Case 5-7Diamond Foods: Accounting for Nuts

Diamond Foods, based in Stockton, California, is a premium snack food and culinary nut company with diversified operations. The company had a reputation of making bold and expensive acquisitions. Due to competition within the snack food industry, Diamond developed an aggressive company culture that placed high emphasis upon performance. The company's slogan was "Bigger is better." However, without strong ethical oversight, questionable behavior started to persist at Diamond Foods in 2009. Serious allegations of fraud against top management led to a restructuring of leadership. Here is the story we dub: "Accounting for Nuts."

On November 14, 2012, Diamond Foods Inc. disclosed restated financial statements tied to an accounting scandal that reduced its earnings during the first three quarters of 2012 as it took significant charges related to improper accounting for payments to walnut growers. The restatements cut Diamond's earnings by 57 percent for FY2011, to $29.7 million, and by 46 percent for FY2010, to $23.2 million. By December 7, 2012, Diamond's share price had declined 54 percent for the year.

Diamond Foods, long-time maker of Emerald nuts and subsequent purchaser of Pop Secret popcorn (2008) and Kettle potato chips (2010), became the focus of an SEC investigation after The Wall Street Journal raised questions about the timing and accounting of Diamond's payments to walnut growers. The case focuses on the matching of costs and revenues. At the heart of the investigation was the question of whether Diamond senior management adjusted the accounting for the grower payments on purpose to increase profits for a given period.

The case arose in September 2011, when Douglas Barnhill, an accountant who is also a farmer of 75 acres of California walnut groves, got a mysterious check for nearly $46,000 from Diamond. Barnhill contacted Eric Heidman, Diamond's director of field operations, on whether the check was a final payment for his 2010 crop or prepayment for the 2011 harvest. (Diamond growers are paid in installments, with the final payment for the prior fall's crops coming late the following year.) Though it was September 2011, Barnhill was still waiting for full payment for the walnuts that he had sent Diamond in 2010. Heidman told Barnhill that the payment was for the 2010 crop, part of FY2011, but that it would be "budgeted into the next year." The problem is under accounting rules, you cannot legitimately record in a future fiscal year an amount for a prior year's crop. That amount should have been estimated during 2010 and recorded as an expense against revenue from the sale of walnuts.

An investigation by the audit committee in February 2012 found payments of $20 million to walnut growers in August 2010 and $60 million in September 2011 that were not recorded in the correct periods. The disclosure of financial restatements in November 2012 and audit committee investigation led to the resignation of former CEO Michael Mendes, who agreed to pay a $2.74 million cash clawback and return 6,665 shares to the company. Mendes' cash clawback was deducted from his retirement payout of $5.4 million. Former CFO Steven Neil was fired on November 19, 2012, and did not receive any severance. The SEC brought a lawsuit against Diamond Foods, Mendes and Neil. It settled with the company and Mendes on January 9, 2014. In a separate action Neil settled charges that he had directed the effort to fraudulently underreport money paid to walnut growers by delaying the recording of payments into later fiscal periods.

As a result of the audit committee investigation and the subsequent analysis 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 remediate these areas of material weakness, including enhanced oversight and controls, leadership changes, a revised walnut cost estimation policy, and improved financial and operation reporting throughout the organization.

A number of questionable transactions took place, including unusual timing of payments to growers, a leap in profit margins, and volatile inventories and cash flows. Moreover, the company seemed to push hard on every lever to meet increasingly ambitious earnings targets and allowed top executives to pull in big bonuses, according to interviews with former Diamond employees and board members, rivals, suppliers and consultants, in addition to reviews of public and nonpublic Diamond records.

Nick Feakins, a forensic accountant, noted the relentless climb in Diamond's profit margins, including an increase in net income as a percent of sales from 1.5 percent in FY2006 to more than 5 percent in FY2011. According to Feakins, no competitors were improving like that; even with rising Asian demand." Reuters did a review of 11 companies listed as comparable organizations in Diamond's regulatory filings and found that only one, B&G Foods, which made multiple acquisitions, added earnings during the period.

Auditors often look at the relationship between earnings and cash flow as part of their risk assessment. At Diamond, net income growth is generally reflected in operating cash flow increases. However, the cash generation was sluggish in FY2010, when earnings were strong. Also, in September 2010, Mendes had promised EPS growth of 15 percent to 20 percent per year for the next five years. In FY2009, FY2010, and FY2011, $2.6 million of Mendes' $4.1 million in annual bonus was paid because Diamond beat its EPS goal, according to regulatory filings.

Diamond falsely disclosed its strong overall financial performance in conference calls with financial analysts. In its call for the third quarter FY 2011, Mendes said: "Earnings per share had increased 73 percent to 52 cents, exceeding the top end of the company's guidance range. Strong operating cash flow for the period helped fund a significant increase in new product and advertising investment as EBITDA [Earnings before interest, taxes, depreciations and amortization] of $31 million was more than double the same period in the prior year." Based on these false reports, the analysts were optimistic about future earnings and share value. They informed the investment banking groups in their firms to recommend a "buy" to their clients.

As for the role of Deloitte in the fraud, the SEC charged that Neil misled them by giving false and incomplete information to justify the unusual accounting treatment for the payments. The SEC's order against Mendes found that he should have known that Diamond's reported walnut cost was incorrect because of information he received at the time, and he omitted facts in certain representations to Deloitte about the special walnut payments. One problem was Neil did not document accounting policies or design the process for which walnut grower payments and the walnut cost estimates were determined. This was exacerbated by the fact that management did not communicate the intent of the payments effectively.

Questions

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.

3.What are auditors' obligations with respect to accounting estimates and judgments made by management? Explain any concerns that should have existed about these areas of the audit. Assume that Deloitte was aware of these issues. Would any of them rise to the level of a critical audit matter? Explain.

4.Do you think non-GAAP information, such as that provided to financial analysts, should be audited? Consider the value of such information to the users of financial reports in answering this question.