Fraud Case Casts Doubt over Sarbox Exemption

An alleged $31 million fraud could quash claims that internal-controls checks don't matter.

If allegations that a finance executive pilfered as much as $31 million over five years from Koss Corp. prove true, it won’t just be bad news for Koss: it may also deal a blow to those who hope that smaller, publicly traded companies will be exempted from full compliance with the Sarbanes-Oxley Act.

The well-known manufacturer of headphones reported $38.3 million in sales last year, so a $31 million theft, even over five years, suggests some serious problems with internal controls. Koss plans to restate its financials for the past two years and may go back as far as 2005 to make corrections. Koss’s stock spent 21 days in limbo after Nasdaq halted its trading toward the end of December. At least one law firm has opened an investigation for a possible shareholder lawsuit.

Koss fired its accounting firm, Grant Thornton, on New Year’s Eve. The auditor responded by pointing out that Koss is among those companies not yet subject to Sarbox’s Section 404(b), which requires an auditor sign-off of internal controls. “The company did not engage Grant Thornton to conduct an audit or evaluation of internal controls over financial reporting,” says a spokesperson for the accounting firm. “Establishing and maintaining effective internal control is management’s and the board’s responsibility.”

Koss’s management claims the company did have effective internal controls, but the management report enclosed in its most recent 10-K acknowledges in boilerplate language that “because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the company have been detected.”

The criminal case against Sujata “Sue” Sachdeva, Koss’s former vice president of finance and secretary, alleges she used more than $4.5 million of the company’s money to buy clothing, furs, and jewelry at various luxury stores in Milwaukee during the past two years. Following those initial allegations, Koss has since disclosed that the extent of the fraud may be worse; an internal investigation has uncovered additional unauthorized transactions from as far back as five years ago that total more than $31 million.

Gauging the Fallout

While the Securities and Exchange Commission has continually delayed the auditor-attestation portion of Section 404 for nonaccelerated filers (companies with market caps below $75 million), companies like Koss will finally have to get their auditors to review their internal controls starting this summer (depending on their fiscal year-end).

Or maybe not. The major regulatory-reform bill passed by the House in mid-December would permanently exempt small businesses from 404(b). Small-business proponents have pushed for the exemption, saying audits of internal controls over financial reporting are disproportionately costly and perhaps even unnecessary since, individually, small companies represent only minuscule blips of total market capitalization in the United States.

That exemption may disappear as the Senate works on its version of the bill. Investor advocates certainly hope so. “Investors believe that auditors’ expertise can provide management with additional perspective on the quality of its system of internal control, which can have a positive impact on the quality of a company’s financial reporting,” wrote four investor groups, including the CFA Centre for Financial Market Integrity, in a recent letter to House members. The Koss case could bolster such arguments.

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