My objective in writing this story was to handily contradict Grant Thornton’s self-serving defense to the Koss fraud.

The defense supported by some commentators:

Audits are not designed to uncover fraud and Koss did not pay for a separate opinion on internal controls because they are exempt from that Sarbanes-Oxley requirement.

But punching holes in that Swiss-cheese defense is like shooting fish in a barrel.  Leading that horse to water is like feeding him candy taken from a baby. The reasons why someone other than American Express should have caught this sooner are as numerous as the acorns you can steal from a blind pig…

Ok, you get the gist.

Listing standards for the NYSE require an internal audit function.  NASDAQ, where Koss was listed, does not.  Back in 2003, the Institute of Internal Auditors (IIA) made recommendations post- Sarbanes-Oxley that were adopted for the most part by NYSE, but not completely by NASDAQ. And both the NYSE and NASD left a few key recommendations hanging.

In addition, the IIA has never mandated, under its own standards for the internal audit profession, a direct reporting of the internal audit function to the independent Audit Committee. The SEC did not adopt this requirement in their final rules, either.

However, Generally Accepted Auditing Standards (GAAS), the standards an external auditor such as Grant Thornton operates under when preparing an opinion on a company’s financial statements – whether a public company or not, listed on NYSE or NASDAQ, whether exempt or not from Sarbanes-Oxley – do require the assessment of the internal audit function when planning an audit.

Grant Thornton was required to adjust their substantive testing given the number of risk factors presented by Koss, based on SAS 109 (AU 314), Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement.  If they had understood the entity and assessed the risk of material misstatement fully, they would have been all over those transactions like _______. (Fill in the blank)

If they had performed a proper SAS 99 review (AU 316), Consideration of Fraud in a Financial Statement Audit, it would have hit’em smack in the face like a _______ . (Fill in the blank.) 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!

When they finished their review according to SAS 65 (AU 322), The Auditor’s Consideration of the Internal Audit Function in an Audit of Financial Statements, it should have dawned on them: There is no internal audit function and the flunky-filled Audit Committee is a sham.  I can see it now. The Grant Thornton Milwaukee OMP smacks head with open palm in a “I could have had a V-8,” moment but more like, “Holy cheesehead, we’re indigestible gristle-laden, greasy bratwurst here! We’ll never be able issue an opinion on these financial statements unless we take these journal entries apart, one-by-one, and re-verify every stinkin’ last number.”

But I dug in and did some additional research – at first I was just working the “no internal auditors” line – and I found a few more interesting things.  And now I have no sympathy for Koss management and, therefore, its largest shareholder, the Koss family.  Granted there is plenty of basis, in my opinion, for any and all enforcement actions against Grant Thornton and its audit partners.  And depending on how far back the acts of deliciously deceptive defalcation go, PricewaterhouseCoopers may also be dragged through the mud.

Yes.

I can not make this stuff up and have it come out more music to my ears. PricewaterhouseCoopers was Koss’s auditor prior to Grant Thornton. In March of 2004, the Milwaukee Business Journal reported, “Koss Corp. has fired the certified public accounting firm of PricewaterhouseCoopers L.L.P. as its independent auditors March 15 and retained Grant Thornton L.L.P. in its place.” The article was short with the standard disclaimer of no disputes about accounting policies and practices.  But it pointedly pointed out that PwC’s fees for the audit had increased by almost 50% from 2001 to 2003, to $90,000 and the selection of the new auditor was made after a competitive bidding process.  PwC had been Koss’s auditor since 1992!

The focus on audit fees by Koss’s CEO should have been no surprise to PwC.  Post-Sarbanes-Oxley, Michael J. Koss the son of the founder, was quoted extensively as part of the very vocal cadre of CEOs who complained vociferously about paying their auditors one more red cent. Koss Jr. minced no words regarding PwC in the Wall Street Journal in August 2002, a month after the law was passed:

“…Sure, analysts had predicted a modest fee increase from the smaller pool of accounting firms left after Arthur Andersen LLP’s collapse following its June conviction on a criminal-obstruction charge. But a range of other factors are helping to drive auditing fees higher — to as much as 25% — with smaller companies bearing the brunt of the rise.

“The auditors are making money hand over fist,” says Koss Corp. Chief Executive Officer Michael Koss. “It’s going to cost shareholders in the long run.”

He should know. Auditing fees are up nearly 10% in the past two years at his Milwaukee-based maker of headphones. The increase has come primarily from auditors spending more time combing over financial statements as part of compliance with new disclosure requirements by the Securities and Exchange Commission. Koss’s accounting firm, PricewaterhouseCoopers LLP, now shows up at corporate offices for “mini audits” every quarter, rather than just once at year-end.”

A year later, still irate, Mr. Koss Jr. was quoted in USA Today:

“Jeffrey Sonnenfeld, associate dean of the Yale School of Management, said he recently spoke to six CEO conferences over 10 days. When he asked for a show of hands, 80% said they thought the law was bad for the U.S. economy.

When pressed individually, CEOs don’t object to the law or its intentions, such as forcing executives to refund ill-gotten gains. But confusion over what the law requires has left companies vulnerable to experts and consultants, who “frighten boards and managers” into spending unnecessarily, Sonnenfeld says.

Michael Koss, CEO of stereo headphones maker Koss, says it’s all but impossible to know what the law requires, so it has become a black hole where frightened companies throw endless amounts of money.

Companies are spending way too much to comply, but the cost is due to “bad advice, not a bad law,” Sonnenfeld says.”

It’s interesting that Koss Jr. has such minimal appreciation for the work of the external auditor or an internal audit function. By virtue, I suppose, of his esteemed status as CEO, COO and CFO of Koss and notwithstanding an undergraduate degree in anthropology, according to Business Week, Mr. Koss Jr. has twice served other Boards as their “financial expert” and Chairman of their Audit Committees.  At Genius Products, founded by the Baby Genius DVDs creator, Mr. Koss served in this capacity from 2004 to 2005. Mr. Koss Jr. has also been a Director, Chairman of Audit Committee, Member of Compensation Committee and Member of Nominating & Corporate Governance Committee at Strattec Security Corp. since 1995.

If I were the SEC, I might take a look at those two companies…Because I warned you about the CEOs and CFOs who are pushing back on Sarbanes-Oxley and every other regulation intended to shine a light on them as public company executives.

No good will come of this.

I don’t want you to shed crocodile tears or pity poor PwC for their long-term, close relationship with another blockbuster Indian fraudster. Nor should you pat them on the back for not being the auditor now. PwC never really left Koss after they were “fired” as auditor in 2004.  They continued until today to be the trusted “Tax and All Other” advisor, making good money filing Koss’s now totally bogus tax returns.

As cheapo as Mr. Koss Jr. seems to be when it comes to audit fees, ostensibly saving a few million on PwC and a Sarbanes-Oxley 404 audit as well as a few internal auditors, his skinflinty-ness has cost his family, and his father’s legacy, more than $30 million.  Who knows? Maybe given Mr. Koss’s progressive attitudes about technology and focus on everything but his family’s business – he has a blog and a Twitter account as well as a penchant for being interviewed in the major media like some kind of CEO idiot savant – we may find out someday, like a plot out of a Bollywood movie, that  something deeper and more spiritual was going on between him and Ms. Sachdeva…

How else to truly explain handing a non-family member the keys to the kingdom?

Maybe, back in 2004, PwC insisted on a Sarbanes-Oxley 404 audit or additional procedures based on the control weaknesses they knew so well? Maybe Koss said no way and found Grant Thornton, an audit firm that would not insist on more work given the risks?

Interestingly, this “problem-child” client hand off mirrors the one at Overstock, another example of paternalistic management preoccupation with everything but the real numbers.  There, PwC walked away and Grant Thornton took over less than a year ago, in spite of whatever PwC knew and could tell them about the muck they were walking into.  In the Overstock case, however, when Grant Thornton woke up and quit/was fired, KPMG, another Big 4 firm, was ready to take their place and take the idiot management’s money for however long they last.

In this case, Koss went down another notch in the public accounting world and selected Baker Tilly, a next-next tier firm to be their next auditor and help them get out of the current mess, if possible, by restating multiple years of financial statements.  Just like Mr. Koss’s other company, Genius Products, had to restate after he stepped down as a Director and Audit Committee Chairman.

You may say, “Who’s getting hurt here?”  After all, the family, the vast majority shareholders, took some risks and we might assume understood full well the cost/benefit equation of running a loosey-goosey shop. (We haven’t even begun to talk about their IT…)

Well…the hundreds of employees at their factories, their vendors, their customers, and business partners, the IRS, the minority shareholders (maybe even their employees in the 401k plan) and, of course, the communities they operate in are getting hurt.

Because it will be a miracle if Koss survives this fiasco as a going concern.

If you cry any tears, they should be for the boutiques that counted on Ms. Sachdeva as their biggest and, I am sure, by a long shot their most lucrative customer.

Valentina was one of 12 retailers, including seven in the Milwaukee area, where Sachdeva allegedly used the card for $4.5 million in purchases and paid the balance with Koss funds.

“You find yourself dumbfounded,” Valentina owner Tony Chirchirillo said of the news. “We never expected anything like this.” She seemed to be “a very nice person” who placed special orders for designer gowns and garments that cost between $2,000 and $8,000, he said. “She always wanted the best — beyond our usual price range,” Chirchirillo said.

Chirchirillo said he and his wife, Cheryl, and daughter, Gina Frakes, who run the store, assumed “she came from money” and that her job at Koss, plus her husband Ramesh Sachdeva’s position as a prominent pediatrician, provided the spending money…The Chirchirillos…are now planning the future of the business with the “devastating” loss of their biggest customer, he said.

“It threw everything upside down,” Chirchirillo said.

How many $1+  million shop-o-holics can there be in Mequon?

Main Page Photo Source

Post Script: In researching what has been written about Sujata Sachdeva already, especially in the Indian press, I came across several references to a classic Indian film of the same name. Here’s an excerpt from one review.  The additional link is to a storyboard of the film.

Sujata is Bimal Roy’s classic on the social issue of untouchability..this film succeeds in making a social malaise which has been plaguing indian society for centuries into an intensely personal study.

Seen from the POV of Nutan who plays the title role of Sujata, the film (its the irony of the highest order that a girl bearing the name of Sujata which in hindi means- a ’’good’’ caste-whatever that means!!! is deemed ’’untouchable’’) sensitively examines the impact and implications it has on the young girl’s life.

The plot is simple: An infant from a ’’low’’ caste…untouchable’’ family is adopted by a well-educated, cultured family in the pre-independence era. She is named Sujata and she becomes a kind of companion of the newly born daughter of the family. They grow up to become Nutan and Shashikala respectively. Nutan considers this to be her own family doing all the household chores and acting as a friend and companion to the younger Shashikala.

A distant relative of the family tries to fix the match of her grandson(Sunil Dutt) with Shashikala but instead Sunil Dutt is drawn towards the simplicity of Sujata who too after initial inhibitions reciprocates. But all hell breaks lose when the grandmother(Lalita Pawar) comes to know of it and she is further shell-shocked to learn that the girl is ’’Achoot’’.

Not so long ago, Dennis Howlett and I went public with a bet:  

Which Big 4 audit firm is the next to fail?

This may seem like a dead pool – a quite depressing and morbid fascination with something that will add pain and misfortune to so many.  I have been accused of being so totally negative that I strain credibility.  After all, isn’t there anything good to say about any of the firms?  

Isn’t some audit failure natural? Isn’t some error and omission in the audit process the result of a rational cost/benefit formula at work – one that determines how much more testing, sampling, investigation, questioning, and verification work should be done to reduce risk of material misstatement to an “acceptable” level?

Isn’t everyone cutting staff in this recession? Why can’t the audit firms run a business like any other capitalist and make a profit? Why are auditors any more responsible for the public interest than lawyers?

Aren’t plaintiffs’ lawyers too aggressive and going after audit firms only because they have “deep pockets” ? Aren’t auditors responsible only for certifying based on what management tells them? Can anyone hold them responsible if they were “duped” by bad guys? 

The litany of crybaby defenses goes on and on.

Frankly, it’s getting a little tedious.

Let’s face facts. Dennis may be right.  It may be EY that’s next.  

Even before the conviction this week of four current and former partners of Ernst & Young for criminal tax fraud involving tax shelters, EY had a bundle of other trouble.  They were the auditors of Lehman Brothers and are being sued for their role in that failure. They have Madoff exposure.  They are also co-auditors for Societe Generale and auditor for UBS – two problem children, for sure. There is speculation about EY in other quarters, and although I don’t agree with their reasoning, the conclusion is the same.

Dennis believes that I’m betting on PwC as next to fail.  I don’t honestly remember committing to that, but I’m willing to go with it for the sake of argument.  This is in spite of the fact that the other Big 4 have plenty to worry about and the next tier firms are in no way ready for prime time.  Wishful thinking that BDO can somehow win their appeal in the Banco Espiritu Santo case, that Grant Thornton won’t get hurt by Refco, or that McGladrey is innocent in the Sentinel case is trumped by the fact all have additional exposure to Madoff.

KPMG, of course, has New Century, Anglo Irish Bank, Citi, Siemens, and others.

Deloitte, well, too many to count. And the Parmalat case is a potential model changer. And a very embarrassing insider trading scandal. Then there’s the loser consulting gigs and a declining demand for consulting, all of which makes for never ending cuts and a not so rosy outlook.

And yet, for my money, PwC is still the closest to the precipice, if only now because of Satyam.

Think about it.  It’s their third strike (at least that we know of) internationally after Japan and Moscow.  Two of their Indian partners, for God’s sake, are still in jail – thrown to the prosecutorial sharks by the Indian Central Bureau of Investigations. The Chairman (soon to be retired ) of Pricewaterhouse International Limited, Sam DiPiazza, has pulled out all stops in investigating what occurred in India, sending US and other professionals to “assist” colleagues in India with comprehensive audit quality reviews, and personally meeting with Indian government officials and others worldwide to try to repair the “lost trust.”

And then there’s PwC’s Madoff exposure.  

And the lawsuit for wage and hour violations in California that they’ve already lost on the facts but are vigorously appealing. They completely flubbed the administrative responsibility test in this case and will lose the licensing argument.  Why?  Because the fear mongering they’re trying to stir up through proxies (there have been friend of the court briefs filed by business organizations sympathetic to PwC) are just that. Empty threats. The law firms have nothing to be afraid of if audit firms are required to pay overtime to not-yet-licensed associates. The law firms exposure is minimal.  After all, you pass the bar and are a licensed attorney in most states by late fall of the year you graduate.  Most law firms don’t tolerate a delay or a failure to pass the bar the first try, especially for top graduates. Contrast this to the audit firms. You can work for five to seven years, eighty hours a week during busy season, before making Manager level, the typical cutoff for future promotions without a CPA.  

And there are still questions lingering over their role in Northern Rock. And their forays into gambling audit have not been so successful all the while they’re advising the US to open up online gambling in order to reap the tax revenues.

The rumbling has also started in the comments on this blog over PwC’s stealth “reductions in force” and their broken promises over start dates and starting salaries to graduates. It’s fully expected that additional staff cuts will come soon and be of such a volume that it will be hard to hide behind the “didn’t fit with our performance culture” excuse.  

Finally, there’s the strategically disastrous purchase of BearingPoint’s Commercial Services practice.  Sources tell me due diligence has been non-existent, it’s solely an ego-trip for current leadership, and there’s a shell game going on in public statements regarding their interest in full blown systems integration services. The probability that  integration of the operations, financials, staff and infrastructure will be smooth and trouble-free is in the low single digits.

Yep.  Of the Big 4, my bet is with PwC US to fail in the next twenty-four months.

Photo Source

I laughed out loud when a Google Alert pointed me to the FT article excerpted below. 

Deloitte Is Protected in “Insolvency” Ruling
A Pennsylvania judge says that a firm that improperly keeps a company out of bankruptcy may not be liable, unless it is negligent in other ways, too.

A recent Pennsylvania Court ruling favoring Deloitte & Touche seems to restrict a company’s ability to win a case against an accountantcy for actions that lead to the company’s “deepening insolvency,” unless the accountant is negligent in other ways as well.

The issue arose in a lawsuit that Reliance Insurance Co. filed in the state’s Commonwealth Court against Deloitte & Touche, over allegations that the accountancy improperly certified that the insurer’s loss reserves in 1999 was reasonable. That caused Reliance to take underwriting losses on payments that it could not really make, to avoid the wrath of regulators, and to go deeper into debt when it should have declared bankruptcy, according to The Legal Intelligencer newspaper.