Anatomy and Motivations of Earnings Manipulation

ISSUES IN ACCOUNTING EDUCATION American Accounting Association Vol. 30, No. 1 DOI: 10.2308/iace-50948 2015 pp. 47–69

Diamond Foods, Inc.: Anatomy and Motivations of Earnings Manipulation

Mahendra R. Gujarathi

ABSTRACT: Diamond Foods is America’s largest walnut processor specializing in processing, marketing, and distributing nuts and snack products. This real-world case presents financial reporting issues around the commodities cost shifting strategy used by Diamond’s management to falsify earnings. By delaying the recognition of a portion of the cost of walnuts acquired into later accounting periods, Diamond Foods materially underreported the cost of sales and overstated earnings in fiscal 2010 and 2011. The primary learning goal of the case is to help students understand the anatomy and motivations of earnings manipulation. Specifically, students will have the opportunity to (1) apply the FASB’s Conceptual Framework to a real-world context, (2) determine the nature of errors and compute their numerical effects on financial statements, (3) understand motivations for earnings management and actions needed for managing earnings of future years, (4) explain the anatomy of financial reporting fraud by reconstructing journal entries, (5) prepare comparative financial statements for retroactive restatements, (6) explain the rationale for clawback provisions in compensation contracts, and (7) understand the difference between the real and accrual-based earnings management.

Keywords: earnings management; financial statement fraud; restatements; error correction; clawback provision; Conceptual Framework.

This company was on the verge of becoming a real global consumer-product company

with Pringlest. I always said if they could make it work, it could be a highflier. And it

worked—until it didn’t.

—RBC Analyst Edward Aaron

(Businessweek, January 12, 2012)

Mahendra R. Gujarathi is a Professor at Bentley University and Adjunct Professor at the Indian Institute of

Management, Ahmedabad.

The author thanks Professors Martha Howe, Donna McConville, Ari Yezegel, participants at the 2013 North American Case Research Association Annual Conference, the 2013 American Accounting Association Northeast Region Annual Meeting, and 2014 American Accounting Association Annual Meeting for their comments and suggestions on the earlier versions of the case. Comments and suggestions of the editor, associate editor, and two anonymous reviewers are also gratefully acknowledged.

Supplemental material can be accessed by clicking the links in Appendix A.

Published Online: October 2014

47

INTRODUCTION

D iamond Foods, Inc. (hereafter, Diamond, or the Company), is America’s largest walnut

processor specializing in processing, marketing, and distributing nuts and other snack

products (Reuters 2012). Diamond’s products are distributed globally in stores where

snacks and culinary nuts are sold. Its major processing and packaging plant is located in California, the

state that accounts for virtually the entire walnut production in the U.S. The Company has

approximately 1,700 employees and its stock trades on the NASDAQ market under the symbol DMND.

History: From Walnut Processor to Innovative Packaged-Food Company1

Diamond began in 1912 as a member-owned agricultural cooperative association, specializing

in processing, marketing, and distributing culinary, snack, in-shell, and ingredient nuts. After

almost a century as a walnut growers’ cooperative, the Company, in an initial public offering (IPO)

in 2005, issued over eight million shares to its grower-members and six million shares to the public.

Soon after incorporation, the Company began a series of acquisitions under the leadership of its

Chief Executive Officer (CEO) Michael J. Mendes. The annual reports of the Company indicate

that Diamond acquired, in May 2006, certain assets of Harmony Foods Corporation. In September

2008, it acquired Pop Secrett, a brand of microwave popcorn products, for $190 million cash from

General Mills. In February 2010, Diamond acquired Kettle Brandt Chips, a premium potato chip

company, for $615 million cash from Lion Capital LLP, U.K. The acquisitions, largely financed by

long-term debt, have changed both the product as well as the risk profile of the company.2

Diamond’s transition from walnuts into the snack business was evinced in the falling

percentage of walnuts sales as a percentage of total net sales. In fiscal 2006, 2007, 2008, and 2009,

the percentage of walnut sales was 67 percent, 59.8 percent, 60.2 percent, and 47 percent,

respectively.3 The transition is also manifested in how the company described its business. In the

annual report for the fiscal year ending July 31, 2011 Diamond described its business as ‘‘an

innovative packaged food company focused on building and energizing brands including Kettle

Brandt Chips, Emeraldt snack nuts, Pop Secrett popcorn, and Diamond of Californiat nuts’’

(Diamond Foods 2006–2012) The acquisitions helped Diamond achieve impressive sales growth

and profitability. The balance sheets, statements of operations, and statements of cash flows of

Diamond for each year since 2006 are presented in Exhibit 1, Panels A, B, and C, respectively.

The price of Diamond’s common stock reflected the Company’s superior financial performance

and its promising growth prospects. It went up from $17 (IPO price in July 2005) to $76.53 in July

2011, earning investors a compound annual return of 28 percent. Figure 1 depicts the history of

Diamond’s financial performance (net sales, gross profit, net income, and EPS) and the performance

of its stock vis-à-vis NASDAQ index.

The Mavericks behind Diamond’s Success: CEO Michael Mendes and CFO Steven Neil

Michael Mendes was the main force in converting Diamond from a cooperative into a

corporation and for making walnuts more mainstream as a healthy snack rather than just a baking

ingredient. He joined Diamond in 1991 as the Company’s vice president of international sales and

marketing. In 1997, at the age of 33, he was promoted to the position of president and CEO. He

1 Information in this section is obtained from various annual reports of the Company filed with the Securities and Exchange Commission.

2 In March 2010, Diamond Foods also raised approximately $180 million through the sale of 175 million shares of common stock.

3 The information regarding percentage of walnut sales was not disclosed in the annual reports for fiscal 2010 and 2011.

48 Gujarathi

Issues in Accounting Education Volume 30, No. 1, 2015

EXHIBIT 1 Financial Statements

Panel A: Balance Sheet

Source: Diamond Foods, 10-K reports filed with the SEC. Note 1: Payable to growers was presented in Diamond’s balance sheet as a separate line item until July 31, 2010. In the balance sheet of July 31, 2011, however, the payable to growers of $15,186 was combined with accounts payable and accrued liabilities of $128,874, for a total of $144,060.

(continued on next page)

Diamond Foods, Inc.: Anatomy and Motivations of Earnings Manipulation 49

Issues in Accounting Education Volume 30, No. 1, 2015

served on Diamond’s board of directors beginning in 2005 and was the chairman of the board from

January 2011 to February 8, 2012.

Mendes worked hard to change Diamond into a more entrepreneurial and performance-driven

organization. ‘‘Through a combination of product innovation, savvy marketing, and acquisitions he

transformed Diamond from a sleepy cooperative for walnut growers into a $1 billion-a-year purveyor

of snacks’’ (Bloomberg Businessweek 2012). Every year since its incorporation in 2005, Diamond reported higher revenues, gross profit, and net income than the year before. The reported EPS

(earnings per share) exceeded the consensus estimate4 of the analysts in most years. In a report filed

EXHIBIT 1 (continued)

Panel B: Statements of Operations

Source: Diamond Foods, 10-K reports filed with the SEC.

(continued on next page)

4 The consensus estimates of fully diluted EPS for fiscal years 2007, 2008, 2009, 2010, and 2011 were $0.508, $0.888, $1.36, $1.373, and $2.319, respectively (Bloomberg Businessweek 2012). In comparison, the actual fully diluted EPS numbers were $0.53, $0.91, $1.44, $1.36, and $2.22, respectively in 2007 through 2011 (Diamond Foods 2006–2011).

50 Gujarathi

Issues in Accounting Education Volume 30, No. 1, 2015

EXHIBIT 1 (continued)

Panel C: Statements of Cash Flows

Source: Diamond Foods, 10-K reports filed with the SEC.

Diamond Foods, Inc.: Anatomy and Motivations of Earnings Manipulation 51

Issues in Accounting Education Volume 30, No. 1, 2015

FIGURE 1 Diamond Foods

(Source: Annual reports of Diamond Foods and Yahoo Finance)

Panel A: Sales, Gross Profit, Net Income, EPS (2005–2011) of Diamond Foods

Panel B: History of Stock Returns

52 Gujarathi

Issues in Accounting Education Volume 30, No. 1, 2015

with the SEC in March 2010, Diamond touted its record of beating consensus analyst estimates for 12

consecutive quarters.

Michael Mendes appreciated the strong work ethic at Diamond and dedicated himself to his

job. His attention to detail provided Mendes with a deeper understanding of all aspects of the

Company’s operations. As one former employee said, ‘‘You could talk to Michael about anything

from nut sourcing to the prices being paid by Diamond’s international and retailer customers.

Mendes’ knowledge of what was happening at Diamond was the best of anyone in the Company’’

(Diamond Foods, Inc. 2012, 10).

Steven Neil, who had served as an independent director on Diamond’s board since 2005,

became Diamond’s executive vice president, and chief financial and administrative officer in March

2008 and served in that position until February 2012. Neil was reportedly the type of CFO who

maintained personal oversight of the general operations of the business and looked after several

functions including logistics, IT, treasury, grower relations, and purchasing. Neil visited walnut

growers in the field at least twice a year, usually once during harvest and once during some stage of

the bloom, either at the beginning of or during the middle of the summer (Diamond Foods, Inc.

2012, 174).

Compensation of Diamond’s Senior Management

Mendes and Neil were handsomely rewarded for their contributions to Diamond’s success.

Mendes’ compensation in fiscal 2004 was $1.1 million. Five years later, in 2009, it had more than

tripled to $3.8 million and for the fiscal year 2011, it almost doubled to approximately $7.3 million

(Diamond Foods 2006–2012). The compensation paid to Neil, who became CFO in March 2008,

was approximately eight times that of his predecessor CFO at the time of Diamond’s conversion

from a cooperative.

Consistent with the goal of becoming a performance-driven organization, the compensation of

Diamond’s senior management was tied to the Company’s success. Diamond’s annual bonus

incentives ‘‘were determined by both a corporate financial objective, representing 60 percent of

bonus potential, and individual objectives for each named executive officer, representing 40 percent

of bonus potential’’ (Diamond Foods, Inc. 2012, 179). In 2010 and 2011 Mendes received bonuses

of approximately $1.4 million and incentive compensation of more than $2.6 million, while Neil

received bonuses totaling more than $875,000 and incentive compensation worth more than $1.1

million (Henning 2012). In fiscal 2009, 2010, and 2011, $2.6 million of Mendes’ $4.1 million in

annual bonus was paid because Diamond beat its EPS goal, according to regulatory filings

(Huffington Post 2012).

Plans for a More Prosperous Future: Diamond’s Attempts to Acquire Pringlest

On the heels of the past fruitful acquisitions and successful integration of Kettle Brandt Chips

in Diamond’s operations, the Company embarked upon an even more ambitious target, Pringlest.

Beginning in May 2010, Diamond submitted several purchase offers to Proctor & Gamble (P&G) to

purchase Pringlest. The Pringlest acquisition would make Diamond the second-largest snack food

company, only behind PepsiCo’s Frito-Layt.

Although Proctor & Gamble initially rejected Diamond’s offers, negotiations resumed in

February 2011. On April 5, 2011, Diamond reached an agreement to acquire Pringlest by

exchanging $1.5 billion of Diamond’s stock and paying $850 million in cash toward the total

purchase price of $2.35 billion. The transaction had a ‘‘cash collar,’’ such that if the price of

Diamond’s stock dropped, Diamond would increase the cash component to as high as $1.05 billion,

and if the stock price rose, the cash component would be reduced to as low as $700 million. In the

Diamond Foods, Inc.: Anatomy and Motivations of Earnings Manipulation 53

Issues in Accounting Education Volume 30, No. 1, 2015

press release announcing the signing of a definitive agreement for the proposed merger, Diamond

provided the following rationale for acquiring Pringlest:

The largest potato crisp brand in the world with sales in over 140 countries and

manufacturing operations in the U.S., Europe, and Asia, Pringlest had a combination of

proprietary products, unique package design and significant advertising investment. The

acquisition of Pringlest would enable Diamond to gain greater merchandising and

distribution influence, leverage its sales and distribution infrastructure, and obtain a

broader global manufacturing and supply chain platform with access into key growth

markets including Asia, Latin America, and Central Europe. (PR Newswire 2011)

The expected benefits of the merger appeared enticing. In the conference call to announce

Pringlest merger, Mendes stated, ‘‘In fiscal 2012 we expect net sales for the combined company to be approximately $1.8 billion and EPS in the range of $3.00 to $3.10. This reflects EPS accretion of

$0.12 to $0.15 per share’’ (Thompson Reuters Streetevents 2011). In the same conference call, CFO Steven Neil mentioned that although Diamond would incur merger and integration related costs of

approximately $100 million5 over the first two years, ‘‘the financial benefits of improved margins, significant EPS accretion, and free cash flow will make Diamond an even stronger company in the

future, delivering exceptional value to Diamond and P&G shareholders’’ (Thompson Reuters Streetevents 2011). News of the Pringlest acquisition and prospects of resulting improvement in

financial performance took Diamond’s share price to an all-time high of $96.13 in September 2011.

The Specter of Accounting Controversy Appears on Diamond’s Horizon

Everything seemed to be going perfectly well for Diamond until the publication of a report on

September 25, 2011 by Mark Roberts, an analyst with the Off Wall Street Consulting Group (Off

Wall Street 2011). Roberts noted that earnings for 2011 were likely overstated because the

Company made payments this year to pay off growers who were underpaid last year.

Roberts’ report on Diamond’s accounting sparked interest in the media. On September 26,

2011, an article in Reuters Breakingviews discussed the issue of payments to walnut growers

stating that ‘‘Diamond’s long-term contracts gave it great leeway to determine a final price at the end of the crop year. And while walnut prices have been rising thanks to Chinese demand, they are

among the most opaque in the agricultural world and can vary widely’’ (Reuters Breakingviews 2011). Quoting the growers contacted by Breakingviews, Reuters stated that ‘‘Based on a closing payment on August 31 for the previous year’s crop, [Diamond] undercut competitors by at least a

third, a far bigger discount than is typical’’ (Reuters Break

"Is this question part of your assignment? We can help"

ORDER NOW