Case 5-7 Diamond Foods: Accounting for Nuts' Diamond Foods, based in Stockton, California, is a premitum snack food and culinacy mut company with diversified operations. The compang had a reputation of making bold and expensive acqusitions. Due to conpetition within the suack food industry. Diamond devefoped ais aggessive compain culture that placed hieh emphasis apon performance. The company's slogan was "Biger is better. "Howewer, without strong ethical owersight. questiomable behavior started to persist at Diamond Foods in 2009. Serious allegations of fraud ogainst top management led to a iestructuring of leadership, Here is the story we dub: "Accounting for Nuts:" On November 14, 2012, Diamond Foods Inc. disclosed iestated financial statements tied to an accounting seandal that-reduced its earmings durine the first thiree quarters of 2012 as it took significant charges related to improper aecounting for payments to walimut growers. The restatenents cut Diamond's earnings by 57 percent for FY2011, to $29.7 mallion, and by 46 percent for FY2010., to \$23:2 millioh. By Deceniber 7.2012, Diamond's share price had declined 54 percent for the year. Diamond Foods, longtime maker of Emerald nuts and subseguent panchaser or Pop Seciet popeorn (200s) and Kettle potato chips (260). became the focus of an SEC investigation after The Wall Street Journal raised questions about the timing and accounting of Diamond'stoyments to walnut growers. The case focuses on the matching of costs and revenues. At the heart of the investipation was the question of whether Dimond senior manapement adjusted the accounting for the giower paymerits on purpose to increase profits for a given period. The case arose in September 2011, when Douglas Bamhil, an accountant who is also a farmer of 75 acres of California walnut groves, got a uysterious check for nearly \$ 46.000 from Diamond. Barnhill coctacted Enc Heidman. Diamond's director of field operations, on whether the check was a final payment for his 2010 crop or prepwyent for the 2011 harvest. (Diamond growers are paid in installments, with the final payment for the prior fall's crops coming Iate the following jear) Drough it was September 2011. Barnhill was stall waiting for fill payment for the walnuts that he had sent Dianond in 2010. Heidman told Barnhill that the paymerit was for the 2010 crop, part of FY2011. but that it would be "hudgeted into the next jear," The problem is, ander accounting rules, sou camot lentimately record in a future fiscal sear an amount for a pror sear's crop. That amount ahoula have been estimated during 2010 and recorded as an expense against tevenue from the sale of walnuts. An investigation by the audit conumittee in February 2012 found payments of $20 million to walnut groweis in Augnst 2010 and $60 million in September 2011 that were not reconded in the correct periods. Die disclosue of financial restatements in Nowviber 2012 and abdit conumittee investipation led to the retienation of former CEO Michael Mendes, who agreed to pay a \$2.74 million cash clawback and return 6.665 shares to the conoam. Mendes' casti clawback was deducted from his retirement pavout of 55.4 milion. Former CFO Steveil Neil was fircd on November 19.2012. and did not receive amy severance. The SEC brought a lawsuit against Dianond Foods, Meodes, and Neil. It settled with the company and Merides ofi January 9. 2014. In a separate action. Neil setrled charges that lie had directed tie effort to frandulently undericport money paid to walnut growers by delaying the tecording of payments into later fiseal periods. As a result of the audit committee imestization and the subsequent anabysis and procedures performed, the company identified material weaknesses in three areas: control environment, walnut grower accounting and accounts payable timing recognition. The company announced efforts to sernediate these areas of material weakness, including enhanced owersight and controls, leadership changes, a revired walaut cost estimation policy, and improved financial and operation reporting throughout the ofganization. A number of questionable transactions took place, inclading zunusual timing of paysueats fo zrouecs, a leap in profit marains, and volatile inventories and cash flows. Moreover, the company seemed to posh hard on every lever to bicet iacreasingly ambitious earmings targets and allowed top executives to pull in big bonuses, acconding to interviews with former Dianond emploses and board members, rivals, suppliers, and coisuliants, in addition to revievs of poblic and noopoblic Diamond records. Nick Feakins, a forensie accocmintant, noted the relentless climb in Disnond's protit maryins, including an increase in net income as a percent of sales from IS percenf in FY006 to more than s pereent in FY2011. According to Feakins, "no competitors were improwing like thar: even with rising Asian demand: Reuters did a review of II companies litied as comparable organizations in Diamond's regulatory filings and found that only one. BkG Foods, which made multiple acquisitions, added eartiogs during the period. Aaditors offen look at the relationship between eamings and cash flow as part of their ritk assesment. At Diamond, net incone growth is nenerally reflected in operating cash flow increases. However, the cash generation was slugeish in FY70l0, when earnings were strong Also, in September 20I0. Mendes had promised EPS growiti of 15 percent to 20 percent per seat for the next five sears. In FY2009, FY2010, and FY2011.52.6 millich of Mendes' 54.1 milion in annual bonu was paid because Diamond beat its EPS goal, according to requlatory flings. Mendes said: "Earninge per share had increased 73 percent to 52 cents, exceding the tog end of ilie compuny's guidance range. Strong operaing cash. flow for the period helped fund a sienificant inciease in new ptodist and advertising imvestment as EBITDN IEatnings before interest, taves. As for the role of Deloinc in the fraud, the SEC charged that Neil misled them by givine false and incomplete information to jentify the unusuat aceounting treatment for the payments. The SEC's oider agaiuss Mendes foond that he should have knowa that Diamond's reported walnut cost wan incorrect becouse of information he received at the time, and he omitted facts in cettain representations to Deloitie about the apecial walaut pasments. One problem was Neit did not document accountine policies or desiqu the process for which walnut groser payments and the walnat cost estimates were detecmined. This was exacerbated by the fact that manasement did not communicate the intent of the payments effectively. 1. Use the Fraud Triangle to analyze the business and audit risks that existed at Diamond Foods during the period of its accounting fraud. 2. How would you characterize Diamond's accounting? Did they commit an error in recording walnut grower payments? Was it an illegal act? A fraudulent act? For each one, explain the reporting requirements for Deloitte assuming they were aware of the transactions