University of Maryland Diamond Foods Inc and GAAP Case Study Only complete requirements 1-3. Diamond Foods, Inc.: Anatomy and Motivations of Earnings Manip

University of Maryland Diamond Foods Inc and GAAP Case Study Only complete requirements 1-3. Diamond Foods, Inc.: Anatomy and Motivations of Earnings Manipulation Mahendra R. GujarathiThe case is attached..Please i need the solution in your own words as TURNITIN is activated, and please cite references with APA format. ISSUES IN ACCOUNTING EDUCATION
Vol. 30, No. 1
2015
pp. 47–69
American Accounting Association
DOI: 10.2308/iace-50948
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; ?nancial 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
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Gujarathi
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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-a?-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
2
3
Information in this section is obtained from various annual reports of the Company filed with the Securities and
Exchange Commission.
In March 2010, Diamond Foods also raised approximately $180 million through the sale of 175 million shares of
common stock.
The information regarding percentage of walnut sales was not disclosed in the annual reports for fiscal 2010 and 2011.
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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)
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EXHIBIT 1 (continued)
Panel B: Statements of Operations
Source: Diamond Foods, 10-K reports filed with the SEC.
(continued on next page)
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
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).
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Diamond Foods, Inc.: Anatomy and Motivations of Earnings Manipulation
EXHIBIT 1 (continued)
Panel C: Statements of Cash Flows
Source: Diamond Foods, 10-K reports filed with the SEC.
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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
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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
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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 Breakingviews 2011).6 On September 27,
2011, Wall Street Journal quoted that ‘‘Pressure from growers could quickly become an issue for
Diamond. After all, growers can go elsewhere when contracts expire’’ (Wall Street Journal 2011).
Walnut Costs and Long-Term Grower Contracts
Walnut growers have long-term walnut purchase agreements with Diamond. Farmers deliver
their crop during the Fall harvest season (September-October-November) and the Company pays
the farmers in installments as per the guidelines issued at the beginning of the season. Typically, the
payments are made in three installments: the delivery payment (10–14 days after delivery); the
5
6
On September 16, 2011, Diamond announced in its proxy statement an increase of $50 million in the estimated
transaction and integration costs of the Pringlest acquisition, raising the figure from $100 million to $150 million
(Diamond Foods 2006–2011).
The article also reported that ‘‘Based on Diamond’s estimated market share, this makes the company’s costs around
$60 million lower than they would be had Diamond paid something closer to rivals’’ (Reuters Breakingviews 2011).
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progress payment (February 15); and the final payment (August 15 of the following year). The
Company’s fiscal year ends July 31.
The final price for the walnuts delivered was not known at the time of delivery. Growers
accepted the price uncertainty in return for Diamond’s willingness to buy their entire crop,
recognition of their longstanding relationship with the Company, and the past experience of
Diamond’s paying a fair price for walnuts, especially in lean years. For example, in 2008, walnut
prices declined to about 60 cents a pound, but Diamond paid its growers more than 70 cents
(Barron’s 2011).
The policy for Diamond’s accounting for inventories from its annual report for the fiscal year
ending July 31, 2011 (filed with the Securities and Exchange Commission [SEC] on September 15,
2011) stated:
All inventories are accounted for on a lower of cost (first-in, first-out) or market basis.
We have entered into long-term Walnut Purchase Agreements with growers, under which
they deliver their entire walnut crop to us during the Fall harvest season and we determine
the minimum price for this inventory by March 31, or later, of the following calendar year.
The final price is determined no later than the end of the Company’s fiscal year. This
purchase price will be a price determined by us in good faith, taking into account market
conditions, crop size, quality, and nut varieties, among other relevant factors. Since the
ultimate price to be paid will be determined subsequent to receiving the walnut crop, we
must make an estimate of price for interim financial statements. Those estimates may
subsequently change and the effect of the change could be significant. (Diamond Foods
2006–2012)
The ‘‘Unusual’’ Recording of the Payments for the Fall 2009 and Fall 2010 Crops
While the delivery and progress payments for the Fall 2009 crop were made in a customary
fashion, the third and final payment in August 2010 was unusual. Diamond sent a letter to growers,
signed by CEO Mendes, stating that the August 2010 check was intended to ‘‘represent both the final
payment of the Fall 2009 crop and a continuity payment reflecting the value of the multi-year supply
arrangement’’ (Diamond Foods, Inc. 2012, 182). The term ‘‘continuity payment’’ was not used before
by Diamond, and not mentioned to growers in the annual guidelines for the Fall 2009 crop.7
The payment pattern for the Fall 2010 crop was similar to that for the Fall 2009 crop, except
that the phrase ‘‘momentum payment’’ was substituted for the phrase ‘‘continuity payment.’’
Diamond sent out two checks to each grower toward the final payment, one dated August 31, 2011
and the other dated two days later, September 2, 2011. Neither of these payments used the word
‘‘final payment’’ as Diamond did in the past. In the letter accompanying the September…
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