Diamond Foods Financial Fraud Scandal
Adrienne M Somers
David F McCormick
Acct 320
February 27 2012

In April 2011, Diamond Food Inc (DMND), the nation's largest walnut processor and maker of Emerald nuts announced plans to buy Pringles from Proctor and Gamble for $1.5 billion in stock (Reuters, 2012). This move was part of the company's aggressive growth strategy to become a leader of the snack food industry. Former chief executive officer, Michael Mendes, and former chief financial officer, Steven Neil, spearheaded this effort. However, plans were postponed as questions arose about two large payments that were made to walnut growers in August of 2010 and September 2011 for $20 million and $60 million respectively. An internal audit of the financial records found that these payments were improperly booked into the wrong accounting period, which artificially reduced the company's costs, and boosted earnings in that period making the company look more profitable than it actually was. It is a technique known as earnings management. Because of the probe, Michael Mendes and Steven Neil were removed from their positions as CEO and CFO (Dalai, 2012). The financial records for 2010 and 2011 were found to be unreliable meaning that would have to restate their financial results for both these years. This scandal caused Diamond Foods Inc shares to fall by 40 percent. It seriously damaged the reputation of the company and the trust of their shareholders. It also ruined any chance of Diamond food Inc becoming the leader in the snack food industry. This paper will address the significance of why two well-respected executives would commit fraud and then try to conceal their actions. It will address the reason that was the lack of corporate governance that provided the opportunity to for this fraud to be committed, the conflict of interests existing at the time, and I will give my opinion on what actions should have been taken to prevent and deter the fraudulent activities. First, I will give some background information on the company and the top two executives which is necessary in order to understand the fraud.
A group of California walnut growers founded Diamond Food Inc, (DMND) in 1912. They were the first nut company to start selling overseas in 1950. They were also the first company to advertise on TV in the same year. In 1956, the company became centralized and over the next 40 years, the company continued to grow and expand their products (Diamond Food Corporation, 2013). In 1997, Michael J Mendes became CEO of the company. His goal for the company was to reduce Diamonds reliance on low-margin nut sales by entering the branded snack business and by following a very aggressive growth strategy. This required acquisitions and a lot of cash outflow for marketing. Therefore, he convinced the company to go public so that the company would be listed on the NASDAQ and could raise the capital needed to boost its marketing efforts. He was advised against this and stated that it would be better if they sold the company but unfortunately Mr. Mendez preferred to "get big ourselves" and the company went public (HANNAH KARP, 2012) in his desire to get the company to be the leader in the snack food industry. However, this meant that Diamond Food Inc would now have to compete against the bigger companies for their share in the marketplace. This required vast sums of money to advertise their products and to acquire acquisitions. With the help of his CFO, Steven Neils, they pushed the company to its limits. They reached their projected target and secured their big bonuses and compensation. They started by acquiring Kettle Chips in 2008 and Pop Secret in 2010. Their profit margin increased at a huge rate from 1.5 in 2006 to 5% in 2011. They were on track in making Diamond Food Inc, the largest snack food company in the world. However, by their acts, it became apparent that not everything was as it seemed and in April of 2010 when questions arose about the timing of payment to walnut growers. This is when the scandal broke. As I stated above, the problem with the timing of the payments first arose in April 2010. Under GAAP, you cannot pay in a future fiscal payment for a prior years' crop. According to Douglas Barnhill, an accountant and walnut grower, he contacted Eric Heidman, Diamonds director of field operations when he received a check in the mail in September of 2011. He wanted clarification on which crop the check was paying. He was told that the payment was for the 2010 crop, part of fiscal 2011, but that it would be "budgeted into next year's crop" (Diamond Foods Accounting Scandal Seeds Sown Years Ago, 2012),which was a direct violation of accounting rules. However, news stories quoted the payments as being an advance payment on next year's crop, which means that that they were moving grower payments around, a technique known as earning management which is delay-recording payments from one fiscal year to the next reduces the company's cost, boosts earnings, so that you reach your target earnings and receive your bonus. These inquiries about the payments eventually made it all the way to the audit committee and it was at this time that a probe was initiated. They were booked in the wrong period, artificially boosting revenue and at a crucial time for the company to look profitable and acquire Pringles. Then once they had acquired Pringles they could straighten out their accounting by integrating the two businesses resulting in a one-time momentum expense and covering up the improperly accounted supplier payments in 2010 and 2011 (Jennings, 2012). This also guaranteed that Mendes and Neil received their bonuses because it looked as though they had met the projected targets. This raised a red flag, due to the fact that, because Steven Neil, as CFO, would normally be the closest to the accounting decision process and would have signed off on the payments. This indicates that self-interest was placed ahead of company interest and it made for a very hostile working environment due to the pressure put on everyone to meet the targets so that Mendes and Neil would not lose their bonuses. In total, Mendez received $1.4 million in bonuses and $2.6 million in incentive compensation while Neil received $875 million in bonuses and $1.1 million in incentive compensation for 2010 and 2011 (Jennings, 2012). It also prompted the SEC and the department of justice to launch on investigation into the walnut growers payments in December of 2011. It also jeopardized the Pringle deal and Diamond Foods lost the deal to Kellogg. Diamond Food company had to restate their financial results for 2010 and 2011 and were nearly delisted from the NASDAQ. However, the NASDAQ panel gave them an extension to get their records current by December 7 2012. At this time Diamond has restated their financial results. The restatements resulted in reductions in income before taxes of $39.5 million in fiscal year 2011 and $17.0 million on fiscal year 2010 (Reuters, 2012). Their shareholders are currently suing them for failure to oversee the snack food company, damaging the brand reputation and costing the company a chance to buy rival Pringles. The Board of Trustees of City of Hialeah Employees' Retirement System is also suing them for misrepresentation of the company's financial condition (Reuters, 2012).
Additionally the SEC discovered that Diamond failed to maintain adequate internal controls to properly report the payments and for maintaining accurate books and records. (Jennings, 2012) This shows a clear indication that Diamond Food Inc, did not enforce their code of ethics nor did they not oversee their internal controls to prevent and deter fraud from happening within their company. If they had been in place, the opportunity to commit this fraud would not have been present and they would have know of any conflict of interests within their company if they had enforced the code of ethics and there was management oversight of internal controls. The walnut growers and shareholders uncovered this fraud.
According to their website (Diamond Food Corporation, 2013), they do have corporate governance policies and procedures that specifically address the conduct for employees and officers or the company. They are (1.2) General Legal and Ethical obligations, a policy on the maintenance of Corporate Books, Records and Accounts, (7) Financial Integrity: Public reporting and (4) Conflicts of Interest.
1.2 states that all employees and director's should read and understand the code and to use it as a guide to the performance of his responsibility for the company. This clearly did not happen as Mendes and Neil acted in their own "self-interest" securing their bonuses at the expense of the company. Instead of promoting the code by fostering a commitment to the company, they tried to conceal the improper accounting while hoping that the Pringles deal would help them straighten out their accounting records. This is neither fair nor honest to the company, investors, shareholder and employees of the company. There was no accountability and they were able to over ride the policies and procedures.
The board should have also checked for a conflict of interest before hiring Neils. First, he was an independent director and chairperson of the Audit committee prior to becoming the CFO. While he did step down from the audit committee, he remained on the board and was privy to all sorts of private information in addition to being paid by the board. In my opinion, as the CFO who works the closest to the accounting decision process, there is definitely a conflict of interest between receiving payments from the board and being on the board. As I mentioned above, he did receive compensation and bonuses that could have affected the decisions he made on behalf of the company.
Furthermore, they both failed to comply with rule 7 which states that you should behave in an ethical manner by exercising common sense and judgment. How they thought that they booking these lump sum payments in a different accounting period and then straightening then out when they acquired Pringles is misleading, unethical and promotes fraudulent activities instead of ethical activities. According to the Sarbanes-Oxley act of 2002, the CEO and CFO must sign off that the financial records are a true picture of the financial condition of the company. This is not the case and it is against GAAP rules. In addition, the other issue that arose from this was in connection with the auditors Deloitte and Touche to see whether they signed off on the accounting for these two payments that would be an indication of lack of independence that is also against the AICPA's code of conduct. This could also mean that if they signed off on the payments than the corporate officers could defend themselves against the charges by arguing they did not have the requisite intent because they relied on the approval of the accountants (Jennings, 2012).
In conclusion, the lack of internal controls contributed to Mendes and Neil's opportunity to commit fraud. They were so well trusted that no one questioned their activities. While Michael Mendes resigned and had to pay back $2.7 and give back 6,665 shares because of the clawback provision in the Sarbanes- Oxley Act (San Fransico Business Times, 2012), that requires all bonuses and shares to be paid back due to the restatement of the financial records, he will still receive his retirement payout of $5.4 million. Steven Neil was let go and received no compensation. In my opinion, they should not have received anything. They ruined the reputation of the company, lost the trust of their shareholders, investors and the public and all due to greed. The two executive due to their competitiveness and self-interest destroyed the investments of the employees, vendors, supplier, shareholders and investors. While, Diamond Food Inc, has taken proactive steps by firing Mendes and Neil's, a complete overhaul of their internal controls should be executed and the code of ethics must be enforced in this company. Fairness, honesty and integrity needs be promoted. Additionally segregation of duties should be enforced to prevent and deter future collusion, fraud and conflicts of interests. Diamond Food Inc faces many challenges as they try rebuild their reputation. However, they are a strong company with a strong brand portfolio, and with the right management, and strategic approach they might rebuild their reputation so that they can once again be a company that investors can trust again.

References
Dalai, M. (2012, 2 8). Diamond removes CEO, CFO after walnut payment probe. Retrieved from Reuters.com: http://www.reuters.com/article/2012/02/09/us-diamondfoods-idUSTRE8172EJ20120209
Diamond Food Corporation. (2013, 02 27). Retrieved from http://www.diamondfoods.com/index2.php
Diamond Foods Accounting Scandal Seeds Sown Years Ago. (2012, 03 19). Retrieved from The Huffington Post: http://www.huffingtonpost.com/2012/03/19/diamond-foods-accounting-scandal_n_1361234.html
Geller, M. (2012, 11 14). Diamond Foods restatement wipes out $56.5 million in profit. Retrieved from Reuters: http://www.reuters.com/article/2012/11/14/us-diamondfoods-results-idUSBRE8AD1QU20121114
HANNAH KARP, J. S. (2012, 02 10). "Big" was Diamond CEO Style. Retrieved from The Wall Street Journal: http://online.wsj.com/article/SB10001424052970204642604577213513713315158.html
Jennings, P. (2012, 2 13). Next Steps in Diamond Foods Accounting Inquiry. Retrieved from New York Times: http://dealbook.nytimes.com/2012/02/13/next-steps-in-diamond-foods-accounting-inquiry/
Reuters. (2012, 02 08). A timeline of Diamond Foods' accounting woes. Retrieved from Reuters: http://www.reuters.com/article/2012/02/09/diamond-idUSL2E8D8ILZ20120209
Reuters. (2012, 06 27). Diamond Foods' board sued over financial problems. Retrieved from Reuters: http://www.reuters.com/article/2012/06/27/diamondfoods-shareholder-lawsuit-idUSL2E8HRHUL20120627
Reuters. (2012, 11 14). Press Releases: Diamond Foods Reports Financial Results for First Three Quarters of Fiscal 2012. Retrieved from Reuters: http://www.reuters.com/article/2012/02/09/us-diamondfoods-idUSTRE8172EJ20120209
San Fransico Business Times. (2012, 11 21). Diamond Foods ex-CEO resigns and will pay $2.7M clawback. Retrieved from San Fransico Business Times: http://www.bizjournals.com/sanfrancisco/blog/2012/11/diamond-foods-clawback-ex-ceo-resigns.html