As Koss Inc.’s financial statement auditor, what responsibilities did Grant Thornton have to detect the embezzlement and accounting fraud? List and briefly describe at least three red flags that could have alerted the auditor to the fraud. What audit procedures might the auditor have used to discover the accounting fraud and the embezzlement?

Question

What will be an ideal response?

Answer 1

Auditors have an important responsibility to add assurance and credibility to an entity’s audited financial statements, and owe a vital duty to the public trust. The financial statement auditor’s role is to gather sufficient, competent evidence to provide him or her with “reasonable assurance” (clarified by the
PCAOB to mean a “high level of assurance”) as to whether the entity’s financial statements are free
from material misstatement, and then to express an opinion as to such to the public. The auditor’s role
has been characterized as that of a “watchdog” to help provide assurance to the investing public that
the information disseminated by audited entities is reliable. While the primary responsibility to design,
implement, and maintain an effective system of internal control over financial reporting and to produce
reliable financial statements rests with the company’s management, the auditor plays an important
role in adding assurance to management’s assertions about the effectiveness of its ICFR and the fair
presentation of its financial statements.
? PCAOB auditing standards indicate that: “The auditor should obtain a sufficient understanding of
each component of internal control over financial reporting to (a) identify the types of potential
misstatements, (b) assess the factors that affect the risks of material misstatement, and (c) design
further audit procedures. (PCAOB AS 2110).” An adequate assessment of ICFR by the auditor
likely would have identified the serious control deficiencies at Koss, and thus the substantive tests
of account balances they designed would have reflected the tremendously increased risk of material
misstatement presented by the company’s poor controls. Egregiously poor ICFR is, in itself, a red
flag that should have led the auditor to do more careful testing in particular areas (e.g., where
separation of duties was inadequate or where key personnel lacked competence), which in turn
might have led the auditor to detect this highly material fraud.
? According to numerous court documents and the Michael Koss (MK) and Sachdeva depositions,
the fraud cover-up involved numerous, large topside adjusting entries, often labeled “reclass,” and
without further description. It is standard audit practice to “review the General Ledger (GL) for
large or unusual items.” A simple review of the GL in the month following year end should have
brought to the auditor’s attention at least some of these large, undocumented, top-side adjusting
“reclass” entries, causing them to inquire after them.
? Because Sachdeva was stealing cash at an astonishing rate, the cash balance per Koss’s records
was dramatically different than the cash balance per the bank. Sachdeva wanted the cash balance
to reconcile at the company’s June year-end, however, so an accounting clerk would hold up the
accounting for AR and not make any entries in Koss’s records when the cash came in. This would
dramatically overstate receivables, and with the bank having received the cash receipts on receivables
for June, the banks stated account balance matched the accounting records, but only at year-end.
In addition, because of the pattern of cover-up in June of each year, Koss’s GL would each year
show a significant lack of cash payments on receivables posted in June compared to every other
month. If the auditor had compared cash-per-books to cash-per-bank in any month other than June,
adequately confirmed accounts receivable, reviewed patterns of cash receipts on receivables, asked
for back-up for any of the hundreds of fraudulent entries, or asked why there were deposits in the
bank statements that were not posted to the GL, the fraud may have been discovered.
Other possible red flags students may identify are the large volume of cashiers’ checks and wire
transfers, and payments to a personal American Express account and other questionable payees (e.g.
Nieman Marcus, Saks 5th Avenue, etc.). In an email from MK to “Gallagher,” dated July 3, 2010, MK
says: “...all the auditors needed to do was to look at a random bank statement and ask to see the backup
for a single debit memo! Just one would have led them to a cashier’s check made out to Nieman Marcus,
and the whole scam would have been over.”