Case 7-8
Diamond Foods
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 FY 2011 to $29.7 million and by 46 percent for FY 2010 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.
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 a 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 he had sent Diamond in 2010. Heidman
told Barnhill that the payment was for the 2010 crop, part of FY 2011, 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 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.
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 officer 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 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 FY 2006 to more than 5
percent in FY 2011. According to Feakins, “no competitors were improving like that; even with rising
Asian demand…it just doesn’t make sense.” 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 FY 2010 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 FY 2009, FY 2010, and FY 2011, $2.6 million of
Mendes’ $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 properly report
the payments, 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.
When sales are made, the company either receives cash or a promise to pay in the future (normally through
accounts receivable). As the accounts receivable are paid off, there is an increase in cash. Over the long
term, the recorded sales revenue turns into cash matching that number. Thus, using analytical procedures
2. Why were the actions of Diamond Foods with respect to its ‘accounting for nuts’ unethical?
Diamond Foods was not accruing for crop payments or cost of goods sold in the correct year. For example,
the 2010 almond crop purchased from farmers should have been recorded as a debit to inventory purchased
Diamond Foods was manipulating the period during which the company recorded when Eric Heidman, the
director of field operations, told Douglas Barnhill, a customer who had a walnut grove farm, was told that a
check he had received for about $46,000 was a payment for the 2010 crop but would be budgeted into the
2012 results. This practice is unethical because it misleads investors and creditors about the earnings each
3. The role of Deloitte & Touche is unclear in the case. We do not know whether the firm
identified the improper 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?
Deloitte might use the levers of reporting to the board of directors or audit committee. The top management
would not want their actions put under the microscope by the board so that threats to go there might induce
[An interesting article analyzing the fraud that occurred at Diamond Foods is Could You Have Predicted
Diamond Foods Accounting Fraud? The article goes into great detail about how the numbers should have