Based on the information presented in the case, do you believe Grant Thornton failed in its responsibilities to provide reasonable assurance that Koss Inc.’s financial statements were presented fairly in all materials respects? Justify your answer using specific arguments and examples.

Question

What will be an ideal response?

Answer 1

Student answers will vary, but they can use the red flags identified in the previous question to justify an answer that the auditor may have failed in its responsibilities to provide reasonable assurance that Koss Inc.’s financial statements were fairly presented in all material respects. In the end, it can be argued
that the likelihood that Grant Thornton’s audits of Koss Inc.’s financial statements during the years of
substantial Sachdeva embezzlement were of high quality is very low from the standpoint of probability.
Financial statement audits are to be designed to provide a reasonable level of assurance that the
financial statements and disclosures are fairly presented in all materiality respects. The PCAOB (whose
standards govern the audits of public companies like Koss, Inc.) has defined ‘reasonable assurance” as a
“high” level of assurance. PCAOB Standards also indicate that:
“The auditor has a responsibility to plan and perform the audit to obtain reasonable assurance
about whether the financial statements are free of material misstatement, whether caused by
error or fraud. Because of the nature of audit evidence and the characteristics of fraud, the
auditor is able to obtain reasonable, but not absolute, assurance that material misstatements
are detected (PCAOB AS 1001).”
A high level of assurance in auditing is commonly interpreted as being in a range of 95-99
percent confidence (i.e., 1-5% acceptable audit risk) for an overall engagement. From this, it can
be correctly inferred that it is possible, though not likely, for a financial statement audit to have been
conducted in accordance with applicable professional standards and still fail to detect a material
misstatement. However, the likelihood that audits were of high enough quality to provide reasonable
assurance decreases dramatically as the number of audits that repeatedly fail to detect material
misstatements increases or as the size of the misstatement increases.
Grant Thornton was responsible for Koss, Inc.’s financial statement audits from 2004 through
fiscal 2009 (and earlier). GT did not detect the Sachdeva financial statement fraud even as it grew to
over $5 million in 2008, over $8 million in 2009, and over $10 million in first half of fiscal year 2010,
and amounted to about 20 percent of sales revenue in fiscal 2009. From 2004 to the discovery of the
fraud in 2009, Koss reported net income of about $20 million, and Sachdeva stole about $30 million, or
approximately 60% of Koss Inc.’s “true net income” of about $50 million (Sachdeva sentencing hearing
transcript, p. 14). A general rule of thumb for auditors as a starting point for determining a materiality
threshold is 5 percent of income before taxes. In fiscal 2009, Koss originally reported net income
before taxes of about $3 million. An approximation for materiality for the audit, then, would be about
5 percent, or about $150,000. In other words, professional standards would require the auditor to
plan the audit to provide a high level of assurance that the financial statements would not be misstated
by more than about $150,000. Is it possible for a high-quality audit to miss a material misstatement
of perhaps $150,000 or $160,000 or even $200,000? Yes—assurance provided by an audit is not and
cannot be absolute. But Sachdeva embezzled about $8.5 million in fiscal 2009, an amount that is over
fifty times what the auditor would likely have targeted as a materiality threshold on Koss’s 2009 audit.
The odds that highly material misstatements were repeatedly missed by audits designed to provide a
high level of assurance that any misstatements of more than about $150,000 were not present, year
after year from 2004-2009, are quite low.