Reference no: EM131380150

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. A press release issued by the company explains in great detail the accounting and financial reporting issues. 1 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, the company'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 $20 million payments to growers in 2010 caught the eye of Diamond's auditors, Deloitte & Touche. However, it is uncertain whether the firm approved the accounting for the payments.

It is an important determination because corporate officers can defend against securities fraud charges by arguing they did not have the requisite intent because they relied on the approval of the accountants. Case 7-8 Diamond Foods 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's 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.

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. An interesting aspect of the case is the number of red flags, 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 . . . it just doesn't make sense." 2 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. Another red flag was that while net income growth is generally reflected in operating cash flow increases, at Diamond, the cash generation was sluggish in FY2010, when earnings were strong. This raises questions about the quality of earnings.

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's $4.1 million in annual bonus was paid because Diamond beat its EPS goal, according to regulatory filings. It was expected that the company would likely face a civil enforcement action by the SEC for not maintaining accurate books and records and failing to maintain adequate internal controls to report the payments properly, both of which are required for public companies.

If the SEC decides to bring a civil fraud case against any individuals at Diamond Foods, the Dodd-Frank Act gives it the option of filing either an administrative case or a civil injunctive action in Federal District Court. An administrative proceeding is generally considered a friendlier venue for the SEC.

Questions
1. One of the red flags identified in the case was that operating cash flow increases did not seem to match the level of increase in net income. Explain the relationship between these two measures and why it raised questions about the quality of earnings at Diamond Foods.

2. Why were the actions of Diamond Foods with respect to its ‘accounting for nuts' unethical?

3. The role of Deloitte & Touche is unclear in the case. We do not know whether the firm approved the accounting for the payments to walnut growers and periods used to record these amounts. Assume that the firm identified the improper payments and discussed the matter with management (i.e., CFO and CEO). What levers might Deloitte use to convince top management to correct the materially misstated financial statements?