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**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C.  20549**

 

**FORM 10-K**

 

**x****      ANNUAL REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

** **

**For the fiscal year ended June 30, 2010**

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**OR**

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**o****         TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934**

 

**COMMISSION FILE NUMBER 0-3295**

 

**KOSS CORPORATION**

(Exactname of registrant as specified in its charter)

 

| **Delaware**                                                    | ** ** | **39-1168275**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State  or other jurisdiction of incorporation or organization) |       | (I.R.S.  Employer Identification No.) |
|                                                            |       |                                  |
| **4129 North Port Washington Avenue, Milwaukee, Wisconsin**     | ** ** | **53212**                             |
| (Address  of principal executive offices                        |       | (Zip  Code)                           |

 

Registrant’s telephone number, including area code: **(414) 964-5000**

 

Securities registeredpursuant to Section 12(b) of the Act:

 

| ** ** | **Title of Each Class** | ** ** | **Name of Each Exchange on Which Registered** | ** ** |
|------------|----------------------------------------|------------|-----------------------------------------------------------------------------|------------|
|       | Common  Stock $0.005 par value         |       | The  Nasdaq Stock Market LLC                                                |       |

 

**NONE**

(Titleof class)

 

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 ofthe Securities Act.  Yes o  No x

 

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 orSection 15(d) of the Act.  Yes o  No x

 

Indicate by check markwhether the registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the Registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes  x    No o

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporateWeb site, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter)during the preceding 12 months (or for such shorter period that the registrantwas required to submit and post such files). Yes  o    No o

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to thisForm 10-K.   o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, anon-accelerated filer, or a smaller reporting company.  See the definitions of “large acceleratedfiler,” “accelerated filer” and “smaller reporting company” in Rule 12b-2of the Exchange Act.

 

| Large  accelerated filer o                     |   | Accelerated  filer o         |
|------------------------------------------------|--------|------------------------------|
|                                           |   |                         |
| Non-accelerated  filer o                       |   | Smaller  reporting company x |
| (Do  not check if a smaller reporting company) |   |                         |

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).  Yes o No x

 

The aggregate market valueof the common voting stock held by nonaffiliates of the registrant as ofDecember 31, 2009 was approximately $13,772,465****(based on the $5.51 per share closing price of the Company’scommon stock as reported on the NASDAQ Stock Market on December 31, 2009.

 

On September 10, 2010,7,382,706 shares of voting common stock were outstanding.

 

Documents Incorporated by Reference

 

Part III of thisForm 10-K incorporates by reference information from Koss Corporation’sProxy Statement for its 2010 Annual Meeting of Stockholders filed with theCommission under Regulation 14A within 120 days of the end of the fiscal yearcovered by this Form 10-K.

 

 

 

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KOSS CORPORATION

FORM 10-K

JUNE 30, 2010

 

INDEX

 
| ** **       | ** **                                                                                                          | **Page** |
|------------------|---------------------------------------------------------------------------------------------------------------------|----------|
| **PART I**  |                                                                                                                |     |
| Item 1.          | Business                                                                                                            | 5        |
| Item 1A.         | Risk Factors                                                                                                        | 8        |
| Item 2.          | Properties                                                                                                          | 13       |
| Item 3.          | Legal Proceedings                                                                                                   | 13       |
|             |                                                                                                                |     |
| **PART II** |                                                                                                                |     |
| Item 5.          | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities | 14       |
| Item 7.          | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         | 15       |
| Item 8.          | Financial  Statements and Supplementary Data                                                                        | 20       |
| Item 9.          | Changes in and  Disagreements with Auditors on Accounting and Financial Disclosure                                  | 20       |
| Item 9A.         | Controls and  Procedures                                                                                            | 20       |
|             |                                                                                                                |     |
| **PART IV** |                                                                                                                |     |
| Item 15.         | Exhibits and  Financial Statement Schedules                                                                         | 24       |

 

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**EXPLANATORYNOTE**

 

InDecember 2009, Koss Corporation (the “Company”) learned of certainunauthorized transactions made by Sujata Sachdeva, its former Vice President ofFinance and Principal Accounting Officer. The Company first learned of the unauthorized transactions on December 18,2009, when Michael Koss received a call from American Express securityinforming him that certain wire transfers were being made from Koss corporatebank accounts to pay personal American Express expenses of Ms. Sachdeva.  These wire transfers were part of theunauthorized transactions made by Ms. Sachdeva resulting in themisappropriation of approximately $31,500,000 from fiscal year 2005 through December 2009.  The Company subsequently learned that Ms. Sachdevacolluded with two other employees of the accounting department in themisappropriation and circumvention of the Company’s then existing internalcontrols and established operating procedures. The collusion of these former employees, and the actions the Companytook to remedy such collusion and circumvention, are described in detail in theCompany’s Annual Report on Form 10-K/A filed for the year ended June 30,2009 and in “Item 9A. Controls and Procedures” in this Annual Report on Form 10-K.  In July 2010, Ms. Sachdeva pleadedguilty in the criminal case filed against her; and her sentencing is currentlyscheduled for November 18, 2010. Additional legal proceedings related to the unauthorized transactionsare described in “Item 3. Legal Proceedings” of this Annual Report on Form 10-K.

 

Asa result of the unauthorized transactions, the Company restated its previouslyissued consolidated financial statements and related notes thereto for thefiscal year ended June 30, 2009, and for the three month period ended September 30,2009.  These restatements were disclosedin the Company’s Annual Report on Form 10-K/A for the year ended June 30,2009 and its Quarterly Report on Form 10-Q/A for the three months ended September 30,2009, respectively.  The Company alsoamended its Quarterly Reports on Form 10-Q/A for the three months ended December 31,2009 and March 31, 2010 to include condensed consolidated financialstatements and related notes thereto, which were delayed as a result of therestatements.  All of these amendedreports were filed on June 30, 2010, and should be read in conjunctionwith this Annual Report on Form 10-K. The financial effect of the unauthorized transactions during fiscal year2010 is described in “Item 7. Management’s Discussion and Analysis of FinancialCondition and Results of Operations” and in Note 2 of the Notes to ConsolidatedFinancial Statements in this Annual Report on Form 10-K.

 

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**CAUTIONARYSTATEMENT REGARDING FORWARD-LOOKING STATEMENTS**

 

This Annual Report onForm 10-K contains forward-looking statements within the meaning of thatterm in the Private Securities Litigation Reform Act of 1995 (the “Act”)(Section 27A of the Securities Act of 1933 and Section 21E of theSecurities Exchange Act of 1934). Additional written or oral forward-looking statements may be made by theCompany from time to time in filings with the Securities Exchange Commission,press releases, or otherwise.  Statementscontained in this Form 10-K that are not historical facts areforward-looking statements made pursuant to the safe harbor provisions of theAct.  Forward-looking statements mayinclude, but are not limited to, projections of revenue, income or loss andcapital expenditures, statements regarding future operations, anticipatedfinancing needs, compliance with financial covenants in loan agreements, plansfor acquisitions or sales of assets or businesses, plans relating to productsor services of the Company, assessments of materiality, predictions of futureevents, the effects of pending and possible litigation and assumptions relatingto the foregoing.  In addition, when usedin this Form 10-K, the words “anticipates,” “believes,” “estimates,” “expects,”“intends,” “plans” and variations thereof and similar expressions are intendedto identify forward-looking statements.

 

Forward-looking statementsare inherently subject to risks and uncertainties, some of which cannot bepredicted or quantified based on current expectations.  Consequently, future events and actualresults could differ materially from those set forth in, contemplated by, orunderlying the forward-looking statements contained in this Form 10-K, orin other Company filings, press releases, or otherwise.  In addition to the factors discussed in thisForm 10-K, other factors that could contribute to or cause suchdifferences include, but are not limited to, developments in any one or more ofthe following areas: future fluctuations in economic conditions, thereceptivity of consumers to new consumer electronics technologies, the rate andconsumer acceptance of new product introductions, competition, pricing, thenumber and nature of customers and their product orders, production by third partyvendors, foreign manufacturing, sourcing, and sales (including foreigngovernment regulation, trade and importation concerns), borrowing costs,changes in tax rates, pending or threatened litigation and investigations, andother risk factors which may be detailed from time to time in the Company’sSecurities and Exchange Commission filings.

 

Readers are cautioned not toplace undue reliance on any forward-looking statements contained herein, whichspeak only as of the date hereof.  TheCompany undertakes no obligation to publicly release the result of anyrevisions to these forward-looking statements that may be made to reflectevents or circumstances after the date hereof or to reflect the occurrence ofunexpected events.

 

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**PART I**

 

**ITEM 1.                  BUSINESS.**

 

**GENERAL**

 

As used herein, the term “Company”means Koss Corporation and its consolidated wholly-owned subsidiary, KossClassics Ltd. (“Koss Classics”), unless the context otherwise requires.  The Company was incorporated in Delaware in1971.

 

The Company operates in theaudio/video industry segment of the home entertainment industry through itsdesign, manufacture and sale of stereo headphones and related accessoryproducts.  The Company reports itsresults as a single reporting segment, as the Company’s principal business lineis the design, manufacture and sale of stereo headphones and relatedaccessories.

 

The Company’s products aresold through national retailers, international distributors, audio specialtystores, the Internet, direct mail catalogs, regional department store chains,discount department stores, military exchanges and prisons under the “Koss”name.  The Company also sells products todistributors for resale to school systems, and directly to other manufacturesfor inclusion with their own products. The Company has more than 250 domestic dealers and its products arecarried in approximately 17,000 domestic retail outlets and numerous retailersworldwide.  International markets areserved by domestic sales representatives and a sales office in Switzerlandwhich utilizes independent distributors in several foreign countries.  The Company has one subsidiary, KossClassics.

 

Ninety-nine percent of theCompany’s products are stereo headphones for listening to music.  The products are not significantlydifferentiated by their retail sales channel or application with the exceptionof products sold to school systems and prisons. There are no other product line differentiations other than the qualityof the sound produced by the stereo headphone itself, which is highlysubjective.  The business could also beclassified by distribution channel.

 

The Company sources completeheadphones manufactured to its specifications from various manufacturers inAsia as well as raw materials used to produce headphones at its plant inMilwaukee.  Management believes that ithas sources of complete headphones and raw materials that are adequate for itsneeds.

 

There are no employment orcompensation commitments between the Company and its dealers.  The Company has several independentmanufacturer’s representatives as part of its distribution efforts.  The Company typically signs one yearcontracts with these manufacturer’s representatives.  These agreements are seldom renewed inwriting, but continue from year to year. The Company has a manufacturer’s representative agreement with a firm inDetroit to work exclusively in the automotive arena.  The automotive representative is paid 2% forall business in this area. The Company’s remaining agreements withdistributors, past or present, pertain to distribution arrangements in foreigncountries.  The arrangements with foreigndistributors do not contemplate that the Company pays any compensation otherthan any profit the distributors make upon their sale of the Company’sproducts.  The Company has the right toterminate these agreements with foreign distributors without cause.

 

**INTELLECTUALPROPERTY**

 

John C. Koss is recognizedfor creating the stereophone industry with the first SP3 stereophone in1958.  The Company regularly applies forregistration of its trademarks in many countries around the world in which itdoes business, and over the years the Company has had numerous trademarksregistered and patents issued in countries in North America, South America,Asia, Europe, Africa, and Australia.  TheCompany currently has approximately 394 trademarks registered in 87 countriesaround the world and patents in 26 countries. The Company has trademarks to protect the brand name, Koss, and its logoon its products.  These trademarks aremaintained throughout the countries in which the Company sells itsproducts.  The Company also holds manydesign patents that protect the unique visual appearance of some of itsproducts.  These trademarks and patentsare 

 

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important to differentiatethe Company from its competitors. Certain of the Company’s trademarks are of material value and importanceto the conduct of its business.  TheCompany considers protection of its proprietary developments important;however, the Company’s business is not, in the opinion of management,materially dependent upon any single trademark or patent.  During the year ended June 30, 2010, theCompany took steps to update and monitor its patents and trademarks to protectits intellectual property around the world.

** **

**SEASONALITY**

 

Although retail sales ofconsumer electronics have typically been higher during the holiday season,stereophones have also seen increased interest as gift items over theyears.  Management of the Companybelieves that its business and industry segment are no longer seasonal asevidenced by the fact that 59% of net sales occurred in the first six months ofthe year ended June 30, 2010, and 41% of net sales occurred in the lattersix months of the year.  Management believesthat the reason for this level performance of sales to retailers is related tothe fact that stereo headphones have become replacement items for portableelectronic products.  Therefore, upgradesand replacements appear to have as much interest over the course of the year asgifts of stereophones during the holiday season.

 

**WORKINGCAPITAL AND BACKLOG**

 

The Company’s workingcapital needs do not differ substantially from those of its competitors in theindustry and generally reflect the need to carry significant amounts ofinventory to meet delivery requirements of its customers.  From time to time, although rarely, theCompany may extend payment terms to its dealers for a special promotion.  For instance, the Company has in the pastoffered a 90-120 day payment period for certain customers, such as computerretailers and office supply stores. Based on historical trends, management does not expect these practicesto have any material effect on net sales or net income.  The Company’s backlog of orders as ofJune 30, 2010 is not considered material in relation to net sales during2010 or anticipated 2011 net sales.

 

**CUSTOMERS**

 

The Company markets a lineof products used by consumers to listen to music, DVD’s in vehicles, soundbytes on computer systems, and other audio related media.  The Company distributes these productsthrough retail channels in the U.S. and independent distributors throughout therest of the world.  The Company marketsits products to approximately 17,000 domestic retailers and numerous retailersworldwide.  During 2010, the Company’ssales to its largest single customer, Tura Scandinavia AB, were approximately25% of net sales and sales to Wal-Mart Stores, Inc. accounted for 17% of2010 net sales.  In 2009, net sales toTura Scandinavia AB and Wal-Mart Stores, Inc, accounted for 17% and 22% ofconsolidated net sales, respectively. The Company is dependent upon its ability to retain a base of retailersand distributors to sell the Company’s line of products.  Loss of retailers and distributors means lossof product placement.  The Company hasbroad distribution across many channels including specialty stores, massmerchants, electronics stores, and computer retailers.  Management believes that any loss of revenueswould be partially offset by a corresponding decrease, on a percentage basis,in expenses; thereby partially reducing the impact on the Company’s operatingincome.  The five largest customers ofthe Company (including Tura Scandinavia AB and Wal-Mart Stores, Inc.)accounted for approximately 52% and 54% of total net sales in 2010 and 2009,respectively.

 

**COMPETITION**

 

The Company focuses on thestereo headphone industry.  In thestereophone market, the Company competes directly with approximately five majorcompetitors, several of which are large and diversified and have greater totalassets and resources than the Company. The Company’s single product focus is unique in the marketplace.  The extent to which retailers view theCompany as an innovative vendor of high quality headphone products, and aprovider of excellent after sales customer service, is the extent to which theCompany maintains a competitive advantage. The Company relies upon its unique sound, quality workmanship, brandidentification, engineering skills, and customer service to maintain itscompetitive position.

 

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**RESEARCHAND DEVELOPMENT**

 

The amount expensed onengineering and research activities relating to the development of new productsor the improvement of existing products was approximately $766,000 during 2010as compared with $1,559,000 during 2009. These activities were conducted byboth Company personnel and outside consultants. The Company expects that research and development costs will continueand it is planning to introduce a new offering during fiscal year 2011.

 

**ENVIRONMENTALMATTERS**

 

The Company believes that ithas materially complied with all currently existing federal, state and localstatutes and regulations regarding environmental standards and occupationalsafety and health matters to which it is subject.  During the years 2010 and 2009, the amountsincurred in complying with federal, state and local statutes and regulationspertaining to environmental standards and occupational safety and health lawsand regulations did not materially affect the Company’s operating results orfinancial condition.

 

**EMPLOYEES**

 

As of June 30, 2010,the Company employed 65 people, who are all non-union.  The Company also utilizes temporarypersonnel.

 

**FOREIGNSALES**

 

The Company’s competitiveposition and risks relating to the conduct of its business in foreign marketsare comparable to the domestic market. In addition, the governments of foreign nations may elect to erect tradebarriers on imports.  The creation ofadditional barriers would reduce the Company’s net sales and profit.  In addition, any fluctuations in currencyexchange rates could affect the pricing of the Company’s products and divertcustomers who might choose to purchase lower-priced, less profitable products,and could affect overall demand for the Company’s products.  For further information, see Part II, Item7 and Note 14 to the consolidated financial statements accompanying thisForm 10-K.

 

The Company has a smallsales office in Switzerland to service the international exportmarketplace.  The Company is not aware ofany material risks in maintaining this operation.  Loss of this office would result in atransfer of sales and marketing responsibility. The Company sells its products to independent distributors in countriesand regions outside the United States including Europe, the Middle East,Africa, Asia, South America, Latin America, the Caribbean, and Mexico.  The Company sells products in the Canadianmarket through a distributor who services smaller specialty accounts.  During the last two years, net sales of allKoss products, were distributed as follows:

 
| ** **          | ** ** | **2010**   | ** ** | **2009**   | ** ** |
|---------------------|------------|------------|------------|------------|------------|
| U.S.                |       | $          | 20,182,347 |       | $          | 24,222,039 |   |
| Europe              |       | 17,710,672 |       | 15,744,430 |       |
| All other countries |       | 2,705,703  |       | 1,750,645  |       |
| Net sales           |       | $          | 40,598,722 |       | $          | 41,717,114 |   |

 

In addition to amanufacturing facility in the United States, the Company uses contractmanufacturing facilities in the People’s Republic of China, Taiwan and SouthKorea.  These independent supplierentities are distant from the Company, which means that we are at risk ofbusiness interruptions due to natural disasters, war, disease and governmentintervention through tariffs or trade restrictions that are of less concerndomestically.  The Company maintainsfinished goods inventory in its U.S. facility to mitigate this risk.  The Company’s goal is to stock finished goodsinventory at an average of approximately 90 days demand per item.  Recovery of a single facility throughreplacement of a supplier in the event of a disaster or suspension of supplycould take 120 days.  The Companybelieves that it could restore production of its top ten selling models (whichrepresent approximately 70% of the Company’s sales revenue) within oneyear.  The Company is also at risk if thetrade restrictions are 

 

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introduced on its productsbased upon country of origin.  Inaddition, most increases in tariffs and freight charges would not be acceptableto pass along to the Company’s customers and would directly impact the Company’sprofits.

 

**AVAILABLEINFORMATION**

 

The Company’s internetwebsite is http://www.koss.com.  TheCompany makes available free of charge through its internet website the Company’sannual report on Form 10-K, quarterly reports on Form 10-Q, currentreports on Form 8-K, proxy statements and all amendments to those reportsas soon as reasonably practicable after they are electronically filed with (orfurnished to) the SEC.  These reports andother information regarding the Company are also available on the SEC’sinternet website at http://www.sec.gov.

 

**ITEM 1A.               RISK FACTORS.**

 

Investing in the Company’scommon stock involves a high degree of risk. Any of the following risks couldhave a material adverse effect on the Company’s financial condition, liquidityand results of operations or prospects, financial or otherwise.

 

**REDUCTIONIN PRESENT LEVELS OF CASH FLOW COULD ADVERSELY AFFECT THE COMPANY’S BUSINESS**

 

The Company’s primary sourceof liquidity over the past 12 months has been operating cash flows.  The Company’s future cash flows from operations(on both a short term and long term basis) are dependent upon, but not limitedto:

 
| · | the Company’s ability to  attract new customers that will sell the Company’s products and pay for them;                                                                       |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| · | the Company’s ability to  retain the Company’s existing customers at the level of sales previously  produced;                                                                 |
| · | the volume of sales for  these customers;                                                                                                                                               |
| · | the loss of business of  one or more primary customers;                                                                                                                                 |
| · | changes in types of  products that the customers purchase in their sales mix;                                                                                                           |
| · | poor or deteriorating  economic conditions which would directly impact the ability of the Company’s  customers to remain in business and pay for their products on a timely basis; |
| · | Management’s ability to  minimize the impact of requests for increases in material or labor cost increases;  and                                                                   |
| · | the ability to collect in  full and in a timely manner amounts due to the Company.                                                                                                      |

 

In addition, as noted above,the Company’s cash flow is also dependent, to some extent, upon the ability tomaintain operating margins. The continuing general downturn in economicconditions or other events that caused the Company’s customers to turn tolower-priced, lower-margin products, could cause the Company’s cash flow andprofitability to be materially and adversely affected.

 

**FAILURE TOATTRACT AND RETAIN CUSTOMERS TO SELL THE COMPANY’S PRODUCTS COULD ADVERSELYAFFECT SALES VOLUME AND FUTURE PROFITABILITY**

 

The Company markets a lineof products used by consumers to listen to music.  The Company distributes these productsthrough retail channels in the U.S. and independent distributors throughout therest of the world.  The Company isdependent upon its ability to retain an existing base of customers to sell theCompany’s line of products.  Loss ofcustomers means loss of product placement. The Company has broad distribution across many channels includingspecialty stores, mass merchants, electronics stores and computerretailers.  Any loss of a customerdirectly translates into a reduction in sales volume which can only be replacedby adding a similar number of representative retail outlets.  The inability of the Company’s sales andmarketing staff to obtain new distribution outlets translates into a lack offuture growth and possibly a setback in sales volumes when loss of 

 

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current customersoccur.  For example, the loss of acustomer representing 10% of the Company’s business would translate into areduction in revenues of up to 10% based upon the point through the year thatthe customer was lost.  Attracting a newcustomer during the course of a year could have a positive impact or simplyreplace an account which has been lost. In addition, a customer can decide to make a change in the models thatit decides to offer for sale.  Suchchanges can occur arbitrarily throughout the course of a year which can causereductions in sales revenues in proportion to the number of retail outlets thatthe store represents in the market.  TheCompany may not be able to maintain customers or model selections and thereforemay experience a reduction in its sales revenue until a model is restored tothe mix or a lost customer is replaced by a new customer.  A reduction in sales volume would cause areduction in profitability.  The Company’sfailure to retain existing customers, obtain new customers or develop newproduct lines that customers would choose to offer to consumers couldsignificantly affect the Company’s future profitability.  The loss of business of one or more principalcustomers or a change in the sales volume from a particular customer could havea material adverse effect on the Company’s sales volume and profitability.

 

**SHIFT INCUSTOMER SPECIFICATIONS TO LOWER PRICED ITEMS CAN REDUCE PROFIT MARGINSNEGATIVELY IMPACTING PROFITABILITY**

 

The Company sells a line ofproducts with a suggested retail price ranging from less than $10 up to$1,000.  The gross margin for each ofthese models is unique in terms of percentages. The price range of the products also produces a different level ofactual dollar contribution per unit.  Forexample, a product with a gross margin contribution of 50% might yield a $5contribution for one item, while another item may feature a 30% gross marginwhich could yield $50.  The Company findsthe low priced portion of the market most competitive and therefore mostsubject to pressure on gross margin percentages, which tends to lower profitcontributions.  Retail preference forlower priced items can reduce profit margins and contributions.  The risk is that a shift in retail customerspecifications toward lower priced items can lead to lower gross margins andlower profit contributions per unit of sale. Due to the range of products that the Company sells, the product salesmix can produce a variation in terms of a range of profit margins.  Some customers sell a limited range ofproducts that yield lower profit margins than others.  Most notably, the budget priced headphonesegment of the market below $10 retail, which is distributed through computerstores, office supply stores and mass market retailers, tends to yield thelowest gross margins.  An increase inbusiness with these types of accounts, if coupled with a simultaneous reductionin sales to customers with higher gross margins, would reduce profit marginsand profitability.

 

**POORECONOMIC CONDITIONS CAN RESTRICT OR LIMIT PRODUCT PLACEMENT, SALES ANDREPLENISHMENT WHICH COULD DECREASE PROFITS**

 

Deteriorating or weakeconomic conditions, or a forecast for the same, can trigger changes ininventory stocking at retail customers. This may in turn lead to a reduction in model offerings and/or out ofstock situations.  If a retail customerof the Company does not have adequate supply of the Company’s products to offerfor sale in a retail store, consumers may choose another competitive modelinstead.  Customers operating retailstores anticipate future sales demands and stock inventory accordingly.  Whenever a general economic slowdown occurs,at both the domestic and/or foreign level, sales volume levels and re-ordervolume levels change.  These changesdirectly impact the Company’s sales and profitability.  The Company is not in a position to determinehow it will be affected by these circumstances, how extensive the effects maybe, or for how long the Company may be impacted by these circumstances.  The Company’s customers respond to changes ineconomic conditions and any adverse changes in economic conditions cantherefore restrict product placement, availability, sales, replenishment andultimately profitability.  These conditionsexist domestically and internationally.

 

**MANAGEMENTIS SUBJECT TO DECISIONS MADE OUTSIDE ITS CONTROL WHICH COULD DIRECTLY AFFECTFUTURE PROFITABILITY**

 

Retail customers determinewhich products they will stock for resale. The Company competes with other manufacturers to secure shelf space inretail stores for the Company’s products. During the course of a year, changes in the customers’ managementpersonnel can ultimately lead to changes in the stock assortment offered toconsumers.  These changes are oftenarbitrary.  In addition to changes inpersonnel within the Company’s

 

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customers, it is alsopossible that a strategic decision can be made by a retail customer toconsolidate vendors, or to discontinue certain product categories altogether.  In these instances, the Company’s managementteam may not be able to convince customers to reverse such decisions.  The Company’s management team is also engagedin the effective procurement, assembly and manufacture of products.  The ability to negotiate with suppliers,maintain productivity and hold the line on cost increases can be subjected topressures outside the control of management. For example, increases in fuel costs can increase freight rates.  Increases of this nature can seldom be avoidedand the Company may not be able to pass such increases along to itscustomers.  Management’s effectivecontrol of the manufacturing processes will have a direct impact on the Company’sfuture profitability.  The Companyregularly makes decisions that affect production schedules, shipping schedules,employee levels and inventory levels. The Company’s ability to make effective decisions in managing theseareas has a direct effect on future profitability.

 

**ACCOUNTSRECEIVABLE AMOUNTS DUE FROM OUR CUSTOMERS CAN BE LOST AS A RESULT OF CUSTOMERBANKRUPTCY, OPERATIONAL DIFFICULTY, OR FAILURE TO PAY, NEGATIVELY IMPACTINGFUTURE PROFITABILITY**

 

The Company has significantaccounts receivable or other amounts due from the Company’s customers.  The outstanding accounts receivable, net ofallowance for doubtful accounts, at the end of the last four quarters averagedapproximately $5,563,000.  Terms ofpayment for customers generally range from cash in advance of delivery to net120 day credit terms.  These credit arrangementsare negotiated at unspecified and irregular intervals.  The largest customers generate the largestreceivable balances.  If a customerdevelops operational difficulty it is not uncommon to temporarily suspendpayment to vendors.  The Company issubject to this risk in the retail marketplace. From time to time a customer may develop severe operating losses whichcan lead to a bankruptcy.  In thesecases, the Company may lose most of the outstanding balance due.  Occasionally, the Company has been currentwith a customer at the time such an event occurs.  The more material risk is that of losing therevenue of the customer which might be more onerous than losing the currentoutstanding accounts receivable.  Inaddition, many companies that will typically insure accounts receivables willnot do so for the Company’s largest mass market customers.  The risk is that the Company derives most ofthe Company’s sales revenue and profits from selling products to retailers forresale to consumers.  The failure of theCompany’s customers to pay in full amounts due to the Company could negativelyaffect future profitability.

 

**COMPANYPROFITS CAN SUFFER FROM INTERRUPTIONS IN SUPPLY CHAIN**

 

The Company uses contractmanufacturing facilities in the People’s Republic of China, Taiwan and SouthKorea.  These independent suppliers aredistant from the Company which means that the Company is at risk of businessinterruptions due to natural disaster, war, disease and government interventionthrough tariffs or trade restrictions that are of less concerndomestically.  Therefore, if there areany interruptions in the supply chain for any of these reasons, this coulddirectly impact the Company’s profits in a negative way.  The Company is also at risk if traderestrictions are imposed on the Company’s products based upon country oforigin.  In addition, any increase intariffs and freight charges may not be acceptable to pass along to the Company’scustomers and could directly impact the Company’s profits.

 

**FLUCTUATIONSIN CURRENCY EXCHANGE RATES COULD AFFECT PRICING OF PRODUCTS AND CAUSE CUSTOMERSTO PURCHASE LOWER-PRICED, LESS PROFITABLE PRODUCTS AND COULD AFFECT OVERALLDEMAND FOR THE COMPANY’S PRODUCTS**

 

The Company receives amaterial portion of its sales and profits from business in Europe.  To the extent that the value of the U.S.dollar increases relative to currencies in those jurisdictions, it increasesthe cost of the Company’s products in those jurisdictions, which could createnegative pressure on the overall demand for the Company’s products.  The Company gets paid by its internationalcustomers in U.S. dollars.  To the extentthat increased prices arising from currency fluctuations decrease the overalldemand for the Company’s products or motivate customers to purchaselower-priced, lower profit products, the Company’s sales, profits and cashflows could be adversely affected.

 

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** **

**COMPANYPROFITS CAN SUFFER FROM INCREASING MANUFACTURING COSTS IN CHINA AS A RESULT OFINCREASED WAGES AND WAGE TAXES**

 

The Company uses contractmanufacturing facilities in the People’s Republic of China.  An increase in the cost of labor or taxes onwages in China may lead to an increase in the cost of goods manufactured inChina.  The cost of labor and wage taxeshave increased in China which means that the Company is at risk of highermanufacturing costs associated with goods manufactured in China.  Significant increases in wages or wage taxespaid by contract manufacturing facilities may increase the cost of goodsmanufactured in China which could have a material adverse effect on the Company’sprofit margins and profitability.

 

**THE COMPANYUSES THIRD PARTY CARRIERS TO SHIP ITS PRODUCTS WHICH MAY PASS ON INCREASESIN TRANSPORTATION-RELATED FUEL COST TO THE COMPANY WHICH CAN REDUCE PROFITMARGINS NEGATIVELY IMPACTING PROFITABILITY**

 

The Company uses numerousthird party carriers to ship product, both domestically andinternationally.  If the price of fuelincreases and the carriers choose to pass on the increase to the Company,freight costs may increase.  As a result,the Company’s freight cost is impacted by changes in fuel prices.  Fuel prices affect freight costs to bothcustomer’s location and the Company’s distribution center.  Increases in fuel prices and surcharges andother factors have increased and may continue to increase freight costs in thefuture.  The inflationary pressure ofhigher fuel costs and continued increase in transportation-related costs couldhave a material adverse effect on the Company’s profit margins andprofitability.

 

**CONSISTENCYOF THE COMPANY’S BUSINESS WITH SEVERAL U.S. RETAILERS**

 

The Company is particularlyconcerned about the consistency of business with several U.S. retailers.  The recent tightening of credit availabilityworldwide caused all retailers to sharply curtail inventory increases.  In addition, many retailers have beennegatively impacted by the economic recession. The Company has experienced some consolidation in product lines and itemelimination, or reductions at several big box retailers.  Finally, the Company is subject tofluctuations in production of the Company’s automobile customers and the potentialimpact that might have upon the Company’s rear seat entertainment products forthe automotive market in the coming year.

 

**THECOMPANY IS CURRENTLY UNABLE TO ASSESS THE AMOUNTS THAT MAY BE RECOVERED THROUGHTHE PROCEEDS FROM THE SALE OF ITEMS SEIZED BY LAW ENFORCEMENT, INSURANCE,POTENTIAL CLAIMS AGAINST THIRD PARTIES OR TAX REFUNDS*.***

 

TheCompany has estimated that the amount of the unauthorized transactions isapproximately $31,500,000 since fiscal year 2005 through December 31, 2009 asdescribed in the Company’s Form 10-K/A for June 30, 2009 that was filed on June30, 2010.  Over 25,000 items have beenseized by law enforcement authorities. Although the Company intends to pursueproceeds from the sale of items seized by law enforcement authorities, as wellas from insurance coverage, potential claims against third parties and taxrefunds, the Company cannot reasonably assess the amounts or timing of suchrecoveries.  Through the date of issuanceof this 10-K, the Company has received $1,746,469 from its insurancecompany.  The Company’s inability torecover its losses could have a significant and adverse effect on its futurefinancial condition.

 

**LEGALPROCEEDINGS RELATED TO THE UNAUTHORIZED TRANSACTIONS MAY ADVERSELY AFFECT THECOMPANY’S RESULTS OF OPERATIONS, CASH FLOWS AND FINANCIAL CONDITION.**

 

As further described in Item 3 Legal Proceedings,the Company is currently addressing several legal matters related to theunauthorized transactions. The Company is unable at this time to quantifyits exposure, if any.  The costs ofdealing with these matters and any penalties and awards that may be assessedagainst the Company could 

 

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besubstantial and may adversely affect the Company’s future results ofoperations, cash flows and financial condition.

** **

**THECOMPANY’S STOCK PRICE MAY FLUCTUATE AS A RESULT OF THE UNAUTHORIZEDTRANSACTIONS AND BECAUSE OF THE UNCERTAINTIES ABOUT THEIR EFFECT ON THE COMPANY’SFINANCIAL CONDITION.**

 

Uncertaintiesabout the effect of the unauthorized transactions and significant developmentsrelated to the unauthorized transactions, such as the legal matters describedabove or the results and recommendations of the Independent Investigation couldcause fluctuation in the Company’s stock price. The Company’s common stock couldalso be subject to wide fluctuations in response to additional business factorssuch as the following:

 

·                                          the sale or availability forsale of substantial amounts of the Company’s common stock;

 

·                                          actual or anticipatedfluctuations in the Company’s operating results or its competitors’ operatingresults;

 

·                                          announcements by the Companyor its competitors of new products;

 

·                                          capacity changes,significant contracts, acquisitions or strategic investments;

 

·                                          the Company’s growth rateand its competitors’ growth rates;

 

·                                          changes in stock marketanalyst recommendations regarding the Company, its competitors or the industryin general, or lack of analyst coverage of the Company’s common stock;

 

·                                          sales of the Company’scommon stock by its executive officers, directors and significant stockholdersor sales of substantial amounts of common stock; and

 

·                                          changes in accountingprinciples.

** **

**THE COMPANY’S INTERNAL CONTROLOVER FINANCIAL REPORTING FAILED TO TIMELY DETECT AND PREVENT THE UNAUTHORIZEDTRANSACTIONS AND IT IS POSSIBLE THAT WE HAVE NOT IMPLEMENTED EFFECTIVE REMEDIALMEASURES.**

 

The Company’s internalcontrols as of June 30, 2009 were not effective in that they failed to timelydetect and prevent the circumvention of the internal controls and proceduresrelating to the unauthorized transactions. Management believes it has implemented remedial measures to address theissues identified, but a sufficient amount of time has not yet elapsed to testthese internal controls and procedures to confirm whether they areeffective.  Thus, there is no assurancethat these deficiencies have been adequately addressed or that the Company hasdiscovered all of the deficiencies that may exist in the internal control overfinancial reporting.  The IndependentInvestigation is ongoing and it is possible that the Company and/or theIndependent Committee may identify additional deficiencies regarding theCompany’s internal control over financial reporting.

** **

**THE RESTATEMENT OF THE COMPANY’SCONSOLIDATED FINANCIAL STATEMENTS HAS SUBJECTED THE COMPANY TO INCREASED COSTSFOR ACCOUNTING AND LEGAL FEES.**

 

The Company issued restatedconsolidated financial statements in the Annual Report on Form 10-K/A for June30, 2009 that was filed on June 30, 2010. This restatement was because oferrors in previously issued financial statements caused by the unauthorizedtransactions.  This restatement has subjectedthe Company to significant costs in the form of accounting, legal fees andsimilar professional fees, in addition to the substantial diversion of time andattention of the Company’s Chief Financial Officer and members of itsaccounting department in preparing the restatement.  Although the restatement is complete, noassurance can be given that the Company will not incur additional costsassociated with the restatement.

 

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** **

**ITEM 2.****                 ****PROPERTIES.**

 

TheCompany leases its facility in Milwaukee, Wisconsin from its Chairman.  On August 15, 2007, the lease was renewed fora period of five years, ending June 30, 2013 and is being accounted for as anoperating lease.  The lease extensionmaintained the rent at a fixed rate of $380,000 per year.  The Company is responsible for all propertymaintenance, insurance, taxes, and other normal expenses related toownership.  All facilities are in goodrepair and, in the opinion of management, are suitable and adequate for theCompany’s business purposes.

 

**ITEM 3.****                 ****LEGALPROCEEDINGS.**

 

As of June 30, 2010, theCompany is party to the matters related to the unauthorized transactions describedbelow:

 

·                                          On January 11, 2010, theCompany received a letter from a law firm stating that it represented ashareholder and demanding that the Company’s Board of Directors investigate andtake legal action against all responsible parties to ensure compensation for theCompany’s losses stemming from the unauthorized transactions. The Company’slegal counsel has responded preliminarily to the letter indicating that theBoard of Directors will determine the appropriate course of action after theIndependent Investigation is completed.

 

·                                          On January 15, 2010, a classaction complaint was filed in federal court in Wisconsin against the Company,Michael Koss and Sujata Sachdeva. The suit alleges violations of Section 10(b),Rule 10b-5 and Section 20(a) of the Exchange Act relating to the unauthorizedtransactions and requests an award of compensatory damages in an amount to beproven at trial. See *David A. Puskala v.Koss Corporation, et al.*, United States District Court, EasternDistrict of Wisconsin, Case No. 2:2010cv00041.

 

·                                          On January 26, 2010, the SEC’sDivision of Enforcement advised the Company that it obtained a formal order ofinvestigation in connection with the unauthorized transactions. The Companyvoluntarily brought the unauthorized transactions to the SEC staff’s attentionwhen they were discovered in December 2009, and is cooperating with the ongoingSEC investigation.

 

·                                          On February 16 and 18, 2010,separate shareholder derivative suits were filed in Milwaukee County CircuitCourt in connection with the previously disclosed unauthorized transactions.The first suit names as defendants Michael Koss, John Koss Sr., the other Kossdirectors, Sujata Sachdeva, Grant Thornton, LLP, and Koss Corporation (as anominal defendant); the second suit names the same parties except GrantThornton, LLP. Among other things, both suits allege various breaches offiduciary and other duties, and seek recovery of unspecified damages and otherrelief. See *Ruiz**v. Koss, et al.*, Circuit Court, MilwaukeeCounty, Wisconsin, No. 10CV002422 (February 16, 2010) and *Mentkowski v. Koss, et al*., Circuit Court,Milwaukee County, Wisconsin, No. 10CV002290 (February 18, 2010). These twoshareholder derivative suits have been consolidated under Master File No.10CV002422.

 

·                                          On February 18, 2010, theCompany filed an action against American Express Company, American ExpressTravel Related Services Company, Inc., AMEX Card Services Company, DecisionScience, and Pamela S. Hopkins in Superior Court of Maricopa County, Arizona,case no. CV2010-006631, alleging various claims of aiding and abetting breachof fiduciary duty, aiding and abetting fraud, conversion, and negligencerelating to the unauthorized transactions.

 

·                                          On June 24, 2010, theCompany filed an action against its former independent auditor, Grant Thornton,LLP, and Ms. Sachdeva, in Circuit Court of Cook County, Illinois, allegingvarious claims of accounting malpractice, negligent misrepresentation, and fraudrelating to the unauthorized transactions.

 

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**PART II**

 

**ITEM 5.****                 ****MARKET FORREGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OFEQUITY SECURITIES.**

 

**MARKET INFORMATION ON COMMONSTOCK**

 

TheCompany’s common stock is traded on The Nasdaq Stock Market under the tradingsymbol KOSS.  There were approximately535 record holders of the Company’s common stock as of August 1, 2010.  This number does not include individualparticipants in security position listings. The quarterly high and low sale prices of the Company’s common stock forthe last two fiscal years as well as dividends declared are shown below.

 
| ** **             | ** ** | ** ** | ** ** | ** ** | ** ** | **Per Share** | ** ** |
|------------------------|------------|------------|------------|------------|------------|--------------------|------------|
| **Quarter Ended** | ** ** | **High**   | ** ** | **Low**    | ** ** | **Dividend**       | ** ** |
| September  30, 2008    |       | $          | 9.46       |       | $          | 6.76               |       | $ | 0.065 |   |
| December  31, 2008     |       | $          | 8.36       |       | $          | 4.63               |       | $ | 0.065 |   |
| March  31, 2009        |       | $          | 6.30       |       | $          | 4.675              |       | $ | 0.065 |   |
| June  30, 2009         |       | $          | 7.98       |       | $          | 5.875              |       | $ | 0.065 |   |
| September  30, 2009    |       | $          | 7.725      |       | $          | 5.52               |       | $ | 0.065 |   |
| December  31, 2009     |       | $          | 8.12       |       | $          | 5.50               |       | $ | 0.06 |   |
| March  31, 2010        |       | $          | 6.00       |       | $          | 3.76               |       | $ | 0.06 |   |
| June  30, 2010         |       | $          | 5.83       |       | $          | 5.04               |       | $ | 0.06 |   |

 

The Company’s stockholdersare entitled to receive dividends as may be declared by the Board of Directorsand paid out of funds legally available therefore.  The Company began paying dividends for thequarter ended September 30, 2002 and has paid a dividend for each quartersince, including the last fiscal quarter ended June 30, 2010.  On May 17, 2010 the Company announced itsquarterly dividend of $0.06 per share for stockholders of record on June 30,2010.  The dividend was distributed on oraround July 15, 2010.  Although theCompany anticipates it will continue to pay a quarterly dividend, the decisionto pay dividends and the amount of such dividends are within the solediscretion of the Board of Directors, who meet quarterly.  The decision to pay dividends will depend onthe Company’s operating results, financial condition, tax considerations, alternativeuses for such funds, and other factors the Board of Directors deem relevant,and there can be no assurance that dividends will be paid in the future.

 

**COMPANY REPURCHASES OF EQUITY SECURITIES**

 
| **Period (2010)** | ** ** | **Total  Number  of Shares  Purchased** | ** ** | **Average  Price Paid  per Share** | ** ** | **Total Number of  Shares Purchased as  Part of Publicly  Announced Plan (1)** | ** ** | **Approximate Dollar Value of  Shares Available under  Repurchase Plan** | ** ** |
|------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------|------------|
| April 1-April 30       |       | 0                                            |       | $                                            | 0.00       |                                                                                                                   | 0          |                                                                                                   | $          | 2,139,753 |   |
| May 1-May 31           |       | 0                                            |       | $                                            | 0.00       |                                                                                                                   | 0          |                                                                                                   | $          | 2,139,753 |   |
| June 1-June 30         |       | 0                                            |       | $                                            | 0.00       |                                                                                                                   | 0          |                                                                                                   | $          | 2,139,753 |   |

 

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(1)  In Aprilof 1995, the Board of Directors approved a stock repurchase program authorizingthe Company to purchase from time to time up to $2,000,000 of its common stockfor its own account.  Subsequently, theBoard of Directors periodically has approved increases in the stock repurchaseprogram.  As of June 30, 2010, the mostrecently approved increase was for additional purchases of $2,000,000, whichoccurred in October of 2006, for an aggregate maximum of $45,500,000, of which$43,360,247 had been expended through June 30, 2010.

 

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**ITEM 7.****                                            ****MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS.**

 

*The purpose of this discussion and analysis is to enhancethe understanding and evaluation of the results of operations, financialposition, cash flows, indebtedness and other key financial information of theCompany for fiscal years 2010 and 2009.  For a more completeunderstanding of this discussion, please read the Notes to ConsolidatedFinancial Statements included in this report.*

 

**Overview**

 

TheCompany developed stereo headphones in 1958 and has been a leader in theindustry.  We market a complete line ofhigh-fidelity stereophones, speaker-phones, computer headsets,telecommunications headsets, active noise canceling stereophones, wirelessstereophones and compact disc recordings of American Symphony Orchestras on theKoss Classics label. We operate as one business segment.

 

***Unauthorized Transactions*** — In December 2009, theCompany learned of significant unauthorized transactions which totaledapproximately $31,500,000 from fiscal 2005 through December 2009.  The volume of these unauthorized transactionswas $8,498,434 in 2009, and $10,286,988 from July 1, 2009 until theunauthorized transactions were discovered in December 2009**. **As a result of these unauthorizedtransactions, the Company restated its consolidated financial statements onForm 10-K/A for June 30, 2009.

 

***Operations*** — Net sales declined to $40,598,722 in 2010compared with $41,717,114 in 2009.  This $1,118,392 decrease in netsales was primarily driven by soft retail sales in the United States andincreased promotions with one major customer. Including the unauthorized transactions as an expense, the Company had aloss from operations of $4,955,767 in 2010, compared to a loss from operationsof $340,094 in 2009.  The increased loss from operations wasprimarily driven by the increased unauthorized transactions, decrease in grossprofit from 44.5% to 41.6%, unauthorized transaction related costs and lowersales volume.   In 2010 and 2009, thelosses related to the unauthorized transactions, exclusive of corrections foraccounting errors, were $10,286,988 and $8,498,434, respectively, an increaseof $1,788,554 in 2010.  The 2010operating results also included $1,666,986 of unauthorized transaction relatedcosts net of recoveries.  Operatingincome, excluding the unauthorized transactions and related costs andrecoveries, was $6,998,207 in 2010 or 17.2% of net sales compared to $8,158,340or 19.6% of net sales in 2009.

 

**2010Results of Operations Compared with 2009**

 

***Sales and Gross Profit***

 

Netsales for 2010 totaled $40,598,722, compared with $41,717,114 in2009.  This $1,118,392 or 2.7% decrease in net sales was driven bysoft retail sales in the United States and increased promotions ofapproximately $700,000 with one major customer in the United States.  The decline came in the United States asexport sales increased 16.7% from the 2009 level.

 

Grossprofit in 2010 was $16,868,411 or 41.6% of net sales compared to $18,548,692 or44.5% of net sales in 2009.  Thisdecreased gross margin percentage was driven by increased cost of promotionsand increased overhead spending.  Theincreased cost of promotions totaled approximately $700,000 for the agreedperiod which occurred in advance of significant sales volumes for thiscustomer.  The overhead spendingincreased by approximately $357,000 as a result of spending approximately$169,000 for prototypes and engineering tests for products expected to beintroduced in fiscal 2011 and for increased fringe benefit costs of $87,000.

 

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*** ***

***Selling, General and Administrative Expenses***

 

Selling,general and administrative expenses for 2010 were $9,870,204, as compared to$10,390,352 for 2009.  The decrease in selling, general and administrativeexpenses was the result of decreased new product research and developmentactivities, not participating in a large dealer show and a loss on fixed assetdisposals in 2009.  New productdevelopment decreased from approximately $1,559,000 in 2009 to approximately$766,000 in 2010 due to timing of project phases as we focus on expanding theproduct line in high-end stereo headphones and expand consumers’ listeningoptions with new products.  Spending onnew product development in 2011 is anticipated to be similar to 2010levels.  In 2009, the Companyparticipated in the Consumer Electronics Show but did not participate in2010.  Disposals of equipment andleasehold improvements resulted in a loss of approximately $10,000 in 2010 and$224,000 in 2009. These decreases were partially offset by increased legal feesin support of general corporate activities and patent work.

 

***Unauthorized Transactions***

 

In2010, the unauthorized transactions totaled $10,286,988 compared to $8,498,434in 2009.

 

Afterlearning of the unauthorized transactions in December 2009, the Companyincurred net cost of $1,666,986 in the second half of fiscal 2010.  These net costs related to investigation ofthe unauthorized transactions, defense of legal actions, restatement of thefinancial statements for the years ended June 30, 2009 and 2008 and the quarterended September 30, 2009, and issuance of the quarterly reports for December31, 2009 and March 31, 2010.  This netcost was comprised of approximately $3,580,000 of legal and professional feespartially offset by approximately $1,913,000 of recoveries.  Included in recoveries is approximately$1,746,000 of insurance proceeds.

 

***Operating Loss***

 

2010had an operating loss including the unauthorized transactions of $4,955,767compared to operating loss of $340,094 in 2009.  The increasedoperating loss was primarily driven by the increased unauthorized transactions,unauthorized transaction related costs, lower gross profit of 41.6% for 2010and 44.5% for 2009 and lower sales volume. Operating income, excluding the unauthorized transactions and relatedcosts and recoveries, was $6,998,207 in 2010 or 17.2% of net sales compared to$8,158,340 or 19.6% of net sales in 2009.

 

 ***Provision for Income Tax Benefit***

 

Incometax benefit for 2010 was $1,812,417 as compared to $75,434 of income taxbenefit in 2009.  The effective income tax rate was 33.7% in 2010 and22.7% in 2009.  For 2010, the effective tax rate is driven by changesto the valuation allowance.  The mainvariance in effective tax rate for 2009 compared to the combined federal andstate statutory rate of 37% was the impact of permanent tax differences in ayear that was close to breakeven earnings.

 

**Liquidity andCapital Resources**

 

***Operating Activities***

 

Wecurrently use cash generated from operations and underlying working capital asfinancial measurements to evaluate the performance of our operations and ourability to meet our financial obligations.  We require workingcapital investment to maintain our position as a leading developer andmanufacturer of high quality stereophones. The primary drivers of these requirements are production costs,distribution costs and finished goods inventories to support our customers’requirements for short lead time.  As part of our continuousimprovement of purchasing and manufacturing processes, we continue to strivefor alignment of inventory levels with customer demand and current productionschedules.

 

During2010, cash provided by operations was $982,631, and during 2009, cash providedby operations was $2,646,146.  Workingcapital was $5,371,158 at June 30, 2010 and $6,308,239 at June 30,2009.  The net decrease 

 

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inworking capital of $937,081 from June 30, 2009 to June 30, 2010 representsprimarily the decrease in cash and cash equivalents and increases in accountspayable and accrued liabilities.  Theunauthorized transactions in 2010 were funded through cash, delays in paymentsof trade payables and borrowing on the line of credit.  Although significant progress was made sincediscovery of the unauthorized transactions in the latter part of 2010 to payoff some of these outstanding balances, accounts payable and the line of creditare still elevated above 2009 levels. The increase in accrued liabilities was driven by accrued legal fees relatedto the investigation of the unauthorized transactions and the defense ofvarious legal actions.

*** ***

***Investing Activities***

 

Cashused in investing activities for 2010 was $1,760,333 as compared to $2,345,298used in investing activities for 2009.  Cash used in investingactivities for 2010 was driven by $797,042 of capital expenditures, includingtooling to support production, and $639,788 of product software developmentexpenditures.  In 2009, capitalexpenditures for tooling and other equipment was $1,018,057 and $1,053,738 wasspent on product software development expenditures.  Budgeted capital expenditures for equipmentand product software for year 2011 are approximately $2,500,000.  The Company expects to generate sufficientfunds through operations to fund these expenditures.

 

***Financing Activities***

 

Netcash used in financing activities declined from $1,964,205 in 2009 to $595,678in 2010.  Dividends paid to stockholdersdeclined from $1,920,585 in 2009 to $1,845,678 in 2010.  The Company intends to continue to payregular quarterly dividends for the foreseeable future.  As of June 30, 2010, the Company had netborrowing of $1,250,000 on its line of credit. On August 31, 2010, the Company had net borrowing of $2,800,000 andavailability of $5,189,000.

 

Therewere no purchases of common stock in 2010 under the stock repurchaseprogram.  In 2009, the Company purchased$43,620 of common stock.  No stockoptions were exercised in 2010 or 2009.

 

***Liquidity***

 

Inaddition to capital expenditures for tooling and completion of the softwaredevelopment, the Company has interest payments on its line of credit,commitments with vendors to reduce the outstanding balance and planned normalquarterly dividend payments. The Company believes that cash generated fromoperations, together with borrowings available under its credit facility,provide it with adequate liquidity to meet operating requirements, debt servicerequirements, accounts payable reduction, planned capital expenditures, anddividend payments.  The long-term outlook for the business remains positive,however, the Company continually reevaluates new product offerings, inventorylevels and capital expenditures to ensure that it is effectively allocatingresources in line with current market conditions.

 

***Credit Facilities***

 

On May 12, 2010, the Companyentered into a new secured credit facility with JPMorgan Chase Bank, N.A. (“Lender”).  The Credit Agreement dated May 12, 2010between the Company and the Lender (“Credit Agreement”) provides for an$8,000,000 revolving secured credit facility and for letters of credit for thebenefit of the Company of up to a sublimit of $2,000,000.  The Credit Agreement expires on July 31,2013.  The Company and the Lender alsoentered into the Pledge and Security Agreement dated May 12, 2010 under whichthe Company granted the Lender a security interest in substantially all of theCompany’s assets in connection with the Company’s obligations under the CreditAgreement.  The balance on this facilitywas $1,250,000 as of June 30, 2010.

 

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***Stock Repurchase Program***

 

InApril 1995, the Board of Directors approved a stock repurchase programauthorizing the Company to purchase from time to time up to $2,000,000 of itscommon stock for its own account. Subsequently, the Board of Directors periodically has approved increasesof between $1,000,000 to $5,000,000 in the stock repurchase program.  As of June 30, 2010, the most recentlyapproved increase was for additional purchases of $2,000,000, which occurred inOctober 2006, for an aggregate maximum of $45,500,000, of which $43,360,247 hadbeen expended through June 30, 2010. The Company intends to effect all stock purchases either on the openmarket or through privately negotiated transactions and intends to finance allstock purchases through its own cash flow or by borrowing for such purchases.

 

Therewere no stock repurchases under the program in 2010.  During 2009, the Company purchased 7,996shares of its common stock at an average net price of $5.46 per share, for atotal purchase price of $43,620.  As ofJune 30, 2010, the Board of Directors has authorized the repurchase by theCompany of up to $2,139,753 in Company common stock at the discretion of theChief Executive Officer of the Company. Future stock purchases under this program are dependent on management’sassessment of value versus market price.

 

***Off-Balance Sheet Arrangements***

 

TheCompany has no off-balance sheet arrangements other than the lease for thefacility in Milwaukee, Wisconsin, which it leases from its Chairman.  On August 15, 2007, the lease wasrenewed for a period of five years, ending June 30, 2013, and is being accountedfor as an operating lease.  The lease extensionmaintained the rent at a fixed rate of $380,000 per year.  The Company is responsible for all propertymaintenance, insurance, taxes and other normal expenses related to ownership.  The facility is in good repair and, in theopinion of management, is suitable and adequate for the Company’s businesspurposes.

 

**CriticalAccounting Policies**

 

Ourdiscussion and analysis of financial condition and results of operations isbased upon our Consolidated Financial Statements, which have been prepared inaccordance with accounting principles generally accepted in the UnitedStates.  The preparation of these Consolidated Financial Statementsrequires us to make estimates and judgments that affect the reported amounts ofassets, liabilities, revenues and expenses, and related disclosure ofcontingent assets and liabilities.  We continually evaluate ourestimates and judgments, including those related to doubtful accounts, productreturns, excess inventories, warranties, impairment of long-lived assets,deferred compensation, income taxes and other contingencies.  We baseour estimates on historical experience and assumptions that we believe to bereasonable under the circumstances.  Actual results may differ fromthese estimates.

 

***Revenue Recognition***

 

The Company recognizes revenue when all of thefollowing criteria are met: persuasive evidence of an arrangement exists;delivery has occurred; the seller’s price to the buyer is fixed anddeterminable; and collectibility is reasonably assured.  When these criteria are generally satisfied,the Company recognizes revenue.  TheCompany also offers certain customers the right to return products that do notmeet the standards agreed with the customer. The Company continuously monitors such product returns, and while suchreturns have historically been minimal, the Company cannot guarantee that theywill continue to experience the same return rates that they have experienced inthe past.  Any significant increase inproduct quality failure rates and the resulting credit returns could have amaterial adverse impact on the Company’s operating results for the period orperiods in which such returns materialize.

 

The Company provides for certain salesincentives.  The Company records aprovision for estimated incentives based upon the incentives offered tocustomers on product related sales in the same period as the related revenuesare recorded.  The provision is recordedas a reduction of sales.  The Companyalso records a provision for estimated sales returns and allowances on productrelated sales in the same period as the related revenues are 

 

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recorded.  These estimates are based on historical salesreturns, analysis of credit memo data and other known factors.  If the historical data the Company uses tocalculate these estimates does not properly reflect future returns, adjustmentsmay be required in future periods.

 

***Accounts Receivable***

 

TheCompany performs ongoing credit evaluations of its customers and adjusts creditlimits based upon payment history and the customer’s current credit worthiness,as determined by the review of the customer’s current credit information.  The Company continuously monitors collectionsand payments from customers and maintains a provision for estimated creditlosses based upon the Company’s historical experience and any specific customercollection issues that have been identified. The Company values accounts receivable net of an allowance for doubtfulaccounts.  The allowance is calculatedbased upon the Company’s evaluation of specific customer accounts where theCompany has information that the customer may have an inability to meet itsfinancial obligations.  In these cases,the Company uses its judgment, based on the best available facts andcircumstances and records a specific reserve for that customer against amountsdue to reduce the receivable to the amount that is expected to becollected.  These specific reserves arere-evaluated and adjusted as additional information is received that impactsthe amount reserved.  However, theultimate collectability of the unsecured receivable is dependent upon thefinancial condition of an individual customer, which could change rapidly andwithout warning.

 

***Inventories***

 

TheCompany values its inventories at the lower of cost or market.  Cost is determined using the last-in,first-out (“LIFO”) method.  As ofJune 30, 2010, 100% of the Company’s inventory was valued using LIFO.  Valuing inventories at the lower of cost or marketrequires the use of estimates and judgment. The Company continues to use the same techniques to value inventory ashave been used in the past.  Ourcustomers may cancel their orders or change purchase volumes.  This, or certain additional actions, couldcreate excess inventory levels, which would impact the valuation of ourinventories.  Any actions taken by ourcustomers that could impact the value of our inventory are considered whendetermining the lower of cost or market valuations.  The Company regularly reviews inventoryquantities on hand and records a provision for excess and obsolete inventorybased primarily on historical usage and production requirements.  If the Company is not able to achieve its expectationsof the net realizable value of the inventory at its current value, the Companywould have to adjust its reserves accordingly.

 

***Product Software Development Costs***

 

Productsoftware development costs consist of costs incurred by outside parties for thedevelopment of software used to support new products.  These assets have been evaluated to ensurethat the capitalized costs do not exceed the estimated net realizable value ofthe related products.  As part of the impairment analysis, we use adiscounted cash flow model based on estimated sales to be derived in the futureuse of the asset and other estimated costs directly related to theproduct.   No amortization was recorded in 2010 or 2009 as therelated products have not yet been introduced. The Company expects the products to be introduced during fiscal year2011.

 

Thediscounted cash flow model involves many assumptions, including operatingresults forecasts and discount rates.  Inherent in the operatingresults forecasts are certain assumptions regarding revenue growth rates,projected cost saving initiatives and projected long-term growthrates.  The Company performed impairment testing as of June 30, 2010and 2009 and no impairment was identified.

 

***Product Warranty Obligations***

 

Productssold are generally covered by a lifetime warranty.  We record accruals for potential warrantyclaims based on prior product returns experience.  Warranty costs areaccrued at the time revenue is recognized.  These warranty costs arebased upon management’s assessment of past claims and current experience.  However,actual claims could be higher or lower than amounts estimated, as the amountand value of warranty claims are subject to variation as a result of manyfactors that cannot be predicted with certainty.

 

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***Income Taxes***

 

Weestimate the effective tax rate expected to be applicable for the full fiscalyear.  If the actual results are different from these estimates, adjustmentsto the effective tax rate may be required in the period such determination ismade.  Additionally, discrete items are treated separately from theeffective rate analysis and are recorded separately as an income tax provisionor benefit at the time they are recognized.

 

Deferredincome taxes are accounted for under the asset and liability method wherebydeferred income tax assets and liabilities are recognized for the future taxconsequences attributable to differences between the financial statementcarrying amounts of existing assets and liabilities and their respective taxbases.  Deferred income tax assets and liabilities are measured usingstatutory tax rates.  Deferred income tax provisions are based onchanges in the deferred tax assets and liabilities from period to period.  Additionally, we analyze our ability torecognize the net deferred income tax assets created in each jurisdiction inwhich we operate to determine if valuation allowances are necessary based onthe “more likely than not” criteria.

 

**NewAccounting Pronouncements**

 

Applicablenew accounting pronouncements are set forth under Item 15 of this annual reportand are incorporated herein by reference.

 

**ITEM 8.                  FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA.**

 

See the Consolidated FinancialStatements attached hereto.

 

**ITEM 9.**                  **CHANGES AND DISAGREEMENTS WITH AUDITORS ON ACCOUNTINGAND FINANCIAL DISCLOSURE**

 

None.

 

**ITEM 9A.               CONTROLSAND PROCEDURES.**

 

**DisclosureControls and Procedures****.**

 

Disclosure controls andprocedures (as defined in Rules 13(a)-15(e) and 15(d)-15(e)) ofthe Securities Exchange Act of 1934, as amended (the “Exchange Act”) aredesigned to ensure that (1) information required to be disclosed in reportsfiled or submitted under the Exchange Act is recorded, processed, summarizedand reported within the time periods specified in SEC rules and forms; and (2)that such information is accumulated and communicated to management, includingthe principal executive officer and principal financial officer, to allowtimely decisions regarding required disclosures.  There are inherent limitations to theeffectiveness of any system of disclosure controls and procedures, includingthe possibility of human error, the circumvention or overriding of controls andprocedures and collusion to circumvent and conceal the overriding of controlsand procedures.  Accordingly, eveneffective disclosure controls and procedures can only provide reasonableassurance of achieving their control objectives.

 

The Company’s management,including the Company’s Chief Executive Officer and Chief Financial Officer,evaluated the effectiveness of the design and operation of the Company’sdisclosure controls and procedures as of June 30, 2010.  As discussed in “Changes in Internal Controls”below, the Company recently implemented remedial measures in response to thepreviously disclosed unauthorized transactions. Although the Company’smanagement believes that these remedial measures have addressed the weaknessesin the Company’s disclosure controls and procedures, the Company must allow asufficient amount of time to elapse to permit testing of these controls inorder to confirm their effectiveness. Subject to this testing and confirmation process, management believesthat the Company’s disclosure controls and procedures will be deemed effective.

 

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The Company’s management,including the Company’s Chief Executive Officer and Chief Financial Officer,continues to evaluate the effectiveness of the Company’s disclosure controlsand procedures to identify any additional enhancements that may provide greatercomfort that the Company’s disclosure controls and procedures are effective toprovide reasonable assurance that information required to be disclosed by theCompany in the reports that it files or submits under the Exchange Act isaccumulated and communicated to the Company’s management, including its ChiefExecutive Officer and Chief Financial Officer, as appropriate to allow timelydecisions regarding required disclosure and are effective to provide reasonableassurance that such information is recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and forms.

 

**Management’sAnnual Report on Internal Controls over Financial Reporting***.*

 

The Company’s management,including its Chief Executive Officer and Chief Financial Officer, isresponsible for establishing and maintaining adequate internal control offinancial reporting (as defined in Exchange Act Rules 13(a)-15(f) and15(d)-15(f)) and designing such internal controls to provide reasonableassurances regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with accountingprinciples generally accepted in the United States of America.  Because of inherent limitations, a system ofinternal control over financial reporting may not prevent or detectmisstatements.  Also, projections of anyevaluation of effectiveness to future periods are subject to the risk thatcontrols may become inadequate due to change in conditions, or that the degreeof compliance with the policies or procedures may deteriorate.

 

Management conducted itsevaluation of the effectiveness of its internal control over financialreporting based on the framework in “Internal Control-Integrated Framework”issued by the Committee of Sponsoring Organizations of the Treadway Commission(“COSO”).  Based on this assessment, theCompany’s management, including its Chief Executive Officer and Chief FinancialOfficer, has concluded that the Company’s internal controls and operatingprocedures were circumvented during the fiscal year and the circumvention wasconcealed from management as previously described in the Form 10-K/A for June30, 2009.  The Company has alreadyimplemented the internal control improvements described in Changes in InternalControls below, and the Company is planning to implement a new computer systemtowards the end of fiscal year 2011 that will further enhance the segregationof duties within information technology. Based on the criteria set forth by COSO in “Internal Control-IntegratedFramework,” although the Company’s management believes that these enhancementsand remedial measures have addressed the weaknesses in the Company’s disclosurecontrols and procedures, the Company must allow a sufficient amount of time toelapse to permit testing of these controls in order to confirm their effectiveness.  Subject to this testing and confirmationprocess, management believes that the Company’s disclosure controls andprocedures will be deemed effective.

 

Changes in Internal Controls

 

The Company has identifiedhow its controls over financial reporting were circumvented and how it isaddressing these matters below.

 

·                        *Auditor review*.  The circumvention of the Company’s internalcontrols and procedures was not detected as part of the Company’s annual auditsand quarterly reviews by its former independent auditor, Grant Thornton,LLP.  As described in Item 3 LegalProceedings, on June 24, 2010, the Company filed an action against GrantThornton, LLP and Ms. Sachdeva.

 

·                        *Wire transfers and cashier’schecks.*  Approximately $30,900,000 or98.1% of the total $31,500,000 of unauthorized transactions from fiscal year2005 through December 2009 was misappropriated by circumventing the Company’sinternal controls and other operating procedures for the payment of Companyexpenditures by using wire transfers or cashier’s checks from the Company’sbank accounts to pay for personal expenditures. Of the $30,900,000, approximately $8,500,000 was misappropriated by useof these means during 2009. Misappropriations by use of wire transfers or cashier’s checks totaled$10,300,000 during 2010.  Theseunauthorized transactions were processed by circumventing the Company’s policythat all invoices over $5,000 were required to be submitted and approved by 

 

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Michael Koss as the CEO, and all accounts payable checks generated fromthe Company’s accounts payable system were signed by the CEO.  Moreover, wire transfers were to be used onlyfor authorized transactions including certain inventory purchases and transfersof funds between the Company’s bank accounts. Wire transfers for inventory purchases and the recurring expense itemsrequired the approval by several employees including authorized VicePresidents, while the wire transfers between the Company’s bank accounts wereprocessed and approved by Ms. Sachdeva and one of the other terminatedemployees in the accounting department. Ms. Sachdeva, by herself and/or by directing other employees in theaccounting department, ordered cashier’s checks from the Company’s bankaccounts to pay for personal expenditures directly, thereby circumventing theinternal controls and procedures as described above so that these paymentswould not be submitted through the Company’s normal accounts payablesystem.  Ms. Sachdeva, by herself and/orby directing others in the accounting department, processed wire transfers fromthe Company’s bank accounts to pay for personal expenditures directly, therebycircumventing the internal controls and procedures as described above so thatthese payments would not be submitted through the Company’s normal accountspayable system.  This has been remediatedby: (1) disallowing the use of any cashier’s checks; (2) enforcing that allwire transfers are initiated within the financial function and electronicallyapproved by the CEO; and (3) performing an enhanced review, reconciliation andreporting of cash activities.

 

·                        *Petty cash, manual checks andtraveler’s checks*.  Theremaining misappropriations of approximately $600,000 or 1.9% from the totalamount of $31,500,000 from fiscal year 2005 through December 2009 were carriedout by circumventing the Company’s internal controls and other standardoperating procedures involving the Company’s petty cash system, manual checksystem and policy for using traveler’s checks. In doing so, the Company’s policy requiring that all expense reports besubmitted and approved by the CEO was circumvented.  Out of the estimated $600,000 of these typesof transactions, approximately $91,000 occurred during 2009.  Approximately $107,000 of misappropriationsinvolving the use of the Company’s petty cash system, manual check system andtraveler’s checks policy occurred during 2010. Remediation of these issues has been accomplished by: (1) eliminatingthe petty cash fund so all reimbursements run through normal controlledaccounts payable channels; (2) eliminating the use of manual checks so allcheck disbursements are generated from the Company’s accounts payable systemcheck run; and (3) eliminating the use of traveler’s checks.

 

·                        *Recording of unauthorizedtransactions.*  Ms. Sachdevaand one of the other terminated employees concealed the unauthorizedtransactions by recording numerous erroneous accounting entries in variousaccounts to hide the true nature of the transactions.  The Company has improved the controls andprocedures related to journal entries and account reconciliations to includeimproved segregation of duties, review and approval of reconciliations, andapproval of all manual journal entries.

 

·                        *Performance and review of accountreconciliations. *The Company’sinternal controls and procedures included the performance and review of keyaccount reconciliations, including cash, by the accounting department employeesincluding Ms. Sachdeva, who collectively had over 50 years of experience at theCompany.  Ms. Sachdeva and one of theother terminated employees further concealed the unauthorized transactions byfailing to properly perform and review these key account reconciliations on aregular basis, and failing to properly perform the Company’s period endfinancial close and reporting processes that were designed to accurately reportthe Company’s financial information.  Theaccount reconciliation process has been improved and includes propersegregation of duties as well as review and approval by another person in thefinancial function.

 

·                        *Corporate standards andwhistleblower policy.*  Thethree terminated employees, including Ms. Sachdeva, failed to comply with theCompany’s established standards of integrity, ethical values and its Code ofConduct, Code of Ethics and Whistleblower policy.  The Company has taken steps to reinforcethese policies with all of its employees, officers and directors.

 

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·                        *Application of GAAP.*  The terminated employees, including Ms.Sachdeva, as the principal accounting officer in charge of financial reportingfailed to properly apply the Company’s established accounting policies andadherence with GAAP.  As a result, certainestablished accounting policies were not applied correctly and resulted ininaccuracies, both from the fraudulent activity directed by Ms. Sachdeva andthe misapplication of GAAP.  The affectedaccounts include equipment and leasehold improvements, cash surrender value oflife insurance, accrued deferred compensation, accrued product warrantyobligations and income taxes payable.  Aspart of the restatement of the consolidated financial statements, the accountswere reviewed in detail and reconciled.  Integralto the reconciliation process was a review of all critical accountingestimates.

 

·                        *Information Technology.*  The Company’s internal controls andprocedures relating to the Company’s computer system for processing financialtransactions were manipulated to conceal the unauthorized transactions.  The Company expects to implement a newcomputer system that will be used to improve its processing of financialtransactions and overall segregation of duties towards the end of fiscal 2011.

 

We believe the changes toour system of internal controls resulting from these efforts have enhanced theCompany’s control over financial reporting. We continue to diligently and vigorously review our financial andreporting controls and procedures.  As wecontinue to evaluate and work to improve our internal control over financialreporting, we may take additional measures to address any additional controldeficiencies we may identify.

 

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** **

**PART IV**

 

**ITEM 15.EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.**

 

The following documents arefiled as part of this report:

 

1.                                       ConsolidatedFinancial Statements

 
| Report  of Independent Registered Public Accounting Firm                                               | 25 |
|--------------------------------------------------------------------------------------------------------|----|
| Consolidated  Statements of Operations for the Years Ended June 30, 2010 and 2009                 | 26 |
| Consolidated  Balance Sheets as of June 30, 2010 and 2009                                         | 27 |
| Consolidated  Statements of Cash Flows for the Years Ended June 30, 2010 and 2009                 | 28 |
| Consolidated  Statements of Stockholders’ Equity for the Years Ended June 30, 2010 and  2009 | 29 |
| Notes to Consolidated Financial Statements                                                             | 30 |

 

2.                                       FinancialStatement Schedules

 

All schedules have beenomitted because the information is not applicable, is not material or becausethe information required is included in the consolidated financial statementsor the notes thereto.

 

3.                                       Exhibits Filed

 

SeeExhibit Index attached hereto.

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

 

Tothe Board of Directors

KossCorporation

Milwaukee,Wisconsin

 

Wehave audited the accompanying consolidated balance sheets of Koss Corporationand Subsidiary (the “Company”) as of June 30, 2010 and 2009, the relatedconsolidated statements of operations, stockholders’ equity and cash flows forthe years then ended. These consolidated financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audits.

 

Weconducted our audits in accordance with the standards of the Public CompanyAccounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the consolidated financial statements arefree of material misstatement.  TheCompany is not required to have, nor were we engaged to perform, an audit ofits internal control over financial reporting. Our audits included consideration of its internal control over financialreporting as a basis for designing audit procedures that are appropriate in thecircumstances, but not for the purpose of expressing an opinion on theeffectiveness of the Company’s internal control over financial reporting.  Accordingly, we express no such opinion.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the consolidated financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement as well as evaluating the overall consolidated financial statementpresentation.  We believe that our auditsprovide a reasonable basis for our opinion.

 

Inour opinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of Koss Corporationand Subsidiary as of June 30, 2010 and 2009 and the results of their operationsand their cash flows for the years then ended, in conformity with U.S.generally accepted accounting principles.

 

Asdiscussed in Note 16 to the consolidated financial statements, the Company hasbeen named in several legal matters.  Inaddition, the Company has also initiated certain legal actions against thirdparties.

 

/s/Baker Tilly Virchow Krause, LLP

 

Milwaukee,Wisconsin

September20, 2010

 

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KOSS CORPORATION ANDSUBSIDIARY

CONSOLIDATED STATEMENTS OFOPERATIONS

 
| **Years Ended June 30,**                     | ** ** | **2010**   | ** **       | **2009**   | ** ** |
|-------------------------------------------------------------|------------|------------|------------------|------------|------------|
|                                                        |       |       |             |       |       |
| Net sales                                                   |       | $          |  40,598,722 |       | $          |  41,717,114 |   |
| Cost of goods sold                                          |       | 23,730,311 |             | 23,168,422 |       |
| Gross profit                                                |       | 16,868,411 |             | 18,548,692 |       |
|                                                        |       |       |             |       |       |
| Operating Expenses:                                         |       |       |             |       |       |
| Selling, general and administrative expenses                |       | 9,870,204  |             | 10,390,352 |       |
| Unauthorized transactions                                   |       | 10,286,988 |             | 8,498,434  |       |
| Unauthorized transaction related costs and  recoveries, net |       | 1,666,986  |             | —     |       |
| Total Operating Expenses                                    |       | 21,824,178 |             | 18,888,786 |       |
|                                                        |       |       |             |       |       |
| Loss from operations                                        |       | (4,955,767 | )                | (340,094   | )          |
|                                                        |       |       |             |       |       |
| Other Income (Expense):                                     |       |       |             |       |       |
| Royalty income                                              |       | —     |             | 208,750    |       |
| Interest income                                             |       | 263        |             | 15,503     |       |
| Interest expense                                            |       | (429,138   | )                | (216,751   | )          |
| Total Other Income (Expense), net                           |       | (428,875   | )                | 7,502      |       |
| *** ***                                                |       |       |             |       |       |
| Loss before income tax benefit                              |       | (5,384,642 | )                | (332,592   | )          |
|                                                        |       |       |             |       |       |
| Income tax benefit                                          |       | (1,812,417 | )                | (75,434    | )          |
|                                                        |       |       |             |       |       |
| Net loss                                                    |       | $          |  (3,572,225 | )          | $          |  (257,158 | ) |
|                                                        |       |       |             |       |       |
| Loss per common share:                                      |       |       |             |       |       |
| Basic                                                       |       | $          |  (0.48      | )          | $          |  (0.03 | ) |
| Diluted                                                     |       | $          |  (0.48      | )          | $          |  (0.03 | ) |
|                                                        |       |       |             |       |       |
| Dividends declared per common share                         |       | $          |  0.245      |       | $          |  0.260 |   |

 

The accompanying notes arean integral part of these consolidated financial statements.

 

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KOSS CORPORATION ANDSUBSIDIARY

CONSOLIDATED BALANCE SHEETS

 
| **As of June 30,**                                                                      | ** ** | **2010**   | ** ** | **2009**   | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
| ASSETS                                                                                                 |       |       |       |       |       |
| Current Assets:                                                                                        |       |       |       |       |       |
| Cash and cash equivalents                                                                              |       | $          | 125,496    |       | $          | 1,498,876 |   |
| Accounts receivable, less allowance for doubtful  accounts of $757,535 and $1,588,923, respectively    |       | 4,213,327  |       | 4,660,727  |       |
| Inventories                                                                                            |       | 8,457,325  |       | 8,708,835  |       |
| Prepaid expenses                                                                                       |       | 254,658    |       | 151,337    |       |
| Income taxes receivable                                                                                |       | 928,550    |       | —     |       |
| Deferred income taxes                                                                                  |       | 1,144,086  |       | 1,385,497  |       |
| Total Current Assets                                                                                   |       | 15,123,442 |       | 16,405,272 |       |
|                                                                                                   |       |       |       |       |       |
| Equipment and leasehold improvements, net                                                              |       | 2,392,772  |       | 2,240,572  |       |
|                                                                                                   |       |       |       |       |       |
| Other Assets:                                                                                          |       |       |       |       |       |
| Product software development costs                                                                     |       | 2,366,828  |       | 1,727,040  |       |
| Deferred income taxes                                                                                  |       | 2,527,764  |       | 6,311,282  |       |
| Cash surrender value of life insurance                                                                 |       | 3,339,485  |       | 2,917,223  |       |
| Other assets                                                                                           |       | —     |       | 25,000     |       |
| Total Other Assets                                                                                     |       | 8,234,077  |       | 10,980,545 |       |
|                                                                                                   |       |       |       |       |       |
| Total Assets                                                                                           |       | $          | 25,750,291 |       | $          | 29,626,389 |   |
|                                                                                                   |       |       |       |       |       |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                              |       |       |       |       |       |
| Current Liabilities:                                                                                   |       |       |       |       |       |
| Accounts payable                                                                                       |       | $          | 4,794,598  |       | $          | 3,122,721 |   |
| Accrued liabilities                                                                                    |       | 4,514,724  |       | 2,090,054  |       |
| Dividends payable                                                                                      |       | 442,962    |       | 479,876    |       |
| Income taxes payable                                                                                   |       | —     |       | 4,404,382  |       |
| Total Current Liabilities                                                                              |       | 9,752,284  |       | 10,097,033 |       |
|                                                                                                   |       |       |       |       |       |
| Long-Term Liabilities:                                                                                 |       |       |       |       |       |
| Line of credit                                                                                         |       | 1,250,000  |       | —     |       |
| Deferred compensation                                                                                  |       | 1,752,459  |       | 1,541,240  |       |
| Derivative liability                                                                                   |       | 125,000    |       | 125,000    |       |
| Other liabilities                                                                                      |       | 678,300    |       | 725,000    |       |
| Total Long-Term Liabilities                                                                            |       | 3,805,759  |       | 2,391,240  |       |
|                                                                                                   |       |       |       |       |       |
| Total Liabilities                                                                                      |       | 13,558,043 |       | 12,488,273 |       |
|                                                                                                   |       |       |       |       |       |
| Stockholders’ Equity:                                                                             |       |       |       |       |       |
| Common stock, $0.005 par value, authorized  20,000,000 shares; issued and outstanding 7,382,706 shares |       | 36,914     |       | 36,914     |       |
| Paid in capital                                                                                        |       | 1,492,096  |       | 1,056,975  |       |
| Retained earnings                                                                                      |       | 10,663,238 |       | 16,044,227 |       |
| Total Stockholders’ Equity                                                                        |       | 12,192,248 |       | 17,138,116 |       |
|                                                                                                   |       |       |       |       |       |
| Total Liabilities and Stockholders’ Equity                                                        |       | $          | 25,750,291 |       | $          | 29,626,389 |   |

 

The accompanying notes arean integral part of these consolidated financial statements.

 

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KOSS CORPORATION ANDSUBSIDIARY

CONSOLIDATED STATEMENTS OFCASH FLOWS

 
| **Years Ended June 30,**                                          | ** ** | **2010**   | ** ** | **2009**   | ** ** |
|----------------------------------------------------------------------------------|------------|------------|------------|------------|------------|
|                                                                             |       |       |       |       |       |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                            |       |       |       |       |       |
| Net loss                                                                         |       | $          | (3,572,225 | )          | $          | (257,158 | ) |
| Adjustments to reconcile net loss to net cash  provided by operating activities: |       |       |       |       |       |
| Provision for doubtful accounts                                                  |       | 374,961    |       | 245,537    |       |
| Loss on disposals of equipment and leasehold  improvements                       |       | 9,670      |       | 224,286    |       |
| Depreciation of equipment and leasehold  improvements                            |       | 635,172    |       | 728,054    |       |
| Stock-based compensation expense                                                 |       | 435,121    |       | 442,660    |       |
| Provision for deferred income taxes                                              |       | 4,024,929  |       | (2,755,314 | )          |
| Increase in cash surrender value of life insurance                               |       | (73,759    | )          | (58,564    | )          |
| Deferred compensation                                                            |       | 211,219    |       | 214,542    |       |
| Net changes in operating assets and liabilities  (see note 10)                   |       | (1,062,457 | )          | 3,862,103  |       |
| Net cash provided by operating activities                                        |       | 982,631    |       | 2,646,146  |       |
|                                                                             |       |       |       |       |       |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                            |       |       |       |       |       |
| Maturity of investments                                                          |       | 25,000     |       | 75,000     |       |
| Life insurance premiums paid                                                     |       | (348,503   | )          | (348,503   | )          |
| Purchases of equipment and leasehold improvements                                |       | (797,042   | )          | (1,018,057 | )          |
| Product software development expenditures                                        |       | (639,788   | )          | (1,053,738 | )          |
| Net cash used in investing activities                                            |       | (1,760,333 | )          | (2,345,298 | )          |
|                                                                             |       |       |       |       |       |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                            |       |       |       |       |       |
| Net proceeds from line of credit                                                 |       | 1,250,000  |       | —     |       |
| Dividends paid to stockholders                                                   |       | (1,845,678 | )          | (1,920,585 | )          |
| Purchase of treasury shares                                                      |       | —     |       | (43,620    | )          |
| Net cash used in financing activities                                            |       | (595,678   | )          | (1,964,205 | )          |
|                                                                             |       |       |       |       |       |
| Net decrease in cash and cash equivalents                                        |       | (1,373,380 | )          | (1,663,357 | )          |
| Cash and cash equivalents at beginning of year                                   |       | 1,498,876  |       | 3,162,233  |       |
| Cash and cash equivalents at end of year                                         |       | $          | 125,496    |       | $          | 1,498,876 |   |

 

The accompanying notes arean integral part of these consolidated financial statements.

 

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KOSS CORPORATION ANDSUBSIDIARY

CONSOLIDATED STATEMENTS OFSTOCKHOLDERS’ EQUITY

 
| ** **                                   | ** ** | **Common Stock** | ** ** | **Paid in** | ** ** | **Retained** | ** ** | ** **   | ** ** |
|----------------------------------------------|------------|-----------------------|------------|------------------|------------|--------------|------------|--------------|------------|
| ** **                                   | ** ** | **Shares**            | ** ** | **Amount**       | ** ** | **Capital**  | ** ** | **Earnings** | ** ** | **Total** | ** ** |
| Balance, July 1, 2008                        |       | 7,390,702             |       | $                | 36,954     |         | $          | 657,895      |       | $ | 18,221,451 |   | $ | 18,916,300 |   |
| Net loss                                     |       | —                |       | —           |       | —       |       | (257,158     | )          | (257,158 | ) |
| Dividends declared                           |       | —                |       | —           |       | —       |       | (1,920,066   | )          | (1,920,066 | ) |
| Stock-based compensation expense             |       | —                |       | —           |       | 442,660      |       | —       |       | 442,660 |   |
| Purchase and cancellation of treasury shares |       | (7,996                | )          | (40              | )          | (43,580      | )          | —       |       | (43,620 | ) |
| Balance, June 30, 2009                  |       | 7,382,706             |       | 36,914           |       | 1,056,975    |       | 16,044,227   |       | 17,138,116 |   |
| Net loss                                     |       | —                |       | —           |       | —       |       | (3,572,225   | )          | (3,572,225 | ) |
| Dividends declared                           |       | —                |       | —           |       | —       |       | (1,808,764   | )          | (1,808,764 | ) |
| Stock-based compensation expense             |       | —                |       | —           |       | 435,121      |       | —       |       | 435,121 |   |
| Balance, June 30, 2010                       |       | 7,382,706             |       | $                | 36,914     |         | $          | 1,492,096    |       | $ | 10,663,238 |   | $ | 12,192,248 |   |

 

The accompanying notes arean integral part of these consolidated financial statements.

 

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KOSS CORPORATION ANDSUBSIDIARY

NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS

 

1.                                      ACCOUNTINGPOLICIES

 

NATURE OF BUSINESS — KossCorporation (“Koss”) and its wholly-owned subsidiary (collectively the “Company”),a Delaware Corporation, reports its finances as a single reporting segment, asthe Company’s principal business line is the design, manufacture and sale ofstereo headphones and related accessories. The Company leases its plant and office in Milwaukee, Wisconsin.  In addition, the Company has more than 250domestic dealers and its products are carried by approximately 17,000 domesticretailers and numerous retailers worldwide. International markets are served by domestic sales representatives and asales office in Switzerland which utilizes independent distributors in severalforeign countries.  The Company has onesubsidiary, Koss Classics Ltd. (“Koss Classics”).

 

BASIS OF CONSOLIDATION — Theconsolidated financial statements include the accounts of Koss and itssubsidiary, Koss Classics, which is a wholly-owned subsidiary.  All significant intercompany accounts andtransactions have been eliminated.

 

STOCKSPLIT —  On September 10, 2009, NASDAQnotified the Company that it no longer met the minimum 750,000 publicly heldshares requirement under Listing Rule 5450(b)(1)(B). The Company remedied itsnoncompliance with Listing Rule 5450(b)(1)(B) by implementing a two-for-oneforward stock split on December 1, 2009. All share and per-share datahave been adjusted retroactively to give effect to the stock split.

 

CONCENTRATION OF CREDIT RISK— The Company operates in the audio/video industry segment of the homeentertainment industry through its design, manufacture and sale of stereoheadphones and related accessory products. The Company’s products are sold through national retailers,international distributors, audio specialty stores, the Internet, direct mailcatalogs, regional department store chains and military exchanges under the “Koss”name and dual label.  The Company grantsunsecured credit to its domestic and international customers based on theextension of credit from 30 to 120 days, depending on the customer.  Collection is dependent on the retailing industryeconomy.  The vast majority ofinternational customers, outside of Canada, are sold on a cash againstdocuments or cash in advance basis. Approximately 20% and 14% of the Company’s accounts receivable atJune 30, 2010 and 2009, respectively, were foreign receivables denominatedin U.S. dollars.

 

REVENUE RECOGNITION —Revenue is recognized by the Company when all of the following criteria aremet:  persuasive evidence of anarrangement exists; delivery has occurred; the seller’s price to the buyer is fixedand determinable; and collectibility is reasonably assured.  These criteria are generally satisfied uponshipment of the Company’s products.  TheCompany may periodically offer slotting fees, cooperative advertising programs,rebates and sales discounts and the estimated costs for these items are accruedfor at the time revenue is recognized. These amounts are recorded as a reduction to sales.

 

ROYALTY INCOME — The Companyrecognizes royalty income when earned under the terms of its license agreements.  Historically, royalty payments werecalculated based upon predetermined percentages of net sales of the licensedproducts or based upon minimum quarterly royalty payments, as set forth in theCompany’s license agreements.  Royaltyincome is booked monthly, on an accrual basis, and the amount that the Companyaccrues is the monthly equivalent of the minimum royalty payment.  When the royalty payments are received eachquarter, the Company then applies the payment to accounts receivableaccordingly.  In 2009, the Company hadone license agreement that terminated in the fourth quarter of 2009.  As of June 30, 2010 the Company had nolicense agreements in effect that would provide for royalty income.

 

SHIPPING AND HANDLING FEESAND COSTS — Shipping and handling fees are included in cost of goods soldwithin the accompanying consolidated statements of operations.

 

RESEARCH AND DEVELOPMENT —Research and development activities charged to operations amounted toapproximately $766,000, in 2010 and $1,559,000 in 2009.

 

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ADVERTISING COSTS —Advertising costs included within selling, general and administrative expensesin the accompanying consolidated statements of operations were approximately$57,000 in 2010 and $130,000 in 2009. Such costs are expensed as incurred.

 

INCOMETAXES — The Company operates as a C Corporation under the Internal Revenue Codeof 1986, as amended (the “Code”). Amounts provided for income tax expense are based on income reported forfinancial statement purposes and do not necessarily represent amounts currentlypayable under tax laws. Deferred income tax assets and liabilities are computedannually for differences between the financial statement and tax bases ofassets and liabilities that will result in taxable or deductible amounts in thefuture based on enacted tax laws and rates applicable to the periods in whichthe differences are expected to affect taxable income. As changes in tax lawsor rates are enacted, deferred income tax assets and liabilities are adjustedthrough the provision for income taxes. The differences relate principally todifferent methods used for depreciation for income tax purposes, net operatinglosses, capitalization requirements of the Code, allowances for doubtfulaccounts and inventory valuation methods, unauthorized transactions, warrantyreserves, and other income tax related carryforwards. Valuation allowances areestablished when necessary to reduce deferred income tax assets to the amountexpected to be realized.

 

EARNINGS (LOSS) PER COMMON SHARE — Earnings (loss) per common share iscalculated under the provisions of Topic 260 in the Accounting Standards Codificationwhich provides for calculation of “basic” and “diluted” earnings pershare.  Basic earnings (loss) per commonshare includes no dilution and is computed by dividing net income (loss) by theweighted average common shares outstanding for the period.  Diluted earnings (loss) per common sharereflect the potential dilution of securities that could share in the earningsof an entity.

 

CASH AND CASH EQUIVALENTS —The Company considers depository accounts and investments with a maturity atthe date of acquisition and expected usage of three months or less to be cashand cash equivalents.  The Companymaintains its cash on deposit at commercial banks located in the United Statesof America.  The Company periodically hascash balances in excess of insured amounts. The Company has not experienced and does not expect to incur any losseson these deposits.

 

ACCOUNTS RECEIVABLE —Accounts receivable consists of unsecured trade receivables due fromcustomers.  The Company performs creditevaluations of its customers and does not require collateral to establish anaccount receivable.  The Companyevaluates collectibility of accounts receivable based on a number offactors.  Accounts receivable areconsidered to be past due if unpaid one day after their due date.  An allowance for doubtful accounts isrecorded for significant past due receivable balances based on a review of thepast due item, general economic conditions and the industry as a whole.  The Company writes off accounts receivablewhen they become uncollectible.  Therewere no recoveries of previously written-off accounts receivable during 2010 or2009.  Changes in the allowance fordoubtful accounts are as follows:

 
| **Year Ended June 30,** | ** ** | **Balance,  Beginning  of Year** | ** ** | **Provision  Charged to  Expense** | ** ** | **Amounts  Written-off ** | ** ** | **Balance at  End Year** | ** ** |
|----------------------------------------|------------|---------------------------------------|------------|-----------------------------------------|------------|--------------------------------|------------|------------------------------------|------------|
| 2010                                   |       | $                                     | 1,588,923  |                                    | 374,961    |                           | (1,206,349 | )                                  | $          | 757,535 |   |
| 2009                                   |       | $                                     | 1,343,386  |                                    | 245,537    |                           | —     |                               | $          | 1,588,923 |   |

 

INVENTORIES — As ofJune 30, 2010 and 2009, 100% of the Company’s inventory was valued at thelower of last-in, first-out (“LIFO”) cost or market.  If the first-in, first-out (“FIFO”) method ofinventory accounting had been used by the Company for inventories valued atLIFO, inventories would have been $793,972 and $776,307 higher than reported atJune 30, 2010 and 2009, respectively. The Company did not maintain any work-in-process inventories atJune 30, 2010 and 2009.

 

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The components ofinventories at June 30 are as follows:

 
| ** **     | ** ** | **2010**  | ** ** | **2009**  | ** ** |
|----------------|------------|-----------|------------|-----------|------------|
| Raw materials  |       | $         | 2,407,715  |      | $          | 2,019,919 |   |
| Finished goods |       | 6,049,610 |       | 6,688,916 |       |
|           |       | $         | 8,457,325  |      | $          | 8,708,835 |   |

 

EQUIPMENTAND LEASEHOLD IMPROVEMENTS — Equipment and leasehold improvements are stated atcost.  Depreciation and amortization isprovided using the straight-line method over the estimated useful lives of therespective assets.  Leaseholdimprovements are amortized using the straight-line method over the shorter ofthe lease term or the estimated useful life of the asset.  Major expenditures for property and equipmentand significant renewals are capitalized. Maintenance, repairs and minor renewals are expensed as incurred.  When assets are retired or otherwise disposedof, their costs and related accumulated depreciation and amortization areremoved from the accounts and any resulting gains or losses are included inoperations.

 

PRODUCT SOFTWARE DEVELOPMENT COSTS — The Companyfollows the guidance of ASC 985-20 “Costs of Software to be Sold, Leased, orMarketed” when capitalizing development costs associated with software to beincorporated into its products.  The costof purchased software technology is capitalized and stated at the lower ofunamortized cost or expected net realizable value.  Software is subject to rapid technologicalobsolescence and future revenue estimates supporting the capitalized softwarecost can be negatively affected based upon competitive products, services andpricing.  Such adverse developments couldreduce the estimated net realizable value of our product software developmentcosts and could result in impairment or a shorter estimated life.  Such events would require us to take a chargein the period in which the event occurs or to increase the amortization expensein future periods and would have a negative effect on our results ofoperations. At a minimum, we review for impairments each balance sheetdate.  The Company expects to launch therelated products and begin amortization in 2011.

 

LIFEINSURANCE POLICIES — The Company carries its cash surrender value of lifeinsurance at values stated by the insurance carriers, reduced by the value ofoutstanding policy loans made to the insured, or at the amount the Companywould receive in the case of split-dollar arrangements.  Increases in cash surrender value areincluded in other income in theConsolidated Statements of Operations. The carrying value of cash surrender value of life insurance has beenreduced by $61,157 of policy loans at June 30, 2010 and 2009.

 

INVESTMENTS — Included in “OtherAssets” at June 30, 2009 is $25,000 of Israel government bonds which matured inJuly 2009.  Securities areclassified as held-to-maturity when the Company has the positive intent andability to hold the securities to maturity. Held-to-maturity securities are stated at cost, adjusted foramortization of premiums and discounts to maturity.

 

PRODUCT WARRANTY OBLIGATIONS — Estimated future warranty costs related toproducts are charged to cost of goods sold during the period the relatedrevenue is recognized. The product warranty liability reflects the Company’sbest estimate of probable obligations under those warranties. As of June 30,2010 and 2009, the Company has recorded a warranty reserve of $1,017,450 and$1,087,000, respectively.  (See Note 11)

 

DEFERRED COMPENSATION — The Company’s deferredcompensation liabilities are for a current and former officer and arecalculated based on compensation, years of service and mortality tables.  The related expense is included in selling,general and administrative expenses in the Consolidated Statements ofOperations.

 

FAIR VALUE OF FINANCIALINSTRUMENTS — Cash and cash equivalents, accounts receivable and accountspayable approximate fair value based on the short maturity of these instruments.

 

IMPAIRMENTOF LONG-LIVED ASSETS — The Company evaluates the recoverability of the carryingamount of long-lived assets whenever events or changes in circumstancesindicate that the carrying amount of an asset may not be fullyrecoverable.  The Company evaluates therecoverability of equipment and leasehold improvements and product softwaredevelopment costs annually or more frequently if events or circumstances 

 

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indicatethat an asset might be impaired.  If anasset is considered to be impaired, the impairment to be recognized is measuredas the amount by which the carrying amount of the asset exceeds its fairvalue.  Assets to be disposed of arereported at the lower of the carrying amount or fair value less cost tosell.  Management determines fair valueusing discounted future cash flow analysis or other accepted valuationtechniques.  Management believes thatthere has not been any impairment of the Company’s long-lived assets as of June30, 2010 and 2009.

 

LEGALCOSTS — All legal costs related to litigation are charged to operations asincurred except settlements, which are expensed when a claim is probable andcan be estimated.  Recoveries of legalcosts are recorded when the amount and items to be paid are confirmed by theinsurance company.

 

STOCK-BASED COMPENSATION —The Company has a stock-based employee compensation plan, which is describedmore fully in Note 6.  The Companyaccounts for stock-based compensation in accordance with ASC 718.  Under the fair value recognition provisionsof this statement, share-based compensation cost is measured at the grant datebased on the fair value of the award and is recognized as expense over thevesting period.  Determining the fairvalue of share-based awards at the grant date requires judgment, includingestimating future volatility of the Company’s stock, the amount of share-basedawards that are expected to be forfeited and the expected term of awardsgranted.  The Company estimates the fairvalue of stock options granted using the Black-Scholes option valuationmodel.  The fair value of all awards isamortized on a straight-line basis over the vesting periods.  The expected term of awards granted representthe period of time they are expected to be outstanding.  The Company determines the expected termbased on historical experience with similar awards, giving consideration to thecontractual terms and vesting schedules. The Company estimates the expected volatility of its common stock at thedate of grant based on the historical volatility of its common stock.  The volatility factor used in theBlack-Scholes option valuation model is based on the Company’s historical stockprices over the most recent period commensurate with the estimated expectedterm of the awards.  The risk-freeinterest rate used in the Black-Scholes option valuation model is based on theimplied yield currently available on U.S. Treasury zero-coupon issues with aremaining term commensurate with the expected term of the awards.  Pre-vesting option forfeitures are estimatedusing historical actual forfeitures. Stock-based compensation is recorded only for those options expected tovest.  If actual results differsignificantly from these estimates, stock-based compensation expense and theCompany’s results of operations could be materially impacted.

 

USE OF ESTIMATES — Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities and disclosure of contingent assets and liabilities at the date ofthe consolidated financial statements and the reported amounts of revenues andexpenses during the reporting period. Actual results could differ from those estimates.

 

RECLASSIFICATIONS — Certainamounts previously reported have been reclassified to conform to the currentpresentation.

 

2.             UNAUTHORIZED TRANSACTIONS

 

InDecember 2009, the Company learned of significant unauthorized transactions,which totaled approximately $31,500,000 from fiscal 2005 through December2009.  The volume of these unauthorizedtransactions was $8,498,434 in fiscal year 2009 and $10,286,988 from July 1,2009 until the unauthorized transactions were discovered in December 2009**. **As a result ofthese unauthorized transactions, the Company restated its consolidatedfinancial statements on Form 10-K/A for June 30, 2009.

 

Theunauthorized transactions line in the Consolidated Statements of Operationsrepresents the total of identified unauthorized transactions in those years.

 

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Theunauthorized transaction related costs and recoveries, net line in theConsolidated Statements of Operations is comprised of the legal fees for theinvestigation, restatement and legal defense costs as well as professional feesfor the forensic accountants, restatement support professionals and generalaccounting support.  The recoveriesrepresent amounts received under the Company’s insurance and othermiscellaneous credits related to the unauthorized transactions.  For the year ended June 30, 2010, these costsand recoveries were as follows:

 
| Legal fees                                                  |   | $          | 2,335,985 |   |
|-------------------------------------------------------------|--------|------------|-----------|--------|
| Professional fees                                           |   | 1,243,733  |      |
| Total costs                                                 |   | 3,579,718  |      |
|                                                        |   |       |      |
| Insurance proceeds                                          |   | (1,746,469 | )         |
| Other recoveries                                            |   | (166,263   | )         |
| Total recoveries                                            |   | (1,912,732 | )         |
|                                                        |   |       |      |
| Unauthorized transaction related costs and  recoveries, net |   | $          | 1,666,986 |   |

 

3.             EQUIPMENT AND LEASEHOLDIMPROVEMENTS

 

Themajor categories of equipment and leasehold improvements at June 30, 2010 and2009 are summarized as follows:

 
| ** **                                      | ** **   | **Estimated**         | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------------------------------------|--------------|-----------------------|------------|------------|------------|------------|------------|
| ** **                                      | ** **   | **Useful Lives** | ** ** | **2010**   | ** ** | **2009**   | ** ** |
| Machinery and equipment                         |         | 5-10 years            |       | $          | 629,757    |       | $          | 701,925 |   |
| Furniture and office equipment                  |         | 5-10 years            |       | 383,554    |       | 370,611    |       |
| Tooling                                         |         | 5-10 years            |       | 4,160,970  |       | 4,498,535  |       |
| Display booths                                  |         | 5-7 years             |       | 287,180    |       | 288,183    |       |
| Computer equipment                              |         | 3-5 years             |       | 724,448    |       | 777,790    |       |
| Leasehold improvements                          |         | 5-10 years            |       | 1,746,763  |       | 1,706,478  |       |
| Assets in progress                              |         | N/A                   |       | 814,335    |       | 337,903    |       |
|                                            | *** *** | *** ***          |       | 8,747,007  |       | 8,681,425  |       |
| Less: accumulated depreciation and amortization |         |                  |       | 6,354,235  |       | 6,440,853  |       |
| Equipment and leasehold improvements, net       |         |                  |       | $          | 2,392,772  |       | $          | 2,240,572 |   |

 

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4.             EARNINGS (LOSS) PER COMMON AND COMMON EQUIVALENT SHARE

 

Basic earnings (loss) pershare are computed based on the weighted-average number of common sharesoutstanding.  The weighted-average numberof common shares outstanding for the years ended June 30, 2010 and 2009were 7,382,706 and 7,386,250, respectively. When dilutive, stock options are included in earnings per share as shareequivalents using the treasury stock method. For the years ended June 30, 2010 and 2009 there were no common stockequivalents related to stock option grants that were included in thecomputation of the weighted-average number of shares outstanding for dilutedloss per share.  Shares under option of1,159,308 and 863,308 were excluded from the diluted weighted average commonshares outstanding for the years ended June 30, 2010 and 2009 as they would beanti-dilutive due to the Company’s net loss for the year.

 

5.                                      CREDITFACILITIES

 

On February 16, 2009, theCompany entered into a credit facility with Harris N.A. for an unsecured lineof credit for up to a maximum of $10,000,000 up to and including January 29,2010.  On October 9, 2009 the creditfacility was extended to December 31, 2010. The credit facility replaced the Company’s previous credit facility,which was terminated and contained substantially the same terms as the Company’snew credit facility.    The Company coulduse the credit facility for working capital, to refinance existingindebtedness, for stock repurchase and for general corporate purposes.  Borrowings under the credit facility boreinterest at either the bank’s most recently publicly announced prime rate or ata London Interbank Offered Rate (“LIBOR”) based rate plus 1.25% as determinedin accordance with the loan agreement. The credit facility included certainfinancial covenants that required the Company to maintain a minimum tangiblenet worth, liabilities to tangible net worth ratios and interest coverageratios.  The Company used its creditfacility from time to time, although there was no utilization of this creditfacility at June 30, 2009.  The Company’scredit facility with Harris N.A. was terminated on May 12, 2010 and theoutstanding balance of $5,863,349 as of that date was fully repaid.

 

On May 12, 2010, the Companyentered into a new secured credit facility with JPMorgan Chase Bank, N.A. (“Lender”).  The Credit Agreement dated May 12, 2010between the Company and the Lender (“Credit Agreement”) provides for an$8,000,000 revolving secured credit facility with interest rates either rangingfrom 0.0% to 0.75% over the Lender’s most recently publicly announced primerate or 2.0% to 3.0% over LIBOR, depending on the Company’s leverageratio.  The Credit Agreement expires onJuly 31, 2013. In addition to the revolving loans, the Credit Agreement alsoprovides that the Company may, from time to time, request the Lender to issueletters of credit for the benefit of the Company of up to a sublimit of$2,000,000 and subject to certain other limitations.  The loans may beused only for general corporate purposes of the Company.

 

The Credit Agreementcontains certain affirmative, negative and financial covenants customary forfinancings of this type.  The negativecovenants include restrictions on other indebtedness, liens, fundamental changes,certain investments, asset sales, sale and leaseback transactions andtransactions with affiliates, among other restrictions.  The financial covenants include a minimumcurrent ratio, minimum tangible net worth and maximum leverage ratio requirements.  The Company and the Lender also entered intothe Pledge and Security Agreement dated May 12, 2010 under which the Companygranted the Lender a security interest in substantially all of the Company’sassets in connection with the Company’s obligations under the CreditAgreement.  At June 30, 2010, theoutstanding balance on this credit facility was $1,250,000.  The applicable interest rates at June 30,2010 were 2.84% on $1,000,000 of outstanding balance and 3.75% on $250,000 ofoutstanding balance.  The weightedaverage interest rate in effect in the borrowings outstanding as of June 30,2010 was 3.02%.

 

6.                                      STOCK OPTIONS

 

In 1990, pursuant to therecommendation of the Board of Directors, the stockholders ratified thecreation of the Company’s 1990 Flexible Incentive Plan (the “1990 Plan”).  The 1990 Plan is administered by a committeeof the Board of Directors and provides for granting of various stock-basedawards including stock options to eligible participants, primarily officers andcertain key employees.  A total of225,000 shares of common stock were available in the first year of the 1990Plan’s existence.  Each year thereafteradditional shares equal to 0.25% of the shares outstanding as of the first dayof the applicable fiscal year were reserved for issuance pursuant to the 

 

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1990 Plan.  On July 22, 1992, the Board of Directorsauthorized the reservation of an additional 250,000 shares for the 1990 Plan,which was approved by the stockholders. In 1993, the Board of Directors authorized the reservation of anadditional 300,000 shares for the 1990 Plan, which was approved by thestockholders.  In 1997, the Board ofDirectors authorized the reservation of an additional 300,000 shares for the1990 Plan, which was approved by the stockholders.  In 2001, the Board of Directors authorizedthe reservation of an additional 300,000 shares for the 1990 Plan, which wasalso approved by the stockholders.  As ofJune 30, 2010, there are 485,506 options available for future grants.  Options vest over a four or five year periodfrom the date of grant, with a maximum term of five to ten years.

 

The fair value of each stockoption grant was estimated as of the date of grant using the Black-Scholespricing model.  The resultingcompensation cost for fixed awards with graded vesting schedules is amortizedon a straight-line basis over the vesting period for the entire award.  The expected term of awards granted isdetermined based on historical experience with similar awards, givingconsideration to the expected term and vesting schedules.  The expected volatility is determined basedon the Company’s historical stock prices over the most recent period commensuratewith the expected term of the award.  Therisk-free interest rate is based on U.S. Treasury zero-coupon issues with aremaining term commensurate with the expected term of the award.  Expected pre-vesting option forfeitures arebased on historical data.

 

As of June 30, 2010,there was approximately $706,000 of total unrecognized compensation costrelated to stock options granted under the 1990 Plan.  This cost is expected to be recognized over aweighted average period of 2.87 years. Total unrecognized compensation cost will be adjusted for any futurechanges in estimated and actual forfeitures.  The Company recognized stock-based compensation expense of $435,121 and$442,660 in 2010 and 2009, respectively. These expenses were included in selling, general and administrativeexpenses.

 

There was no cash receivedfrom stock option exercises during 2010 or 2009.

 

The per share weightedaverage fair value of the stock options granted during the year ended June 30,2010 was $1.49.  The fair value of each optiongranted is estimated on the date of grant using the Black-Scholesoption-pricing model.  There were nooptions granted in 2009.  For the optionsgranted in 2010, the Company used the following weighted-average assumptions:

 
| ** **                      | ** ** | **2010**  | ** ** |
|---------------------------------|------------|-----------|------------|
| Expected stock price volatility |       | 45        | %          |
| Risk free interest rate         |       | 2.40      | %          |
| Expected dividend yield         |       | 4.14      | %          |
| Expected forfeitures            |       | 1.50      | %          |
| Expected life of options        |       | 4.7 years |       |

 

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The following tableidentifies options granted, exercised, cancelled, or available for exercisepursuant to the 1990 Plan:

 
| ** **                           | ** ** | **Number of  Shares** | ** ** | **Stock  Options  Price Range** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Life - Years** | ** ** | **Aggregate  Intrinsic  Value of  In-The-  Money  Options** | ** ** |
|--------------------------------------|------------|----------------------------|------------|--------------------------------------|------------|----------------------------------------|------------|-----------------------------------------------------------------------|------------|------------------------------------------------------------------|------------|
| Shares under option at June 30, 2008 |       | 1,123,308                  |       | $7.76 - $14.40                       |       | $                                      | 10.75      |                                                                  | 3.90       |                                                             | $          | 816 |   |
| Granted                              |       | —                     |       | —                               |       | —                                 |       |                                                                  |       |                                                             |       |
| Exercised                            |       | —                     |       | —                               |       | —                                 |       |                                                                  |       |                                                             |       |
| Expired                              |       | (260,000                   | )          | $12.055                              |       | $                                      | 12.055     |                                                                  |       |                                                             |       |   |
| Forfeited                            |       | —                     |       | —                               |       | —                                 |       |                                                                  |       |                                                             |       |
| Shares under option at June 30, 2009 |       | 863,308                    |       | $7.76 - $14.40                       |       | $                                      | 10.35      |                                                                  | 3.99       |                                                             | $          | — |   |
| Granted                              |       | 390,000                    |       | $3.90 - $6.905                       |       | $                                      | 6.39       |                                                                  |       |                                                             |       |   |
| Exercised                            |       | —                     |       |                                 |       |                                   |       |                                                                  |       |                                                             |       |
| Expired                              |       | —                     |       |                                 |       |                                   |       |                                                                  |       |                                                             |       |
| Forfeited                            |       | (94,000                    | )          | $6.275 - $13.09                      |       | $                                      | 9.16       |                                                                  |       |                                                             |       |   |
| Shares under option at June 30, 2010 |       | 1,159,308                  |       | $3.90 - $14.40                       |       | $                                      | 9.12       |                                                                  | 3.66       |                                                             | $          | — |   |
|                                 |       |                       |       |                                 |       |                                   |       |                                                                  |       |                                                             |       |
| Exercisable as of June 30, 2009      |       | 532,808                    |       | $7.76 - $14.40                       |       | $                                      | 10.72      |                                                                  |       |                                                             |       |   |
| Exercisable as of June 30, 2010      |       | 627,308                    |       | $7.76 - $14.40                       |       | $                                      | 10.72      |                                                                  |       |                                                             |       |   |

 

Asummary of intrinsic value and cash received from stock option exercises andfair value of vested stock options for the fiscal years ended June 30, 2010 and2009 is as follows:

 
| ** **                                       | ** ** | **2010** | ** ** | **2009** | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|
| Total intrinsic value of stock options exercised |       | $        | —     |     | $          | — |   |
| Cash received from stock option exercises        |       | $        | —     |     | $          | — |   |
| Total fair value of stock options vested         |       | $        | 349,599    |     | $          | 440,137 |   |

 

Total options of 390,000were granted during the year ended June 30, 2010 at a price equal to or greaterthan the market value of the common stock on the date of grant. These optionshad a weighted-average exercise price of $6.39. No options were granted during the year ended June 30, 2009.

 

7.             STOCK PURCHASE AGREEMENTS

 

The Company has an agreementwith its Chairman, John C. Koss, in the event of his death, at the request ofthe executor of his estate, to repurchase his Company common stock from hisestate.  The Company does not have theright to require the estate to sell stock to the Company.  As such, this arrangement is accounted for asa written put option with the fair value of the put option recorded as aderivative liability.

 

The fair value of thewritten put option at both June 30, 2010 and 2009 was $125,000.  The repurchase price is 95% of the fairmarket value of the common stock on the date that notice to repurchase isprovided to the Company.  The totalnumber of shares to be repurchased will be sufficient to provide proceeds whichare the lesser of $2,500,000 or the amount of estate taxes and administrativeexpenses incurred by the Chairman’s estate. 

 

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The Company may elect to paythe purchase price in cash or may elect to pay cash equal to 25% of the totalamount due and to execute a promissory note for the balance, payable over fouryears, at the prime rate of interest. The Company maintains a $1,150,000 life insurance policy to fund a substantialportion of this obligation.

 

In April 1995, theBoard of Directors approved a stock repurchase program authorizing the Companyto purchase from time to time up to $2,000,000 of its common stock for its ownaccount.  Subsequently, the Board ofDirectors periodically has approved increases in the stock repurchaseprogram.  As of June 30, 2010, themost recently approved increase was for additional purchases of $2,000,000,which occurred in October 2006, for an aggregate maximum of $45,500,000, ofwhich $43,360,247 had been expended through June 30, 2010.  The Company repurchased 7,996 shares for$43,620 in 2009.  No shares wererepurchased in 2010.

 

8.             INCOME TAXES

 

The Company utilizes theliability method of accounting for income taxes.  The liability method measures the expectedincome tax impact of future taxable income and deductions implicit in theconsolidated balance sheets.  The incometax benefit in 2010 and 2009 consists of the following:

 
| **Year Ended June 30,** | ** ** | **2010**  | ** ** | **2009**   | ** ** |
|----------------------------------------|------------|-----------|------------|------------|------------|
| Current:                               |       |      |       |       |       |
| Federal                                |       | $         | (5,848,321 | )          | $          | 2,251,167 |   |
| State                                  |       | 10,975    |       | 428,713    |       |
| Deferred                               |       | 4,024,929 |       | (2,755,314 | )          |
|                                   |       | $         | (1,812,417 | )          | $          | (75,434 | ) |

 

The 2010 and 2009 taxbenefit results in an effective rate different than the federal statutory ratebecause of the following:

 
| **Year Ended June 30,**         | ** ** | **2010** | ** ** | **2009** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|
| Federal income tax benefit at statutory rate   |       | $        | (1,830,778 | )        | $          | (113,081 | ) |
| State income taxes, net of federal tax benefit |       | (56,783  | )          | (14,716  | )          |
| Increase in valuation allowance                |       | 109,683  |       | 123,159  |       |
| Research and development tax credits           |       | (14,550  | )          | (126,848 | )          |
| Other                                          |       | (19,989  | )          | 56,052   |       |
| Total income tax benefit                       |       | $        | (1,812,417 | )        | $          | (75,434 | ) |

 

Temporarydifferences which give rise to deferred income tax assets and liabilities atJune 30 include:

 
| ** **                                         | ** ** | **2010**   | ** ** | **2009**  | ** ** |
|----------------------------------------------------|------------|------------|------------|-----------|------------|
| Deferred Income Tax Assets:                        |       |       |       |      |       |
| Deferred compensation                              |       | $          | 648,409    |      | $          | 570,259 |   |
| Stock-based compensation                           |       | 698,891    |       | 588,785   |       |
| Accrued expenses and reserves                      |       | 1,395,982  |       | 1,630,520 |       |
| Package design and trademarks                      |       | 81,000     |       | 100,609   |       |
| Unauthorized transactions                          |       | 2,220,000  |       | 6,392,045 |       |
| Federal and state net operating loss carryforwards |       | 528,622    |       | 28,736    |       |
| Valuation allowance                                |       | (1,027,204 | )          | (917,521  | )          |
|                                               |       | 4,545,700  |       | 8,393,433 |       |
| Deferred Income Tax Liabilities:                   |       |       |       |      |       |
| Equipment and leasehold improvements               |       | (219,600   | )          | (264,968  | )          |
| Capitalized research and development costs         |       | (653,325   | )          | (416,603  | )          |
| Other                                              |       | (925       | )          | (15,083   | )          |
| Net deferred income tax asset                      |       | $          | 3,671,850  |      | $          | 7,696,779 |   |

 

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As of June 30, 2010, theCompany had unused net operating loss carryforwards of approximately $8,700,000to offset against future state taxable income. The state net operating loss carryforwards expire at various datesbeginning in 2011 and continuing through 2025.

 

Deferred income tax assetsas presented on the consolidated balance sheets:

 
| ** **                            | ** ** | **2010**  | ** ** | **2009**  | ** ** |
|---------------------------------------|------------|-----------|------------|-----------|------------|
| Current deferred income tax assets    |       | $         | 1,144,086  |      | $          | 1,385,497 |   |
| Noncurrent deferred income tax assets |       | 2,527,764 |       | 6,311,282 |       |
| Net deferred income tax assets        |       | $         | 3,671,850  |      | $          | 7,696,779 |   |

 

Deferred income tax balancesreflect the effects of temporary differences between the tax bases of assetsand liabilities and their carrying amounts. These differences are stated at enacted tax rates expected to be ineffect when taxes are actually paid or recovered.  The recognition of these deferred taxbalances will be realized through normal recurring operations and, as such, theCompany has recorded the full value of such expected benefits.

 

AccountingStandards Codification (“ASC”) Topic 740 prescribes a recognition threshold andmeasurement attribute for the financial statement recognition and measurementof a tax position taken, or expected to be taken, in a tax return.  There were no significant matters determinedto be unrecognized tax benefits taken or expected to be taken in a tax returnthat have been recorded on the Company’s consolidated financial statements forthe year ended June 30, 2010.  As part ofthe unauthorized transactions, the Company has accrued interest of $660,989 and$354,644 at June 30, 2010 and 2009, respectively.

 

Additionally,ASC Topic 740 provides guidance on the recognition of interest and penaltiesrelated to income taxes.  There were nopenalties related to income taxes that have been accrued or recognized as ofand for the years ended June 30, 2010 and 2009. The Company records interest related to unrecognized tax benefits ininterest expense.

 

Areconciliation of the beginning and ending amount of unrecognized tax benefitsis as follows:

 
| ** **                                           | ** ** | **2010** | ** ** | **2009** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|
| Unrecognized tax benefits at beginning of  year      |       | $        | 300,000    |     | $          | 300,000 |   |
| Gross decreases — tax positions in prior  years |       | —   |       | —   |       |
| Unrecognized tax benefits at end of year             |       | $        | 300,000    |     | $          | 300,000 |   |

 

TheCompany files income tax returns in the United States federal jurisdiction andin a state jurisdiction.  The Company’sfederal tax returns through tax year June 30, 2006 are settled and the incometax returns for tax years beginning July 1, 2006 are open.  Most state jurisdictions have tax returnsopen for tax years beginning July 1, 2005. There is an open examination by the Wisconsin Department of Revenue forthe period July 1, 2005 through June 30, 2009.

 

Thefollowing are the changes in the valuation allowance:

 
| ** **                             | ** ** | **Balance,**                | ** ** | **Increase in**     | ** ** | **Release of**      | ** ** | ** **                         | ** ** |
|----------------------------------------|------------|-----------------------------|------------|--------------------------|------------|--------------------------|------------|------------------------------------|------------|
| **Year Ended June 30,** | ** ** | **Beginning  of Year** | ** ** | **Valuation  Allowance** | ** ** | **Valuation  Allowance** | ** ** | **Balance at  End Year** | ** ** |
| 2010                                   |       | $                           | (917,521   | )                        | (109,683   | )                        | —     |                               | $          | (1,027,204 | ) |
| 2009                                   |       | $                           | (794,362   | )                        | (123,159   | )                        | —     |                               | $          | (917,521 | ) |

 

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9.             ACCRUEDLIABILITIES

 

Accrued liabilities atJune 30 consist of the following:

 
| ** **                                        | ** ** | **2010**  | ** ** | **2009** | ** ** |
|---------------------------------------------------|------------|-----------|------------|----------|------------|
| Cooperative advertising  and promotion allowances |       | $         | 677,844    |     | $          | 401,483 |   |
| Accrued returns                                   |       | 407,576   |       | 364,773  |       |
| Product warranty  obligations                     |       | 339,150   |       | 362,000  |       |
| Interest                                          |       | 660,989   |       | 354,644  |       |
| Payroll taxes and other  employee benefits        |       | 167,171   |       | 208,180  |       |
| Legal and professional  fees                      |       | 2,009,656 |       | 135,739  |       |
| Other                                             |       | 252,338   |       | 263,235  |       |
|                                              |       | $         | 4,514,724  |     | $          | 2,090,054 |   |

 

10.          ADDITIONAL CASH FLOWINFORMATION

 

The net changes in cash as aresult of changes in operating assets and liabilities consist of the following:

 
| ** **                                    | ** ** | **2010**   | ** ** | **2009**  | ** ** |
|-----------------------------------------------|------------|------------|------------|-----------|------------|
| Accounts receivable                           |       | $          | 72,439     |      | $          | 3,264,731 |   |
| Inventories                                   |       | 251,510    |       | (276,500  | )          |
| Income taxes receivable                       |       | (928,550   | )          | —    |       |
| Prepaid expenses                              |       | (103,321   | )          | 47,818    |       |
| Income taxes payable                          |       | (4,404,382 | )          | 1,480,076 |       |
| Accounts payable                              |       | 1,671,877  |       | (73,387   | )          |
| Accrued liabilities                           |       | 2,424,670  |       | (580,635  | )          |
| Other liabilities                             |       | (46,700    | )          | —    |       |
| Net change                                    |       | $          | (1,062,457 | )         | $          | 3,862,103 |   |
|                                          |       |       |       |      |       |
| Net cash (refunded) paid during the year for: |       |       |       |      |       |
| Income taxes                                  |       | $          | (678,512   | )         | $          | 1,190,000 |   |
| Interest                                      |       | $          | 122,793    |      | $          | — |   |

 

11.          PRODUCT WARRANTY OBLIGATIONS

 

The Company records aliability for product warranty obligations at the time of sale based uponhistorical warranty experience.  TheCompany’s products carry a lifetime warranty. The Company also records a liability for specific warranty matters whenthey become known and are reasonably estimated. The Company’s current and non-current product warranty obligations areincluded in accrued liabilities and other liabilities, respectively, in theconsolidated balance sheets.  Changes tothe product warranty obligations for the years ended June 30, 2010 and 2009 areas follows:

 
| **Year Ended June 30,** | ** ** | **Balance,  Beginning  of Year** | ** ** | **Provision  Charged to  Expense** | ** ** | **Warranty  Expenses  Incurred** | ** ** | **Balance at  End Year** | ** ** |
|----------------------------------------|------------|---------------------------------------|------------|-----------------------------------------|------------|----------------------------------|------------|------------------------------------|------------|
| 2010                                   |       | $                                     | 1,087,000  |                                    | 325,226    |                             | (394,776   | )                                  | $          | 1,017,450 |   |
| 2009                                   |       | $                                     | 1,112,000  |                                    | 324,695    |                             | (349,695   | )                                  | $          | 1,087,000 |   |

 

The warranty obligation isrecorded as a current and long-term liability.

 

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12.          EMPLOYEE BENEFIT PLANS

 

Substantially all domesticemployees are participants in the Koss Employee Stock Ownership Trust underwhich an annual contribution in either cash or common stock may be made at thediscretion of the Board of Directors. The expense recorded for such cash contributions approximated $5,000 and$30,000 during 2010 and 2009, respectively.

 

The Company maintains aretirement savings plan under Section 401(k) of the Internal RevenueCode.  This plan covers all employees ofthe Company who have completed one full fiscal quarter of service.  Matching contributions can be made at thediscretion of the Board of Directors. For fiscal years 2010 and 2009, the matching contribution was 100% ofemployee contributions to the plan. Vesting of Company contributions occurs immediately.  Company contributions were $323,540 and$312,822 during 2010 and 2009, respectively.

 

13.          DEFERREDCOMPENSATION

 

The Company has deferred compensation agreements with a former andcurrent officer.

 

The Board of Directorsentered into an agreement to continue the Chairman’s 1991 base salary for theremainder of his life.  These paymentsbegin upon the Chairman’s retirement, and since the Chairman has not retired,he is not currently receiving any payments under this arrangement.  The Company has a deferred compensationliability of $494,755 and $421,469 recorded as of June 30, 2010 and 2009,respectively.  Deferred compensationexpense of $73,286 and $66,808 was recognized under this arrangement in 2010and 2009, respectively.

 

The Board of Directors hasapproved a supplemental retirement plan with an officer that calls for annualcash compensation following retirement from the Company in an amount equal to2% of base salary, as defined in the agreement, multiplied by the number ofyears of service to the Company.  Theretirement payments are to be paid monthly to the officer until his death andthen to his surviving spouse monthly until her death.  The Company has a deferred compensationliability of $1,257,704 and $1,119,771 recorded as of June 30, 2010 and2009, respectively.  Deferredcompensation expense of $137,933 and $147,734 was recognized under thisarrangement in 2010 and 2009, respectively.

 

The Company uses lifeinsurance policies to cover its deferred compensation agreements.

 

14.          FOREIGN SALES ANDSIGNIFICANT CUSTOMERS

 

The Company’s net foreignsales amounted to $20,416,375 during 2010 and $17,495,075 during 2009.

 

The Company’s sales byregion are as follows:

 
| ** **          | ** ** | **2010**   | ** ** | **2009**   | ** ** |
|---------------------|------------|------------|------------|------------|------------|
| U.S.                |       | $          | 20,182,347 |       | $          | 24,222,039 |   |
| Europe              |       | 17,710,672 |       | 15,744,430 |       |
| All other countries |       | 2,705,703  |       | 1,750,645  |       |
| Net sales           |       | $          | 40,598,722 |       | $          | 41,717,114 |   |

 

Sales during 2010 and 2009to the Company’s five largest customers, which are generally large nationalretailers or foreign distributors, represented approximately 52% and 54% of theCompany’s net sales, respectively. Included in these percentages, sales to a single U.S. customerrepresented approximately 17% and 22%, of the Company’s net sales during 2010and 2009, respectively.  Net sales to asingle Scandinavian distributor represented approximately 25% and 17%, of theCompany’s total sales during 2010 and 2009, respectively.

 

Included in accountsreceivable as of June 30, 2010 and 2009 was 50% and 49%, respectively, due fromthe Company’s five largest customers.

 

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15.          COMMITMENTS ANDCONTINGENCIES

 

The Company leases itsfacility in Milwaukee, Wisconsin from its Chairman.  On August 15, 2007, the lease was renewed fora period of five years, ending June 30, 2013, and is being accounted for as anoperating lease.  The lease extensionmaintained the rent at a fixed rate of $380,000 per year.  The Company is responsible for all propertymaintenance, insurance, taxes and other normal expenses related toownership.  Total rent expense was$380,000 in both 2010 and 2009.

 

In July 2010, the Companyentered into agreements totaling approximately $1,578,000 for software and newproduct development.  The term of thesecommitments is less than one year.

 

16.          LEGAL MATTERS

 

Sincelearning of the unauthorized transactions in December 2009, the Company hasbeen named in the matters described below. The Company has also initiated certain actions against third parties,which are also described below, and may bring additional claims against otherthird parties.

 

·      On January 11, 2010, the Company received aletter from a law firm stating that it represented a shareholder and demandingthat the Company’s Board of Directors investigate and take legal action againstall responsible parties to ensure compensation for the Company’s lossesstemming from the unauthorized transactions. The Company’s legal counsel has responded preliminarily to the letterindicating that the Board of Directors will determine the appropriate course ofaction after the Independent Investigation is completed.

 

·      On January 15, 2010, aclass action complaint was filed in federal court in Wisconsin against theCompany, Michael Koss and Sujata Sachdeva. The suit alleges violations of Section 10(b), Rule 10b-5 andSection 20(a) of the Exchange Act relating to the unauthorizedtransactions and requests an award of compensatory damages in an amount to beproven at trial.  See *David A. Puskala v. Koss Corporation, et al.*, United StatesDistrict Court, Eastern District of Wisconsin, Case No. 2:2010cv00041.

 

·      On January 26, 2010, the SEC’s Division ofEnforcement advised the Company that it obtained a formal order ofinvestigation in connection with the unauthorized transactions. The Companyvoluntarily brought the unauthorized transactions to the SEC staff’s attentionwhen they were discovered in December 2009, and is cooperating with theongoing SEC investigation.

 

·       On February 16and 18, 2010, separate shareholder derivative suits were filed in MilwaukeeCounty Circuit Court in connection with the previously disclosed unauthorizedtransactions. The first suit names as defendants Michael Koss, John Koss Sr.,the other Koss directors, Sujata Sachdeva, Grant Thornton, LLP, and KossCorporation (as a nominal defendant); the second suit names the same partiesexcept Grant Thornton, LLP. Among other things, both suits allege variousbreaches of fiduciary and other duties, and seek recovery of unspecifieddamages and other relief. See *Ruiz**v. Koss, et al.*, Circuit Court, Milwaukee County, Wisconsin,No. 10CV002422 (February 16, 2010) and *Mentkowski v. Koss, et al*.,Circuit Court, Milwaukee County, Wisconsin, No. 10CV002290 (February 18,2010).  These two shareholder derivativesuits have been consolidated under Master File No. 10CV002422.

 

·       On February 18,2010, the Company filed an action against American Express Company, AmericanExpress Travel Related Services Company, Inc., AMEX Card Services Company,Decision Science, and Pamela S. Hopkins in Superior Court of Maricopa County,Arizona, case no. CV2010-006631, alleging various claims of aiding and abettingbreach of fiduciary duty, aiding and abetting fraud, conversion, and negligencerelating to the unauthorized transactions.

 

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·       On June 24,2010, the Company filed an action against its former independent auditor, GrantThornton, LLP, and Ms. Sachdeva, in Circuit Court of Cook County, Illinois,alleging various claims of accounting malpractice, negligent misrepresentation,and fraud relating to the unauthorized transactions.

 

The ultimate resolution of these matters is notdeterminable.

 

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SIGNATURES

 

Pursuant to the requirementsof Section 13 or 15(d) of the Securities Exchange Act of 1934, theRegistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
| KOSS  CORPORATION |                          |   |
|-------------------|-------------------------------|--------|
|              |                          |   |   |
| By:               | /s/ Michael J. Koss           |   | Dated: September 20, 2010 |
|              | Michael J. Koss               |   |   |
|              | Vice Chairman                 |   |   |
|              | President                     |   |   |
|              | Chief Executive Officer       |   |   |
|              | Chief Operating Officer       |   |   |
|              |                          |   |
|              |                          |   |
| By:               | /s/ David D. Smith            |   | Dated: September 20, 2010 |
|              | David D. Smith                |   |   |
|              | Executive Vice President      |   |   |
|              | Chief Financial Officer       |   |   |
|              | Principal Accounting  Officer |   |   |
|              | Secretary                     |   |   |

 

Pursuant to the requirementsof the Securities Exchange Act of 1934, this report has been signed below bythe following persons on behalf of the Registrant and in the capacities indicatedon September 20, 2010.

 

 
| /s/ John C. Koss               |   | /s/ Michael J. Koss            |
|--------------------------------|--------|--------------------------------|
| John C. Koss, Director         |   | Michael J. Koss, Director      |
|                           |   |                           |
|                           |   |                           |
| /s/ Lawrence S. Mattson        |   | /s/ John J. Stollenwerk        |
| Lawrence S. Mattson,  Director |   | John J. Stollenwerk,  Director |
|                           |   |                           |
|                           |   |                           |
| /s/ Thomas L. Doerr            |   | /s/ Theodore H. Nixon          |
| Thomas L. Doerr, Director      |   | Theodore H. Nixon,  Director   |

 

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Exhibit INDEX

 
| **Exhibit No.** | ** ** | **Exhibit Description**                                                                                                                                                                                                                                                            |
|----------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                 |       |                                                                                                                                                                                                                                                                                    |
| 3.1                  |       | Amended and Restated  Certificate of Incorporation of Koss Corporation, as in effect on  November 19, 2009. Filed as Exhibit 3.1 to the Company’s Quarterly  Report on Form 10-Q for the period ended December 31, 2009 and  incorporated herein by reference. |
|                 |       |                                                                                                                                                                                                                                                                                    |
| 3.2                  |       | By-Laws of Koss  Corporation, as in effect on September 25, 1996. Filed as  Exhibit 3.2 to the Company’s Annual Report on Form 10-K for the  year ended June 30, 1996 and incorporated herein by reference.                                                    |
|                 |       |                                                                                                                                                                                                                                                                                    |
| 10.1                 |       | Death Benefit Agreement  with John C. Koss. Filed as Exhibit 10.4 to the Company’s Annual Report  on Form 10-K for the year ended June 30, 1996 and incorporated  herein by reference.                                                                              |
|                 |       |                                                                                                                                                                                                                                                                                    |
| 10.2                 |       | Stock Purchase Agreement  with John C. Koss. Filed as Exhibit 10.5 to the Company’s Annual Report  on Form 10-K for the year ended June 30, 1996 and incorporated  herein by reference.                                                                             |
|                 |       |                                                                                                                                                                                                                                                                                    |
| 10.3                 |       | Salary Continuation  Resolution for John C. Koss. Filed as Exhibit 10.6 to the Company’s  Annual Report on Form 10-K for the year ended June 30, 1996 and  incorporated herein by reference.                                                                        |
|                 |       |                                                                                                                                                                                                                                                                                    |
| 10.4                 |       | 1983 Incentive Stock  Option Plan. Filed as Exhibit 10.7 to the Company’s Annual Report on  Form 10-K for the year ended June 30, 1996 and incorporated herein  by reference.                                                                                       |
|                 |       |                                                                                                                                                                                                                                                                                    |
| 10.5                 |       | Assignment of Lease to  John C. Koss. Filed as Exhibit 10.7 to the Company’s Annual Report on  Form 10-K for the year ended June 30, 1988 and incorporated herein  by reference.                                                                                    |
|                 |       |                                                                                                                                                                                                                                                                                    |
| 10.6                 |       | Addendum to Lease. Filed  as Exhibit 10.8 to the Company’s Annual Report on Form 10-K for the  year ended June 30, 1988 and incorporated herein by reference.                                                                                                       |
|                 |       |                                                                                                                                                                                                                                                                                    |
| 10.7                 |       | Amendment to Lease. Filed  as Exhibit 10.22 to the Company’s Annual Report on Form 10-K for  the year ended June 30, 2000 and incorporated herein by reference.                                                                                                     |
|                 |       |                                                                                                                                                                                                                                                                                    |
| 10.8                 |       | Partial Assignment,  Termination and Modification of Lease. Filed as Exhibit 10.25 to the  Company’s Annual Report on Form 10-K for the year ended June 30,  2001 and incorporated herein by reference.                                                             |
|                 |       |                                                                                                                                                                                                                                                                                    |
| 10.9                 |       | Restated Lease. Filed as  Exhibit 10.26 to the Company’s Annual Report on Form 10-K for the  year ended June 30, 2001 and incorporated herein by reference.                                                                                                         |
|                 |       |                                                                                                                                                                                                                                                                                    |
| 10.10                |       | 1990 Flexible Incentive  Plan. Filed as Exhibit 25 to the Company’s Annual Report on Form 10-K  for the year ended June 30, 1990 and incorporated herein by reference.                                                                                              |
|                 |       |                                                                                                                                                                                                                                                                                    |
| 10.11                |       | Consent of Directors  (Supplemental Executive Retirement Plan for Michael J. Koss dated  March 7, 1997). Filed as Exhibit 10.2 to the Company’s Quarterly  Report on Form 10-Q for the quarter ended March 31, 1997 and  incorporated herein by reference.     |
|                 |       |                                                                                                                                                                                                                                                                                    |
| 10.12                |       | Credit Agreement dated  May 12, 2010, between Koss Corporation and JPMorgan Chase Bank, N.A.  Filed as Exhibit 10.12 to the Company’s Quarterly Report on  Form 10-Q for the quarter ended March 31, 2010 and incorporated by  reference herein.               |
|                 |       |                                                                                                                                                                                                                                                                                    |
| 10.13                |       | Pledge and Security  Agreement dated May 12, 2010, between Koss Corporation and JPMorgan  Chase Bank, N.A. Filed as Exhibit 10.13 to the Company’s Quarterly  Report on Form 10-Q for the quarter ended March 31, 2010 and  incorporated by reference herein.  |
|                 |       |                                                                                                                                                                                                                                                                                    |
| 14                   |       | Koss Corporation Code of  Ethics. *                                                                                                                                                                                                                                                     |

 

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| 23.1   |   | Consent of Baker Tilly  Virchow Krause, LLP*                                       |
|--------|--------|------------------------------------------------------------------------------------|
|   |   |                                                                               |
| 31.1   |   | Rule 13(a)-14(a)/15(d)-14(a) Certification  of Chief Executive Officer * |
|   |   |                                                                               |
| 31.2   |   | Rule 13(a)-14(a)/15(d)-14(a) Certification  of Chief Financial Officer * |
|   |   |                                                                               |
| 32.1   |   | Section 1350  Certification of Chief Executive Officer **                     |
|   |   |                                                                               |
| 32.2   |   | Section 1350  Certification of Chief Financial Officer **                     |

 

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| *  |   | Filed herewith     |
|----|--------|--------------------|
| ** |   | Furnished herewith |

 

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