Analysis of a Financial Statement Fraud in Diamond Foods Inc.

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Table of Contents

Introduction
The Business Background
Accounting for Walnut Costs in 2010
Accounting for Walnut costs in 2011
Conclusion
Recommendation
Reference

Introduction

Diamond Foods Inc. is a premium snack food and nuts manufacturing company based out of San Francisco, California. In the beginning, Diamond was a cooperative society formed by Walnut farmers. Diamond has transformed immensely since inception; the cooperative evolved into a company and started trading its stock publicly in 2005. The company has grown through strategic acquisitions over the years, with notable company acquisitions including Kettle Foods, J Stone & Son and more recently (2008), the strategic brand Pop Secrets.

Today, the company’s product portfolio includes potato chips, snack nuts, in-shell nuts, culinary nuts, and popcorn. Evidently, this is quite a tremendous growth from the initial focus on Walnuts. Some of their well-known brands are Kettle Brand, Kettle Chips, Emerald, Pop Secret and Diamond of California. The company’s focus is to grow through strengthening their brands. The aim is to create engaging brand experiences for their consumers and create love for, and loyalty to, their food brands.

This paper focuses on Financial Fraud at Diamond Inc. The Securities Exchange Commission has fined Diamond Inc. $5million as a penalty for financial fraud and earnings management in the period between 2009 and 2011.The paper will investigate how this fraud was conducted, the failures in the internal controls at Diamond and the consequences. Finally, the paper will offer a recommendation to prevent such a recurrence in the future.

The Business Background

Diamond’s original business model involved purchase of Walnuts from farmers and re-sale to retailers at a higher price. This consolidation of farmers’ effort enabled them to obtain good prices for their crops. In 2005, Diamond sold its stock to the public, at $17 for every share, in a popular IPO, which was a huge success. The public company began, and then continued to grow by acquisition.

Despite these new developments, Walnuts remained at the heart of Diamond’s business, which is evident from the fact that the company’s biggest commodity cost was the money paid to farmers for walnuts. This meant that increases in commodity cost would ultimately result in decrease in Diamond’s earnings. On the other side, the company was under pressure because competitors were offering better prices for the walnut crops. If Diamond did not offer a competitive price as well, they would lose the crops to competition or strain their relationship with its suppliers.

Financially, Diamond had been performing quite well, the CFO was under pressure to maintain or improve this performance, however. In addition, the company was under pressure to meet Wall Street analysts’ forecast on its EPS, which meant that the company had minimum profit targets it had to achieve in order to report the expected EPS. Because of the Fraud, Diamond was able to exceed all analysts’ expectations on EPS consistently over the period in question. This resulted in tremendous stock price growth from an average of $39 to $90. The company was also able to raise $181 million through a stock issue.

Accounting for Walnut Costs in 2010

Diamond had received all the Walnuts for the 2010 Financial Year from the farmers as of October 31; 2009.The company accountants recorded the crop price at 82 cents per pound. The following year, the pressure to exceed EPS targets started getting to the CFO, Neil. Analysts estimated that Diamond would report an EPS of $0.47 per share. With the current Walnut price at 82 cents, Neil knew there was no way he would meet analysts’ expectations (Whitehouse, 2014).

The CFO asked the finance team to carry out simulations and return to him with a walnut cost that would enable them to meet or beat the analysts’ expectation. This price was 72 cents. It was a whole 10 cents lower than the actual price. Neil instructed accountants to adjust the books and estimates to reflect this new artificial price of 72 cents. When Diamond filed its returns, it reported a lower EPS. Neil had achieved his objective of exceeding analysts’ expectations.

Diamond Inc. determined the final crop price, which dictated the amount of money farmers would be paid for supplying the year’s walnuts. The price would be determined by several factors: crop size, quality, nut varieties, and market conditions. The company committed to pay this determined price, in good faith, to the farmers.

Generally Accepted Accounting Principles dictated that the company was to record any inventory and payables at the actual cost. In addition, such costs and current liabilities were to be recorded in the period they were incurred. Similarly, any revenue obtained from walnuts sale was to be recorded in the period the nuts were actually sold. It is important to note that this cost under discussion (walnut cost) affected inventory, payables, and cost of goods in Diamond Inc.’s financial statements.

In March 2010, Diamond recorded an estimated final crop price of 71 cents per pound, which caused a lot of dissatisfaction among the company’s walnut suppliers. They knew that competition was paying an average of 87 cents per pound for the same crop and there was a threat that farmers would switch to the competition. The farmers informed Diamond that their expectation was to receive a crop price within 5 cents difference of the competition’s price. At 71 cents, the gap was 16 cents. At this time, Neil assured the farmers, through his Growers Relations Team, that Diamond would ultimately close this gap in the payment.

In 2010, Neil authorized the discharge of a “continuity payment” to the walnut farmers/suppliers who had supplied their crop the previous year. The payment was approximately 10 cents per pound. It closed the gap, as promised, to reach the farmer’s expectations. This payment was issued simultaneously with the 71 cents per pound for the final crop price. In addition, there was a statement accompanying this check titled “Final Payment 2009 crop”. However, in the financial statements, only 71 cents was recorded as the final crop price. The continuity payment was excluded from the expenses. It was recorded as an advance payment for the next year’s crop. In total, the “continuity payment” was $20 million (Whitehouse, 2014).

The independent auditors questioned the continuity payment. Neil reassured them that it was meant for the 2011 crop. However, there was a missing link. Some payments were made to farmers who were not under contract to provide the 2011 crop. These payments totaled $850,000. The only common trend among the farmers, who received the payment, was that they all delivered the 2010 crop.

Diamond reported good results for the year-end July 31, 2010. Wall Street analysts had predicted a full year EPS of between $1.84 and $1.88. Diamond reported EPS of $1.91, exceeding analysts’ expectations by 7 cents. This represented a 52% earnings growth in 2010. Unfortunately, these good results further raised earnings expectations for the following year (Whitehouse, 2014).

Accounting for Walnut costs in 2011

Diamond’s business environment did not change much in 2011. The Walnut farmers were demanding better crop prices, while the Wall Street analysts kept projecting improved financial results. Therefore, Neil repeated the previous year’s fraud. He manipulated the accrual of inventory costs to ensure that Diamond would achieve EPS targets. In 2011, Diamond, yet again, exceeded all EPS targets set by Wall Street analysts. Secondly, Neil and his team excluded a portion of the cost of the Walnuts from the year’s financial statements, which resulted in falsified books and records for the year 2011.

In 2011, Diamond planned to continue expanding by acquisition. The company was interested in acquiring the Pringles brand from Proctor and Gamble. The company’s share price was central to this deal, because part of the payment would be done in 29 million Diamond shares. The anticipated acquisition put further pressure on Neil to report good earnings and ensure a high share price (Whitehouse, 2014).

The final crop payment for the 2010 crop (financial year 2011) was to be paid in the spring of 2011. Competition had paid a minimum of $1 and a maximum of $1.2 per pound to farmers. Diamond on the other hand had paid only 57 cents per pound to its farmers as a first installment. This resulted in dissatisfaction similar to the previous year. Neil was under pressure to calm the disgruntled farmers and simultaneously report good earnings. The Growers Relations Team was assured that Diamond would pay a competitive price in the end. Diamond set the price at around $1 per pound and relayed this information to the farmers.

The finance team settled on a final crop payment of 8 cents per pound, which brought the “supposed” total crop payment to 65 cents. This was almost half of what other handlers had paid farmers for their walnuts. To make up for the difference, Diamond issued a “momentum” payment of 30 cents per pound to its farmers. Instead of recording this payment as part of the cost to acquire the current year’s crop, Diamond recorded it as another advance payment for the coming year’s crop.

Supposing the company failed to pay this “momentum payment”, the crop price offered for the 2011 crop would have been roughly 40 cents lower than other handlers. The Growers Team indicated to some farmers that this payment was to top up the final payment of 8 cents issued earlier. As a result, the EPS reported for the 2011 year was reported as $2.61 in comparison to analysts’ prediction of $2.49, which represented a 37% increase in EPS for the year.

The telltale sign that exposed Neil’s fraud was the criteria used to compute the momentum payment for each farmer. The payment was computed based on the pounds of walnut delivered in 2010.Similarly to the previous year, Neil paid out close to $9 million to growers who were not on contract to deliver the 2012 crop. Additionally, Neil used part of the money to pay growers who were on contract, but did not deliver.

Conclusion

Diamond Foods Inc. was found guilty of financial reporting fraud and earnings management. The company excluded current year expenses from the Income Statement resulting in higher recorded income. In addition, Neil falsely recorded current period inventory costs as pre-payments. Diamond was also found guilty of manipulation of inventory cost (walnut cost) in order to meet its EPS targets.

The result of this financial fraud was devastating to the company and its shareholders. First, Proctor and Gamble cancelled the deal to sell the Pringles brand. Secondly, the company’s stock price dropped radically by an average of $73 per share. The market was not sympathetic, and Diamond lost market capitalization of roughly $1.7 billion. The company also had to file re-stated financial statements with the Securities Exchange Commission, which was done in November 2012. The re-stated financials included the “momentum” and “continuity” payments as cost of inventory for the year 2010 and 2011. The restatement led to an increase in cost of goods, inventory/stock, and credit payables. Additionally, SEC ordered Diamond Inc. to pay $5 million penalty for this fraud.

Recommendation

Diamond Inc. needs to improve internal controls. Additionally, Diamond Inc. needs to ensure that it records the costs of goods in the period they are incurred. Unlike the Chief Financial Officer that falsified accounts for two years, Diamond Inc. should emphasize the importance of ethics to their employees. These will work positively in ensuring the company does not experience a similar situation in future. Lastly, Diamond Inc. should look into processes and procedures with the aim of staying ahead of employees who may identify loopholes. The company should seal these loopholes to prevent a similar situation. Additionally, the company should provide recommendations to the government, regarding the best ethical practices, as a way of creating a pool of such ethical practices.

Reference

Whitehouse, T. (2014). SEC Alleges Accounting Fraud at Diamond Foods. Web.

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