We’ve been following the stories of fraud and embezzlement at commercial headphone-maker Koss for quite some time. We first wrote about it here, in support of our thesis that instances of fraud within the government contracting community are no more prevalent than they are in the commercial sector (or in the government-employee sector for that matter). More than two years ago, we wrote—

On December 24, 2009 reports emerged that Koss Corporation fired its long-time VP of Finance and Corporate Secretary, for allegedly embezzling millions from the company. The individual in question (Ms. Sujata ‘Sue’ Sachdeva), was ‘suspended’ on December 21st, ‘for financial improprieties,’ and was fired on December 24th for embezzling as much as $31 million over the past 18 years.  Two members of the Koss accounting staff who reported to Ms. Sachdeva were also put on unpaid administrative leave. According to the Wall Street Journal, ‘The government alleges she embezzled company funds to pay off her personal American Express credit-card charges for the purchases of furs, jewelry, apparel and home decor.’

Importantly, Ms. Sachdeva, as VP of Finance, was responsible for many ‘management representations’ provided to its external auditors, Grant Thornton.  Because those representations can no longer be relied upon, Koss’ financial statements must be reaudited, and will likely need to be restated.  Koss is a publicly traded company, so the SEC and PCAOB will also be involved in the resolution.  But Grant Thornton won’t be involved in that resolution, because that audit entity was dismissed after the fraud was uncovered.

Quite a lot has happened in the past two years.  In July, 2010, we wrote that—

On July 17, 2010, Ms. Sachdeva pleaded guilty to six counts of wire fraud for embezzling roughly $34 million from her employer over a period of approximately 11 years.  … S-Squared admitted that, ‘During the 12-year span she authorized the issuance of more than 500 cashier's checks costing Koss about $17.5 million. That figure includes $10 million to American Express, plus payments to high-end retailers, including Neiman Marcus and Saks Fifth Avenue. Payments also went to charitable groups.’  In addition, ‘From February 2008 to December 2009, she authorized 206 wire transfers totaling $16 million from Koss accounts to American Express to cover items she bought with the credit card.’  The plea agreement stated that Koss employees worked ‘in concert with Sachdeva or at her direction’ to make fraudulent entries to the company's books to conceal the embezzlement. ‘These entries would falsely overstate assets, understate liabilities, understate sales, overstate cost of sales, and overstate expenses,’ and the false entries ‘concealed the actual receipts and profitability of Koss,’ allowing the scheme to continue.

We further noted a couple of points raised by Francine McKenna on her blog regarding this family-owned and family-operated publicly traded company.  We wrote—

Management oversight of the financial reporting process is severely limited by Mr. Koss Jr.’s lack of interest, aptitude, and appreciation for accounting and finance. Koss Jr., the CEO and son of the founder, held the titles of COO and CFO, also. Ms. Sachdeva, the Vice President of Finance and Corporate Secretary who is accused of the fraud, has been in the same job since 1992 and during one ten year period worked remotely from Houston!

Perhaps Ms. McKenna was prescient—or perhaps she’s just that smart—but Mr. Koss, Jr. has been in hot water with the SEC over his role (or lack of role) in the Koss fraud fiasco.  Recently, Mr. Koss, Jr. and the company reached a settlement with the SEC.

In October, 2011, the SEC filed both a complaint and proposed settlement agreement with Michael J. Koss (former COO, and CFO, and currently CEO).  The complaint alleged improprieties—

… based on Koss Corporation’s preparation of materially inaccurate financial statements, book and records, and lack of adequate internal controls from fiscal years 2005 through 2009. During this period, Sujata Sachdeva (“Sachdeva”), Koss’s former Principal Accounting Officer, Secretary, and Vice-President of Finance, and Julie Mulvaney (“Mulvaney”), Koss’s former Senior Accountant, engaged in a wide-ranging accounting fraud to cover up Sachdeva’s embezzlement of over $30 million from Koss.

Among other control failures, the SEC asserted the following—

• Sachdeva and Mulvaney were able to hide the substantial embezzlements in Koss’s financial records in part because Koss and Michael J. Koss did not adequately maintain internal controls to reasonably assure the accuracy and reliability of financial reporting.

• While Koss’s internal controls policy required Michael J. Koss to approve invoices of $5,000 or more for payment, its controls did not prevent Sachdeva and Mulvaney from processing large wire transfers and cashier’s checks outside of the accounts payable system to pay for Sachdeva’s personal purchases without seeking or obtaining Michael J. Koss’s approval.

• As a result, Sachdeva, with Mulvaney’s assistance, was able both to initiate and authorize wire transfers of Koss’s funds to her personal creditors totaling approximately $16.3 million, and to order cashier’s checks payable to credit card companies and her designated payees totaling approximately $15.5 million.

• Koss’s computerized accounting systems were almost 30 years old and access to the accounting systems could not be locked at the end of the month and there was no audit trail. Sachdeva and Mulvaney were thus able to make undetected post-closing changes to the books and bypass an internal control requiring Michael J. Koss to authorize those changes.

• Many account reconciliations were either not prepared or were not maintained as part of Koss’s accounting records. To the extent that reconciliations were conducted, they were improperly performed by the same persons who initiated or recorded the transactions (i.e. Sachdeva or Mulvaney), enabling those persons to make modifications to the reconciliations to cover up fraudulent entries.

• While Sachedeva provided Michael J. Koss with reporting certifications for his review, he did not conduct an adequate review of Koss’s accounting in connection with these certifications.

This is good stuff, because it tells us what went wrong at Koss.  (Apparently, many things went wrong ….)  Our readers should review their accounting policies, procedures, and controls in light of the SEC’s allegations, and see if they are similarly vulnerable to employee embezzlement.

This report stated: “The proposed settlement would enjoin the company and Mr. Koss from future violations and order Mr. Koss to reimburse Koss $242,419 in cash and 160,000 of options pursuant to Section 304 of the Sarbanes-Oxley Act (Mr. Koss had previously voluntarily reimbursed $208,895 in bonuses to Koss).”  Both Koss the company and Koss the CEO consented to the SEC’s injunctive order without either admitting or denying the underlying allegations, as is commonly done is such matters.  Unfortunately for all parties, the Judge in the case (Judge J. Randa) didn’t believe the proposed settlement was reasonable and thought it was overly vague.  In December, 2011, Judge Randa directed the SEC to explain why its proposed settlement was “fair, reasonable, adequate, and in the public interest."   

In January 2012, the SEC responded to the Judge.  The FedSECLaw story (link above) reports the details of the SEC’s response.  The story concludes with the following—

… Judge Randa is the latest Judge to question how the SEC does things, focusing on the language of the Judgment – language which is similar (if not identical) to the language which it has used for years. The SEC could satisfy Judge Randa by amending the language, but seems reluctant to do so (other than adding language from the consents, which is also similar, if not identical, to language used in other consents).

This story at CFO.com asserts that difficulties in drafting approved settlement agreements may lead to more litigation, stating—

Sachdeva and two other employees in the accounting department were fired long ago. The company restated its financials, dismissed its accounting firm, and changed several procedures in the finance department, including doing away with petty cash. Koss Corp. also hired a new CFO and has pledged to keep the CEO and CFO roles separate.

SEC chairman Mary Schapiro has acknowledged the frustration judges and the public have expressed about the regulator’s settlements. More cases could end up in litigation, consuming the regulator’s time, if agreements are more difficult to reach. Last year the commission made 682 settlements, virtually the same number as 2010, according to a NERA Economic Consulting study released earlier this week.

From our point of view, the fundamental story here concerns the consequences of weak internal controls and oversight failures, and of trusted employees who took the advantage of the opportunities with which they were presented to steal a huge amount of money.  We are not particularly concerned with whether or not corporate attorneys and their external counsel can negotiate quick and relatively inexpensive settlements with the SEC.  

Koss is a commercial company, but don’t think that your company is exempt from the litany of failures recited by the SEC.  What happened to Koss can happen to any company, when management focuses attention on irrelevant or extraneous aspects of the business, instead of focusing on taking care of business.