Diamond foods fraud case

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

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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