Diamond Foods Accounting Scandal

BACKGROUND:
Founded in 1912 as a walnut grower cooperative, Diamond Food’s primary business involved buying walnuts from local California growers, processing the product, and reselling it. The San Francisco-based company converted from a cooperative to a public corporation in July of 2005, issuing its initial shares for $17. By 2010, Diamond Foods (DMND) had expanded and acquired a number of snack food companies including Kettle Brand® Chips and Pop Secret® popcorn and was negotiating the acquisition of the Pringles brand from the Procter & Gamble Company (Diamond Foods, 2014). The addition of the Pringles brand would make Diamond the second-largest global snack foods company behind PepsiCo, Inc., owner of the Frito-Lay brand (Byron & Ziobro, 2011). Although the new ventures took precedence, Diamond’s walnut business remained the highest commodity cost to the company. In order to maintain relations with the growers, Diamond had to assure they offered a competitive price for the product; however any recorded increase in walnut price would decrease both the company’s reported earnings and their reported earnings per share (EPS). Despite rising walnut prices, the company consistently posted EPS that defied analyst projections. Between the 2010 SEC Form 10-Q second quarter filing and the SEC Form 10-K of FY 2011, the price of Diamond stock jumped from $39 dollars per share to $90 per share (SEC, 2014).
On January 9, 2014, the Securities and Exchange Commission (SEC) filed a lawsuit against Diamond Foods for its 2010-2011 financial activities. The case involved alleged accounting fraud and earnings inflation by Diamond’s Chief Financial Officer (CFO) Steven Neil. At the time, Neil was under pressure to reach or exceed earnings projections of Wall Street analysts while facing the issue of rising walnut costs. In order to appease both the growers and the stockholders, Neil instructed his accounting team to utilize a deceptive accounting method to report the company’s walnut costs. The SEC accused Neil of disguising a portion of the walnut costs as an advance on future crop deliveries, as well as misleading auditors by providing false information and omitting facts to justify his usual accounting practice (SEC, 2014). The SEC also charged Diamond’s Chief Executive Officer (CEO) Michael Mendes with negligence for his role in certifying the inaccurate financial statements. The litigation claimed the CEO omitted facts to external auditors and should have recognized the inflated walnut costs on the statements. Diamond replaced both Mendes and Neil in 2012, and the company agreed to pay a $5 million settlement.

ECONOMIC AND SOCIAL ENVIRONMENT:
The case of fraudulent accounting for Diamond Foods can be seen to have two drivers. One is the pressure the executives faced to not only meet, but also exceed the earnings estimates of the Wall Street stock analysts and second to continue to keep the longstanding positive relationships with walnut growers as the price of the raw goods increase, according to the SEC Case. The two issues are interconnected, as the company would not be able to report high earnings and growth as the cost of one of its largest pieces of inventory, walnuts, continue to increase. As the price of walnuts raised, the CFO, Steven Neil, developed a scheme to keep the costs down and show increased earnings to meet the pressure set forth by the Wall Street analysts. This was done through a series of accounting techniques to push the costs of the walnuts into different aspects and timeframes of the company’s financial statements. The details of how these costs were pulled apart and separated will be further explained in the following section.

From the beginning Diamond had put a focus on the commodity walnut market. The company had forged strong relationships with the growers of the nuts and held pride in continuing the positive relationship throughout the future of the company. So as the growers began to hand down larger costs, Diamond needed to find a way to ensure that the growers got the full amount they were seeking in order to keep ties strong and avoid the growers leaving Diamond for one of its competitors, while also continue to meet the earnings per share (EPS) expectations. According to the case filed by the SEC in 2014, “In February 2010, Diamond CFO Neil instructed members of the Finance Team to adjust the walnut costs to hit an EPS target for the second quarter. “Members of the Finance Team provided Neil with a walnut cost estimate that would result in reported EPS that would be higher than the consensus analyst of estimated $0.47 per share for the quarter” (SEC, 2014). However, the growers were not satisfied with this method of determining prices and threatened to leave Diamond if full costs were not received. Neil determined a way to close the gap through “continuity” or “momentum” payments. This technique allowed Diamond to pay the full amount that the growers were giving, but separated the costs out. Diamond only the portion on the financial statements that would allow the company to meet expected earnings, and shifted costs to the next financial statement claiming that it was an advance for the next crop. This way the growers were technically receiving the full amount but shareholders were not able to see the negative impact that this price increase would have caused on the company. This pressure to show such positive growth and EPS came from the recent acquisition of snack food companies and the vision that CEO Michael Mendes had to grow Diamond from a small walnut company to a large force in the market of snack foods.

A larger driver for this scandal was the acquisition of Pringles that was on the table for Diamond. The main determinant of the deal going through between Procter & Gamble and Diamond was the stock price of the company, as it had been rising months before the deal was to be settled. Mendes’ mission to move beyond a simple walnut company to the owner of the strong Pringles brand may have clouded his judgment and closed his mind to catching the misconduct that was occurring in regards to the prices of the walnuts. According to the registration documents filed with the SEC, “Diamond agreed, pursuant to the agreement between Diamond and the potato chip unit’s parent (Procter & Gamble), to issue 29 million shares of its stock to the parent company, the agreement also included a payment of $850 million to the parent of the potato chip business unit, with a provision that Diamond would pay additional amounts of its stock dropped below a certain price” (SEC, 2014). This agreement put intense pressure on the CFO, Neil, to ensure that stock prices stayed high or the deal would fall apart. Because of this pressure, Neil was prepared to do whatever it took to keep that price high and ensure the deal went through and the company continued its climb up to the top of the snack food ladder. According to the Wall Street Journal, “The walnut cost shifting helped Diamond Foods beat estimates every quarter in 2011, and its rising stock price was a key factor in it being able try to buy Pringles from Procter & Gamble. As long as Diamond Foods shares stayed above a certain price, Diamond could fund the acquisition, by far its largest ever” (WSJ, 2014). In order to pull off the scheme, Neil began putting himself as leaders of different internal organizations that would have offered some type of control against this type of situation, such as the Diamond Finance Team and the Grower Relations Team. It was his tight connection to both of these teams that allowed the scheme to be “successful”. And according the SEC, “Diamond failed to devise and maintain an adequate system of internal controls to ensure the accuracy of its books and records. Among other things, Diamond did not implement an policies to ensure the accuracy of the reported walnut costs, the accounting for walnut payments, and the manner in which the walnut cost was incorporated into the financial statements” (SEC, 2014). And this lack of control can be assumed to be the result of Neil having his hands and authority over each part of the company.

Diamond Foods Inc. is set to pay $5 million to settle the accounting dispute investigated through the SEC. While Neil is the one who is in the front of the SEC litigation charges, the role of the CEO should too be mentioned. Michael Mendes has a responsibility as the leader of a company to ensure that it is running in accordance with the laws, including those set forth through GAAP. Thus before sending out the financial statements to the public, Mendes has a responsibility to ensure that the information found in the report is accurate. According to an article from Reuters Business, “in addition to paying the penalty, Mendes has also already forfeited more than $4 million in bonuses and other benefits” (Lynch, 2014). These were benefits that Mendes had received due to the apparent success of the company through high earnings and stock prices. Also according to the Reuters article, Neil denies any wrongdoing and had planned to fight the SEC charges at trial, under the defense that he had only been following long-standing company processes and an accounting treatment that was approved by the company’s outside auditor. Neil believed that he was doing what was in the best interest for the company by ensuring that the price increase did not hurt the company during the delicate time of acquiring more snack food companies and will work to prove that during trial. Neil’s attorney, Michael Shepherd of Hogan Lovell’s LLP is quoted saying that “the charges are not based on the facts, but on an effort to turn a disagreement about accounting into a hunt for a villain” (Lynch, 2014). This is said due to the fact that the SEC had been previously preoccupied with bringing cases against the banks, for roles played during the great recession and has recently began turning their focus on accounting cases. No matter the feelings of the top executives of Diamond, a choice was made to improperly account for costs and have deservingly faced consequences sent forth through the SEC for their misguided actions.

Financial/Accounting Data:
In 2010 and 2011 walnut crops decrease, which in return increased the price, paid to growers. Demand was high for walnuts during these years so although the price was increasing, products were still moving and even selling out for higher demanded growers. With this in mind, Steven Neil knew he had to keep his supplier of walnuts locked in and pays the higher price for the walnuts. In doing this, his finance team forecasted the effects of having to pay the higher prices as we mentioned previously. Their findings showed the higher price paid to growers would negatively impact their EPS. At this time, Diamond Foods was involved in several acquisitions that were solely based on how well their stock price was performing. Neil knew he could not afford to have his stock price decline or else Diamond Foods would lose out on an opportunity to acquire companies, such as Pringle Snack Foods. Neil appointed himself to several committees within the company that enabled him to have the sole decision power over accounting practices. Due to this, he advised his finance team to record payments to growers as “continuing payments”. As previously mentioned, this allowed Diamond Foods to record a price paid to its growers within 1 fiscal year, and make up any differences still owed to the growers within the following fiscal year. Ultimately the internal audit committee of the board of directors found these understated payments to growers in 2011. In February 2012, Diamond Foods released a notice stating adjustments would have to be made to both fiscal years 2010 and 2011 for under estimating payments to walnut growers. This notice also mentioned that the CEO and CFO were placed on administrative leave, termination later followed for both. Per the SEC litigation, “Diamond’s reported EPS for the fiscal year 2010 was overstated by more than 65 percent, and Diamond’s reported EPS for the fiscal year 2011 was overstated by more than 89 percent” (SEC, 2014). Stock prices plummeted from $90 per share to $17 per share in November of 2012 when the financial statements were restated to reflect the true costs of payments to walnut growers.
The auditor for Diamond Foods during this time was Deloitte. Records show that Diamond Foods paid Deloitte almost $16.8 million in fees in 2012 to assist with the adjustments to their financial statements to help correct the errors that were made in payments to walnut growers. Deloitte was mentioned within the SEC’s litigation against Diamond Foods stating the following:
“As Diamond’s independent auditor, Deloitte was charged, inter alia, with auditing Diamond’s financial statements for the Fiscal Years ended July 31, 2010 and July 31, 2011, in accordance with Generally Accepted Auditing Standards (“GAAS”). Deloitte failed to do so and instead issued materially false and misleading unqualified audit opinions stating that Diamond’s Class Period financial statements had been prepared in accordance with GAAP, the internal controls over financial reporting were in place and effective, and that its audits complied with GAAS. Additionally, Deloitte was engaged to perform quarterly reviews of the financial statements included in Diamond’s Form’s 10-Q for the quarters within Fiscal Years 2010 and 2011” (SEC, 2014). Deloitte was released as Diamond Foods auditor in early 2013 in exchange for PricewaterhouseCoopers LLP (PwC). Deloitte was discharged from the SEC litigation on grounds that that the CEO and CFO did not disclose the procedures in which they were utilizing to pay walnut growers that mislead the auditors to believe accounting documents were correct and following GAAP procedures. Since Deloitte was dismissed from this case, they did not pay any fines for their involvement. Diamond Foods, along with their former CEO and CFO, paid $11 million in a settlement.

Below is a snap shot we have created that was simply extracted from the 10-k filings in 2011 VS the amounts shown for 2011 on the most recent 2014 10-k filing. The variances are due to the adjustments that have been made for the understated payments to walnut growers.

CONCLUSION:
Michael Mendes, former CEO of Diamond Foods, agreed to pay $125,000 to settle the allegations against him without admitting or denying them. In addition to the settlement, he paid back more than $4 million in bonuses and other benefits he had collected in 2010 and 2011. Mendes is currently the CEO of a privately held Bay Area maker of premium-baked goods, Just Desserts. Former CFO, Steven Neil, continues to fight the SEC’s charges and is headed for trial.
In December 2012, Diamond Foods’ new president and CEO, Brian Driscoll, informed shareholders on comprehensive strategic initiatives aimed to advance the company past its ethical mistakes. Driscoll issued a statement that identified three primary areas that needed to improve that the company felt led to the accounting scandal. The three areas included: 1) Control Environment, 2) Walnut Grower Accounting, and 3) Accounts Payable and Accrued Expenses. In the process of improving the internal controls of financial statements, six new directors were appointed to strengthen the board. Former CEO, Michael Mendes, focused on competition and quick growth instead of providing ethical leadership or an environment in which employees followed acceptable behavior. To rectify this issue, the company replaced the former CFO as well. The newly appointed CFO led ethics training to reinforce proper accounting procedures. Training led by the CFO and other top management demonstrated the company’s importance of proper accounting procedures as well as an ethical tone at the top. BlackRock investing group believes that Diamond Foods will rebound from this scandal. After investing in them in early February 2013, stock prices began to steadily rise. Given that their 5-year expected earnings growth is 13 percent, Diamond Foods’ future is starting to look promising. They have seen strong sales and profit performance with brands like Pop Secret and Kettle. In addition to rebuilding relationships with stakeholders, Diamond Foods is focusing on innovation and brand building. From a small group of walnut growers to a million dollar company, Diamond Foods has grown significantly over the past 100 years. Although its performance seems to be improving, the accounting scandal in 2011 tarnished the firm’s reputation. The company is currently taking steps to address its ethical risk areas and signs are showing that their ethical culture is improving. In 2013, its Stockton operation received the Green Sustainable Business Award and Certification for leadership in sustainability.

References

(2014) SEC Filings. Diamond Foods. Retrieved from: http://investor.diamondfoods.com/

(2014) SEC Charges Diamond Foods and Two Former Executives Following Accounting Scheme to Boost Earnings Growth. U.S. Securities and Exchange Commission. Retrieved from: http://www.sec.gov/litigation/complaints/

Byron, E & Ziobro, P. (2011). Diamond Buys P&G's Pringles. The Wall Street Journal. Retrieved from: http://online.wsj.com/articles/
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