to the criminal complaint, "neither Koss' auditors nor its executives uncovered the alleged fraud. Rather, American Express alerted the company's CEO, Michael Koss, to several large wire transfers made from a Koss bank account to pay Sachdeva's personal credit card. The purchases in question included $382,400 at two jewelry stores and $1.4 million at one clothing boutique" (Johnson 2010). In February 2010, Koss sued American Express, alleging that the credit card company violated the requirements of the Bank Secrecy Act requiring companies such as American Express to have programs to detect and report activity that may suggest the existence of financial crimes. The suit alleges that American Express was aware as early as February of 2008 that Ms. Sachdeva was paying her personal credit card bill with Kass funds, but did nothing to stop the fraud until December of 2009 (Hajewski 2010a). In the criminal complaint, Sachdeva told FBI agents she had authorized an assistant to make the wire transfers, which she later concealed by falsifying the balance in Koss' bank account. The complaint does not explain how she allegedly made these changes or why they were not detected sooner. Her attorney declined comment on the case (lohnsan 2010). A federal search warrant reveals FBI agents seized 461 boxes of shoes, 34 fur coats, and 65 racks of clothing stored in rented space and at area merchants (Hajewski and Romell 2010b). The U.S. Marshals Service was reported to inventory some 22,000 items seized by the FBI (Hajewski and Romell 2010c). The items are scheduled to be auctioned online with net proceeds remitted to Kass (Hajewski 2010b). Ms. Sachdeva's attorney attempted to block the release of her medical records to the court. As a condition of Sachdeva's release on bail, the court had ordered a mental health evaluation be done by Pre-Trial Services. According to the criminal indictment, Sachdeva spent the money on luxury clothing, jewelry, trips, renovations to her home, and services for herself and her family. In a letter to the court, her attorney said sensitive information in Sachdeva's medical records would be "directiy relevant" to her defense, adding, "We do not believe it is either necessary or appropriate that Pre-Trial Services be in possession of these records." It was previously reported that her attorney planned to raise the issue of mental state in Ms. Sachdeva's defense (Hajewski 2010c). Ms. Sachdeva pled nat guilty to accusations that she embezzled $31 million from Kass. The case is believed to be one of the largest embezzlements in Wisconsin history, and the largest in the U.S. for 2009 (Van de Kamp Nohl 2010). Ms. Sachdeva's attorney said, "As this case proceeds, we intend to show that Ms. Sachdeva's mental and emotional health played a significant role in her conduct." Asked whether that was the basis for her not-guilty plea, he declined additional comment. Later, her attorney issued a statement reiterating his remarks and added, "This is the beginning of an ongoing process, and our focus will be on the arguments we make in court. However, the issues of Ms. Sachdeva's mental and emotional health are essential to this case." Sachdeva also was ordered by the court to refrain from using alcohal and to submit to periodic drug and alcohol testing (Hajewski and Romell 2010c). In April 2010, the Koss case was assigned a preliminary hearing date of June 15, 2010. On June 15, 2010, federal prosecutors indicated they were working toward a plea agreement with Mc. Sachdeva and did not anticipate the case would go to trial (Hajewski 2010b). On June 24, 2010, Koss Corporation filed suit against both Ms. Sachdeva and Koss' former independent auditor, Grant Thorntan, alleging fraud, negligence, and breach of fiduciary duty. The suit seeks more than $30 million in damages (Hajewski 2010d). Epilogue On June 30, 2010, Koss restated its previously audited financial statements for fiscal years 2009 and 2008. The impacts of the unauthorized transactions were treated as a theft loss in a separate operating expense line item totaling $8.5 million and $S.1 million for the fiscal years ended June 30, 2009 and 2008, respectively, and a reduction in opening retained earnings of $3.3 million (SEC 2010d). For fiscal 2009 (2008), net sales were originally understated by $3.5 ($2.1) million, and cost of goods sold averstated by $1.7 ($1.0) million. Substantial balance sheet adjustments at June 30, 2009, included a reduction in accounts receivable of $4.0 million, a reduction in inventories of $1.1 million, capitalization of $1.7 million in product software development casts, recognition of $2.9 million in cash surrender value of life insurance, an increase in accounts payable and accrued liabilities of $2.2 million, and an increase in long-term liabilities of $1.2 million (SEC 2010d). On July 27, 2010, Ms. Sachdeva pled guilty to all six counts of felony fraud against her. Under the plea agreement, Ms. Sachdeva agreed to pay approximately $34 million in restitution to Koss. The plea deal specifies a minimum of five years in prison though federal prosecutors may recommend a longer sentence. Sentencing was scheduled for November 17, 2010 (Hajewski 2010e). Directions for PART A: 1. Is this fraud an example of asset misappropriation or fraudulent financial reporting? 2. Ms. Sachdeva came from a wealthy family, so the theft was not necessary for her to live comfortably. What incentive and attitude/rationalization do you believe drove Ms. Sachdeva to embezzle? Would there have been behavioral red flags that should have alerted auditors to the fraud? 3. There are differences in the ability af an ICFR audit to detect fraud, the ability of a financial statement audit to detect fraud, the ability of a fraud/forensic accountant to detect fraud, and the ability of senior management to detect fraud. With those differences in mind, provide at least four suggestions for improving the ability of financial statement auditors to prevent or detect fraud. This may include the composition of the auditor's brainstorming team, management's evaluation of ICFR, etc. 4. Make a list of at least four factors leading to the Koss embezzlement and fraud not being detected by senior management and/or the independent auditor. For your list, rank order the factors (with "1" being the most contributing factor). Defend your top factor, including why you believe it was the most contributing factor, and why you believe it autweighs the others. Fraud is more difficult to uncover and often goes undetected for a longer period of time when there is collusion among the perpetrators. Koss Corporation, a manufacturer of headphones located in Milwaukee, and their auditors found this aut the hard way when the company was notified by American Express that their vice president of finance, secretary, and principal accounting officer had been wiring funds from Koss Corporation's account into her personal American Express account to fund her lavish lifestyle. Kass Carporation's principal accounting officer, Sujata ("Sue") Sachdeva, embezzled approximately $31 million over 5 years. Koss' Vice President-Finance and Secretary, Sujata Sachdeva, earned total compensation of approximately $200,000 per year for fiscal years 2008 and 2009 (SEC 2009a). Ms. Sachdeva, her husband-an attorney, Ph.D., and M.D. at Children's Hospital of Wisconsin-and their children reportedly enjoyed a lavish lifestyle including numerous trips abroad, private schools for the children, and a house worth nearly $800,000 in the Milwaukee suburbs. While in her 20s, Ms. Sachdeva worked in New York for the brokerage firm of Smith Barney and the now-defunct international accounting firm of Arthur Andersen. Ms. Sachdeva was partrayed as an active fundraiser in the nonprofit community-reportedly raising approximately $1.5 million annually for charitable causes. She was also portrayed as an impeccable dresser with an impressive wardrobe (Hajewski and Romell 2010a). Internal Control Assertions Under Sarbanes-Oxley The Kass Corporation case relates to the financialstatement audit opinions rendered by Koss' independent audit firm, Grant Thornton LLP, and senior management's attestation as to the effectiveness of internal control over financial reporting (ICFR) follawing the passage of the Sarbanes-Oxley Act of 2002 (SOX). Section 404 of SOx requires the CEO and CFO of U.S. registrants, and their external auditor, to separately report on and attest to the effectiveness of ICFR. However, the SEC repeatedly extended the deadline for auditor attestation on the effectiveness of ICFR for nonaccelerated filers (public companies with a market capitalization of less than $75 million, such as Koss). Koss relied on the SEC's extensions related to the required auditor attestation and never engaged Grant Thornton to opine on the effectiveness of Koss' ICFR. In an interview, Michael J. Koss said the new costs associated with SOX were galling to his family, who "pride themselves on being good stewards of their company. However, the Association of Certified Fraud Examiners (ACFE) released an updated Global Fraud Study in 2010. The ACFE has long believed smaller companies (similar to Koss Corporation) are particularly susceptible to fraud given their relatively limited resources. For small businesses, comparing those with fewer than 100 employees and thase with 100 or more (Koss had 72 employees at June 30, 2009; see SEC 2009b), the 15 most frequent anti-fraudcontrols cited for the smallest organizations included external audit of financial atatementa (W1), management'a certification of financiala ( 3), and an external audit of ICFR (# 6) (ACFE 2010). These findings lend credence to the notion that external financial statement and ICFR audits, coupled with management certifications, are viewed to be deterrents to fraud. The fallowing are excerpts from management's attestation on ICFR (signed by Michael J. Koss, CEO and CFO), and Grant Thornton's financial statement audit opinion, respectively, for the company's fiscal year ended June 30, 2009: Kass Attestation (in part): Management's Annual Report on Internal Controls over Financial Reporting: The Company's management, including its Chief Executive Officer/Chief Financial Officer, is responsible for establishing and maintaining adequate internal control of financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(F)) and designing such internal control to provide reasonable assurances regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Management conducted its evaluation of the effectiveness of its internal control over financial reporting based on the framework in "Internal Control-Integrated Framework" issued by the Committee af Sponsoring Organizations of the Treadway Commission ("COSO") as of June 2009. Based on this assessment, the Company's management, including its ChiefExecutive Officer/Chief Financial Officer, believes that as of June 30, 2009, the Company's internal control over financial reporting was effective based on the criteria set forth by coso in "Internal Control-integrated Framework." However, because of the inherent limitations in all control systems, no evaluation of controls can pravide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. This annual report does not include anattestation report of the Company's registered public accounting firmregarding internal control over financial reporting. Management's report was not subject to attestation by the Company's registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management's reportin this Form 10-K. (emphasis added) Grant Thornton's Financial Statement Audit Opinion Scope Paragraph (in part): The Company is not required tohave, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an apinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express nosuch opinion (emphasis added) (SEC 2009b). There are a number of characteristics unique to Koss Corporation in addition to the Company's independent auditor not being required to perform an audit of Koss' ICFR as specified by Section 404 of SOX. Though public, approximately 73 percent of the Company's shares are held by members of the founding family, including John C. Koss, Michael J. Koss, and John Koss, Jr. Note that as joint CEO and CFO, Michael J. Koss was the only member of senior management required to opine on the effectiveness of the Company's ICFR. The only other required signatory on the Form 10-K (beyond directors) was the Company's Vice President of Finance, Principal Accounting Officer, and Secretary-Sujata Sachdeva. Ms. Sachdeva was not required to separately issue an opinion on Koss' internal controls as she was not the Company's CFO, but rather designated as the Principal Accounting Officer. Embezzlement And Financial Statement Fraud At Koss On December 21, 2009, Koss Corporation filed a Form 8-K with the SEC reporting "other events" involving Koss Carporation. The 8-K filing indicated Koss requested the NASDAQ stock exchange to halt trading of its common stock due to the discovery of information regarding certain unauthorized transactions. The company also indicated it had placed Ms. Sachdeva on unpaid administrative leave (SEC 2009c). Holiday celebrations were likely tempered for certain personnel of Grant Thornton LLP, Koss' independent auditor. On ecember 31, 2009, Kass, upon a recommendation from the Company's Audit Committee, dismissed Grant Thornton. In an 8-K filing dated January 4, 2010, the company reported it had dismissed Grant Thornton and expanded its cautionary disclosure of nonreliance on previously issued financial statements, audit reports, and interim reviews, stating, in part: The Company's Audit Committee, on the recommendation of its advisors and management, expanded the scope of the Company's previously disclosed internal investigation of unauthorized financial transactions by Sujata Sachdeva, the Company's former Vice President of Finance and Secretary, to include fiscal years 2005 through the present. The Company has now concluded that its previously issued financial statements on Forms 10-K for the fiscal years ended June 30, 2005 through 2009 and on Form 10-Q for the three months ended September 30, 2009 should no longer be relied upon due to the unauthorized financial transactions. An internal investigation under the supervision of an independent committee of the Board of Directors with the assistance of independent counsel and forensic accountants is continuing. Preliminary estimates indicate that the amount of unauthorized transactions since fiscal year 200S through the present has exceeded $31 million, but at this point the Company and its advisors cannot assess the potential impact an its financial statements or identify the extent that specific fiscal periods may be affected. Nor can the Company and its advisors yet assess the extent of the possible offsets through insurance, asset recoveries and other mechanisms related to the unauthorized transactions. As promptly as possible, the Company plans to restate its financial statements for applicable periods as further investigation indicates. (item 4.02(a) of Kass Corporation's 8-K filed january 4, 2010) (SEC 2010a). On January 6, 2010, Koss filed an amended 8-K with the SEC to include Grant Thornton's required response to the Company's characterization of the auditor dismissal. Grant Thornton responded, in part, as follows: We have read Item 4.01 of Form 8-K of Kass Corporation dated January 4, 2010, and agree with the statements concerning our Firm contained therein. We have no basis to agree or disagree with the statements and conclusions in Item 4.02(a), some of which were not disclosed to Grant Thornton LLP prior to receipt of this filing (SEC 2010b). On lanuary 18, 2010, a Koss press release announced the hiring of a new Executive Vice President, CFO, and Principal Accounting Officer (Michael J. Koss had previously resigned as the company's CFO following news of the alleged embezzlement). The newly hired afficer has a degree in accounting, an M.B.A., and is a licensed CPA with extensive manufacturing experience (SEC 2010c). Safeguards Against Fraud and Embezzlement Theoretically, there are a number of lines of defense against fraud and embezzlement such as those alleged against Ms. Sachdeva. These include the requirement for the CEO and CFO (both Michael J. Koss in this circumstance) to separately attest as to the effectiveness of a Company's ICFR, oversight of those charged with corporate governance (including the board of directors with an independent audit committee), inside whistleblowers, anonymous tipsters, and the independent auditor's opinion as to the effectiveness of ICFR. Recall, Grant Thornton was not engaged to issue such an opinion. Koss Corporation's board of directors in 2009 was comprised of six individuals, including John and MichaelJ. Koss. Excluding one new member in 2006, the remaining five board members had an average tenure of 32 years (AccountingWEB 2010). Ironically, none of these potential safety nets detected the alleged fraud, but rather an independent, outside (not the auditor) third party. According to the criminal complaint, "neither Koss' auditors nor its executives uncovered the alleged fraud. Rather, American Express alerted the company's CEO, Michael Koss, to several large wire transfers made from a Koss bank account to pay Sachdeva's personal credit card. The purchases in question included $382,400 at two jewelry stores and $1.4 million at one clothing boutique" (Johnson 2010). In February 2010, Koss sued American Express, alleging that the credit card company violated the requirements of the Bank Secrecy Act requiring companies such as American Express to have programs to detect and report activity that may suggest the existence of financial crimes. The suit alleges that American Express was aware as early as February of 2008 that Ms. Sachdeva was paying her personal credit card bill with Kass funds, but did nothing to stop the fraud until December of 2009 (Hajewski 2010a). In the criminal complaint, Sachdeva told FBI agents she had authorized an assistant to make the wire transfers, which she later concealed by falsifying the balance in Koss' bank account. The complaint does not explain how she allegedly made these changes or why they were not detected sooner. Her attorney declined comment on the case (lohnsan 2010). A federal search warrant reveals FBI agents seized 461 boxes of shoes, 34 fur coats, and 65 racks of clothing stored in rented space and at area merchants (Hajewski and Romell 2010b). The U.S. Marshals Service was reported to inventory some 22,000 items seized by the FBI (Hajewski and Romell 2010c). The items are scheduled to be auctioned online with net proceeds remitted to Kass (Hajewski 2010b). Ms. Sachdeva's attorney attempted to block the release of her medical records to the court. As a condition of Sachdeva's release on bail, the court had ordered a mental health evaluation be done by Pre-Trial Services. According to the criminal indictment, Sachdeva spent the money on luxury clothing, jewelry, trips, renovations to her home, and services for herself and her family. In a letter to the court, her attorney said sensitive information in Sachdeva's medical records would be "directiy relevant" to her defense, adding, "We do not believe it is either necessary or appropriate that Pre-Trial Services be in possession of these records." It was previously reported that her attorney planned to raise the issue of mental state in Ms. Sachdeva's defense (Hajewski 2010c). Ms. Sachdeva pled nat guilty to accusations that she embezzled $31 million from Kass. The case is believed to be one of the largest embezzlements in Wisconsin history, and the largest in the U.S. for 2009 (Van de Kamp Nohl 2010). Ms. Sachdeva's attorney said, "As this case proceeds, we intend to show that Ms. Sachdeva's mental and emotional health played a significant role in her conduct." Asked whether that was the basis for her not-guilty plea, he declined additional comment. Later, her attorney issued a statement reiterating his remarks and added, "This is the beginning of an ongoing process, and our focus will be on the arguments we make in court. However, the issues of Ms. Sachdeva's mental and emotional health are essential to this case." Sachdeva also was ordered by the court to refrain from using alcohal and to submit to periodic drug and alcohol testing (Hajewski and Romell 2010c). In April 2010, the Koss case was assigned a preliminary hearing date of June 15, 2010. On June 15, 2010, federal prosecutors indicated they were working toward a plea agreement with Mc. Sachdeva and did not anticipate the case would go to trial (Hajewski 2010b). On June 24, 2010, Koss Corporation filed suit against both Ms. Sachdeva and Koss' former independent auditor, Grant Thorntan, alleging fraud, negligence, and breach of fiduciary duty. The suit seeks more than $30 million in damages (Hajewski 2010d). Epilogue On June 30, 2010, Koss restated its previously audited financial statements for fiscal years 2009 and 2008. The impacts of the unauthorized transactions were treated as a theft loss in a separate operating expense line item totaling $8.5 million and $S.1 million for the fiscal years ended June 30, 2009 and 2008, respectively, and a reduction in opening retained earnings of $3.3 million (SEC 2010d). For fiscal 2009 (2008), net sales were originally understated by $3.5 ($2.1) million, and cost of goods sold averstated by $1.7 ($1.0) million. Substantial balance sheet adjustments at June 30, 2009, included a reduction in accounts receivable of $4.0 million, a reduction in inventories of $1.1 million, capitalization of $1.7 million in product software development casts, recognition of $2.9 million in cash surrender value of life insurance, an increase in accounts payable and accrued liabilities of $2.2 million, and an increase in long-term liabilities of $1.2 million (SEC 2010d). On July 27, 2010, Ms. Sachdeva pled guilty to all six counts of felony fraud against her. Under the plea agreement, Ms. Sachdeva agreed to pay approximately $34 million in restitution to Koss. The plea deal specifies a minimum of five years in prison though federal prosecutors may recommend a longer sentence. Sentencing was scheduled for November 17, 2010 (Hajewski 2010e). Directions for PART A: 1. Is this fraud an example of asset misappropriation or fraudulent financial reporting? 2. Ms. Sachdeva came from a wealthy family, so the theft was not necessary for her to live comfortably. What incentive and attitude/rationalization do you believe drove Ms. Sachdeva to embezzle? Would there have been behavioral red flags that should have alerted auditors to the fraud? 3. There are differences in the ability af an ICFR audit to detect fraud, the ability of a financial statement audit to detect fraud, the ability of a fraud/forensic accountant to detect fraud, and the ability of senior management to detect fraud. With those differences in mind, provide at least four suggestions for improving the ability of financial statement auditors to prevent or detect fraud. This may include the composition of the auditor's brainstorming team, management's evaluation of ICFR, etc. 4. Make a list of at least four factors leading to the Koss embezzlement and fraud not being detected by senior management and/or the independent auditor. For your list, rank order the factors (with "1" being the most contributing factor). Defend your top factor, including why you believe it was the most contributing factor, and why you believe it autweighs the others. Fraud is more difficult to uncover and often goes undetected for a longer period of time when there is collusion among the perpetrators. Koss Corporation, a manufacturer of headphones located in Milwaukee, and their auditors found this aut the hard way when the company was notified by American Express that their vice president of finance, secretary, and principal accounting officer had been wiring funds from Koss Corporation's account into her personal American Express account to fund her lavish lifestyle. Kass Carporation's principal accounting officer, Sujata ("Sue") Sachdeva, embezzled approximately $31 million over 5 years. Koss' Vice President-Finance and Secretary, Sujata Sachdeva, earned total compensation of approximately $200,000 per year for fiscal years 2008 and 2009 (SEC 2009a). Ms. Sachdeva, her husband-an attorney, Ph.D., and M.D. at Children's Hospital of Wisconsin-and their children reportedly enjoyed a lavish lifestyle including numerous trips abroad, private schools for the children, and a house worth nearly $800,000 in the Milwaukee suburbs. While in her 20s, Ms. Sachdeva worked in New York for the brokerage firm of Smith Barney and the now-defunct international accounting firm of Arthur Andersen. Ms. Sachdeva was partrayed as an active fundraiser in the nonprofit community-reportedly raising approximately $1.5 million annually for charitable causes. She was also portrayed as an impeccable dresser with an impressive wardrobe (Hajewski and Romell 2010a). Internal Control Assertions Under Sarbanes-Oxley The Kass Corporation case relates to the financialstatement audit opinions rendered by Koss' independent audit firm, Grant Thornton LLP, and senior management's attestation as to the effectiveness of internal control over financial reporting (ICFR) follawing the passage of the Sarbanes-Oxley Act of 2002 (SOX). Section 404 of SOx requires the CEO and CFO of U.S. registrants, and their external auditor, to separately report on and attest to the effectiveness of ICFR. However, the SEC repeatedly extended the deadline for auditor attestation on the effectiveness of ICFR for nonaccelerated filers (public companies with a market capitalization of less than $75 million, such as Koss). Koss relied on the SEC's extensions related to the required auditor attestation and never engaged Grant Thornton to opine on the effectiveness of Koss' ICFR. In an interview, Michael J. Koss said the new costs associated with SOX were galling to his family, who "pride themselves on being good stewards of their company. However, the Association of Certified Fraud Examiners (ACFE) released an updated Global Fraud Study in 2010. The ACFE has long believed smaller companies (similar to Koss Corporation) are particularly susceptible to fraud given their relatively limited resources. For small businesses, comparing those with fewer than 100 employees and thase with 100 or more (Koss had 72 employees at June 30, 2009; see SEC 2009b), the 15 most frequent anti-fraudcontrols cited for the smallest organizations included external audit of financial atatementa (W1), management'a certification of financiala ( 3), and an external audit of ICFR (# 6) (ACFE 2010). These findings lend credence to the notion that external financial statement and ICFR audits, coupled with management certifications, are viewed to be deterrents to fraud. The fallowing are excerpts from management's attestation on ICFR (signed by Michael J. Koss, CEO and CFO), and Grant Thornton's financial statement audit opinion, respectively, for the company's fiscal year ended June 30, 2009: Kass Attestation (in part): Management's Annual Report on Internal Controls over Financial Reporting: The Company's management, including its Chief Executive Officer/Chief Financial Officer, is responsible for establishing and maintaining adequate internal control of financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(F)) and designing such internal control to provide reasonable assurances regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Management conducted its evaluation of the effectiveness of its internal control over financial reporting based on the framework in "Internal Control-Integrated Framework" issued by the Committee af Sponsoring Organizations of the Treadway Commission ("COSO") as of June 2009. Based on this assessment, the Company's management, including its ChiefExecutive Officer/Chief Financial Officer, believes that as of June 30, 2009, the Company's internal control over financial reporting was effective based on the criteria set forth by coso in "Internal Control-integrated Framework." However, because of the inherent limitations in all control systems, no evaluation of controls can pravide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. This annual report does not include anattestation report of the Company's registered public accounting firmregarding internal control over financial reporting. Management's report was not subject to attestation by the Company's registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management's reportin this Form 10-K. (emphasis added) Grant Thornton's Financial Statement Audit Opinion Scope Paragraph (in part): The Company is not required tohave, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an apinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express nosuch opinion (emphasis added) (SEC 2009b). There are a number of characteristics unique to Koss Corporation in addition to the Company's independent auditor not being required to perform an audit of Koss' ICFR as specified by Section 404 of SOX. Though public, approximately 73 percent of the Company's shares are held by members of the founding family, including John C. Koss, Michael J. Koss, and John Koss, Jr. Note that as joint CEO and CFO, Michael J. Koss was the only member of senior management required to opine on the effectiveness of the Company's ICFR. The only other required signatory on the Form 10-K (beyond directors) was the Company's Vice President of Finance, Principal Accounting Officer, and Secretary-Sujata Sachdeva. Ms. Sachdeva was not required to separately issue an opinion on Koss' internal controls as she was not the Company's CFO, but rather designated as the Principal Accounting Officer. Embezzlement And Financial Statement Fraud At Koss On December 21, 2009, Koss Corporation filed a Form 8-K with the SEC reporting "other events" involving Koss Carporation. The 8-K filing indicated Koss requested the NASDAQ stock exchange to halt trading of its common stock due to the discovery of information regarding certain unauthorized transactions. The company also indicated it had placed Ms. Sachdeva on unpaid administrative leave (SEC 2009c). Holiday celebrations were likely tempered for certain personnel of Grant Thornton LLP, Koss' independent auditor. On ecember 31, 2009, Kass, upon a recommendation from the Company's Audit Committee, dismissed Grant Thornton. In an 8-K filing dated January 4, 2010, the company reported it had dismissed Grant Thornton and expanded its cautionary disclosure of nonreliance on previously issued financial statements, audit reports, and interim reviews, stating, in part: The Company's Audit Committee, on the recommendation of its advisors and management, expanded the scope of the Company's previously disclosed internal investigation of unauthorized financial transactions by Sujata Sachdeva, the Company's former Vice President of Finance and Secretary, to include fiscal years 2005 through the present. The Company has now concluded that its previously issued financial statements on Forms 10-K for the fiscal years ended June 30, 2005 through 2009 and on Form 10-Q for the three months ended September 30, 2009 should no longer be relied upon due to the unauthorized financial transactions. An internal investigation under the supervision of an independent committee of the Board of Directors with the assistance of independent counsel and forensic accountants is continuing. Preliminary estimates indicate that the amount of unauthorized transactions since fiscal year 200S through the present has exceeded $31 million, but at this point the Company and its advisors cannot assess the potential impact an its financial statements or identify the extent that specific fiscal periods may be affected. Nor can the Company and its advisors yet assess the extent of the possible offsets through insurance, asset recoveries and other mechanisms related to the unauthorized transactions. As promptly as possible, the Company plans to restate its financial statements for applicable periods as further investigation indicates. (item 4.02(a) of Kass Corporation's 8-K filed january 4, 2010) (SEC 2010a). On January 6, 2010, Koss filed an amended 8-K with the SEC to include Grant Thornton's required response to the Company's characterization of the auditor dismissal. Grant Thornton responded, in part, as follows: We have read Item 4.01 of Form 8-K of Kass Corporation dated January 4, 2010, and agree with the statements concerning our Firm contained therein. We have no basis to agree or disagree with the statements and conclusions in Item 4.02(a), some of which were not disclosed to Grant Thornton LLP prior to receipt of this filing (SEC 2010b). On lanuary 18, 2010, a Koss press release announced the hiring of a new Executive Vice President, CFO, and Principal Accounting Officer (Michael J. Koss had previously resigned as the company's CFO following news of the alleged embezzlement). The newly hired afficer has a degree in accounting, an M.B.A., and is a licensed CPA with extensive manufacturing experience (SEC 2010c). Safeguards Against Fraud and Embezzlement Theoretically, there are a number of lines of defense against fraud and embezzlement such as those alleged against Ms. Sachdeva. These include the requirement for the CEO and CFO (both Michael J. Koss in this circumstance) to separately attest as to the effectiveness of a Company's ICFR, oversight of those charged with corporate governance (including the board of directors with an independent audit committee), inside whistleblowers, anonymous tipsters, and the independent auditor's opinion as to the effectiveness of ICFR. Recall, Grant Thornton was not engaged to issue such an opinion. Koss Corporation's board of directors in 2009 was comprised of six individuals, including John and MichaelJ. Koss. Excluding one new member in 2006, the remaining five board members had an average tenure of 32 years (AccountingWEB 2010). Ironically, none of these potential safety nets detected the alleged fraud, but rather an independent, outside (not the auditor) third party. According to the criminal complaint, "neither Koss' auditors nor its executives uncovered the alleged fraud. Rather, American Express alerted the company's CEO, Michael Koss, to several large wire transfers made from a Koss bank account to pay Sachdeva's personal credit card. The purchases in question included $382,400 at two jewelry stores and $1.4 million at one clothing boutique" (Johnson 2010). In February 2010, Koss sued American Express, alleging that the credit card company violated the requirements of the Bank Secrecy Act requiring companies such as American Express to have programs to detect and report activity that may suggest the existence of financial crimes. The suit alleges that American Express was aware as early as February of 2008 that Ms. Sachdeva was paying her personal credit card bill with Kass funds, but did nothing to stop the fraud until December of 2009 (Hajewski 2010a). In the criminal complaint, Sachdeva told FBI agents she had authorized an assistant to make the wire transfers, which she later concealed by falsifying the balance in Koss' bank account. The complaint does not explain how she allegedly made these changes or why they were not detected sooner. Her attorney declined comment on the case (lohnsan 2010). A federal search warrant reveals FBI agents seized 461 boxes of shoes, 34 fur coats, and 65 racks of clothing stored in rented space and at area merchants (Hajewski and Romell 2010b). The U.S. Marshals Service was reported to inventory some 22,000 items seized by the FBI (Hajewski and Romell 2010c). The items are scheduled to be auctioned online with net proceeds remitted to Kass (Hajewski 2010b). Ms. Sachdeva's attorney attempted to block the release of her medical records to the court. As a condition of Sachdeva's release on bail, the court had ordered a mental health evaluation be done by Pre-Trial Services. According to the criminal indictment, Sachdeva spent the money on luxury clothing, jewelry, trips, renovations to her home, and services for herself and her family. In a letter to the court, her attorney said sensitive information in Sachdeva's medical records would be "directiy relevant" to her defense, adding, "We do not believe it is either necessary or appropriate that Pre-Trial Services be in possession of these records." It was previously reported that her attorney planned to raise the issue of mental state in Ms. Sachdeva's defense (Hajewski 2010c). Ms. Sachdeva pled nat guilty to accusations that she embezzled $31 million from Kass. The case is believed to be one of the largest embezzlements in Wisconsin history, and the largest in the U.S. for 2009 (Van de Kamp Nohl 2010). Ms. Sachdeva's attorney said, "As this case proceeds, we intend to show that Ms. Sachdeva's mental and emotional health played a significant role in her conduct." Asked whether that was the basis for her not-guilty plea, he declined additional comment. Later, her attorney issued a statement reiterating his remarks and added, "This is the beginning of an ongoing process, and our focus will be on the arguments we make in court. However, the issues of Ms. Sachdeva's mental and emotional health are essential to this case." Sachdeva also was ordered by the court to refrain from using alcohal and to submit to periodic drug and alcohol testing (Hajewski and Romell 2010c). In April 2010, the Koss case was assigned a preliminary hearing date of June 15, 2010. On June 15, 2010, federal prosecutors indicated they were working toward a plea agreement with Mc. Sachdeva and did not anticipate the case would go to trial (Hajewski 2010b). On June 24, 2010, Koss Corporation filed suit against both Ms. Sachdeva and Koss' former independent auditor, Grant Thorntan, alleging fraud, negligence, and breach of fiduciary duty. The suit seeks more than $30 million in damages (Hajewski 2010d). Epilogue On June 30, 2010, Koss restated its previously audited financial statements for fiscal years 2009 and 2008. The impacts of the unauthorized transactions were treated as a theft loss in a separate operating expense line item totaling $8.5 million and $S.1 million for the fiscal years ended June 30, 2009 and 2008, respectively, and a reduction in opening retained earnings of $3.3 million (SEC 2010d). For fiscal 2009 (2008), net sales were originally understated by $3.5 ($2.1) million, and cost of goods sold averstated by $1.7 ($1.0) million. Substantial balance sheet adjustments at June 30, 2009, included a reduction in accounts receivable of $4.0 million, a reduction in inventories of $1.1 million, capitalization of $1.7 million in product software development casts, recognition of $2.9 million in cash surrender value of life insurance, an increase in accounts payable and accrued liabilities of $2.2 million, and an increase in long-term liabilities of $1.2 million (SEC 2010d). On July 27, 2010, Ms. Sachdeva pled guilty to all six counts of felony fraud against her. Under the plea agreement, Ms. Sachdeva agreed to pay approximately $34 million in restitution to Koss. The plea deal specifies a minimum of five years in prison though federal prosecutors may recommend a longer sentence. Sentencing was scheduled for November 17, 2010 (Hajewski 2010e). Directions for PART A: 1. Is this fraud an example of asset misappropriation or fraudulent financial reporting? 2. Ms. Sachdeva came from a wealthy family, so the theft was not necessary for her to live comfortably. What incentive and attitude/rationalization do you believe drove Ms. Sachdeva to embezzle? Would there have been behavioral red flags that should have alerted auditors to the fraud? 3. There are differences in the ability af an ICFR audit to detect fraud, the ability of a financial statement audit to detect fraud, the ability of a fraud/forensic accountant to detect fraud, and the ability of senior management to detect fraud. With those differences in mind, provide at least four suggestions for improving the ability of financial statement auditors to prevent or detect fraud. This may include the composition of the auditor's brainstorming team, management's evaluation of ICFR, etc. 4. Make a list of at least four factors leading to the Koss embezzlement and fraud not being detected by senior management and/or the independent auditor. For your list, rank order the factors (with "1" being the most contributing factor). Defend your top factor, including why you believe it was the most contributing factor, and why you believe it autweighs the others.

Answer rating: 100% (QA)

QUESTION 1 This type of fraud illustrated above is asset misappropriation This is because asset misappropriation fraud happens when people who are entrusted to manage the assets of an organization ste... View the full answer