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The case study,

The case study,
requirement:
· Read the question closely; be sure you know what is being asked. Briefly, indicated the facts of the case and write a brief outline of what you want to fit into your 3 pages.
· Identify the dilemma: explain the ethical issue and support for alternative choices. Contrast reasons using prepositions: benefit/consequences of doing or not doing
· Explain the benefits/ consequences in terms of who, when, dollar amount, and certainty positive and negative consequences. Consider long run versus short run consequence.
· Choose one position and explain the reason it is more ethical than the alterbatives refuting your support for the other positions. Where there is a dilemma, explain why ethical support for one choice is better than support for the other choices. Explain why this case is important.
Case also can be found at the attached PDF file page 491.
Please use the knowledge related to the book. No outside resource allowed.
Thanks.
Case 7-8
Diamond Foods
On November 14, 2012, Diamond Foods Inc. disclosed
restated financial statements tied to an accounting scandal
that reduced its earnings during the first three quarters
of 2012 as it took significant charges related to improper
accounting for payments to walnut growers. The restatements
cut Diamond’s earnings by 57 percent for FY2011, to
$29.7 million, and by 46 percent for FY2010, to $23.2 million.
By December 7, 2012, Diamond’s share price had declined
54 percent for the year. A press release issued by the company
explains in great detail the accounting and financial
reporting issues. 1
Diamond Foods, long-time maker of Emerald nuts and
subsequent purchaser of Pop Secret popcorn (2008) and
Kettle potato chips (2010), became the focus of an SEC
investigation after The Wall Street Journal raised questions
about the timing and accounting of Diamond’s payments to
walnut growers. The case focuses on the matching of costs
and revenues. At the heart of the investigation was the question
of whether Diamond senior management adjusted the
accounting for the grower payments on purpose to increase
profits for a given period.
The case arose in September 2011, when Douglas
Barnhill, an accountant who is also a farmer of 75 acres of
California walnut groves, got a mysterious check for nearly
$46,000 from Diamond. Barnhill contacted Eric Heidman,
the company’s director of field operations, on whether the
check was a final payment for his 2010 crop or prepayment
for the 2011 harvest. (Diamond growers are paid in installments,
with the final payment for the prior fall’s crops coming
late the following year.) Though it was September 2011,
Barnhill was still waiting for full payment for the walnuts that
he had sent Diamond in 2010. Heidman told Barnhill that the
payment was for the 2010 crop, part of FY2011, but that it
would be “budgeted into the next year.” The problem is under
accounting rules, you cannot legitimately record in a future
fiscal year an amount for a prior year’s crop. That amount
should have been estimated during 2010 and recorded as an
expense against revenue from the sale of walnuts.
An investigation by the audit committee in February 2012
found payments of $20 million to walnut growers in August
2010 and $60 million in September 2011 that were not
recorded in the correct periods. The $20 million payments
to growers in 2010 caught the eye of Diamond’s auditors,
Deloitte & Touche. However, it is uncertain whether the firm
approved the accounting for the payments. It is an important
determination because corporate officers can defend against
securities fraud charges by arguing they did not have the
requisite intent because they relied on the approval of the
accountants.
The disclosure of financial restatements in November 2012
and audit committee investigation led to the resignation of former
CEO Michael Mendes, who agreed to pay a $2.74 million
cash clawback and return 6,665 shares to the company.
Mendes’s cash clawback was deducted from his retirement
payout of $5.4 million. Former CFO Steven Neil was fired on
November 19, 2012, and did not receive any severance.
As a result of the audit committee investigation and the
subsequent analysis and procedures performed, the company
identified material weaknesses in three areas: control environment,
walnut grower accounting, and accounts payable
timing recognition. The company announced efforts to remediate
these areas of material weakness, including enhanced
oversight and controls, leadership changes, a revised walnut
cost estimation policy, and improved financial and operation
reporting throughout the organization.
An interesting aspect of the case is the number of red
flags, including unusual timing of payments to growers,
a leap in profit margins, and volatile inventories and cash
flows. Moreover, the company seemed to push hard on every
lever to meet increasingly ambitious earnings targets and
allowed top executives to pull in big bonuses, according to
interviews with former Diamond employees and board members,
rivals, suppliers and consultants, in addition to reviews
of public and nonpublic Diamond records.
Nick Feakins, a forensic accountant, noted the relentless
climb in Diamond’s profit margins, including an increase in
net income as a percent of sales from 1.5 percent in FY2006
to more than 5 percent in FY2011. According to Feakins,
“no competitors were improving like that; even with rising
Asian demand . . . it just doesn’t make sense.” 2 Reuters did a
review of 11 companies listed as comparable organizations in
Diamond’s regulatory filings and found that only one, B&G
Foods, which made multiple acquisitions, added earnings
during the period.
Another red flag was that while net income growth is generally
reflected in operating cash flow increases, at Diamond,
the cash generation was sluggish in FY2010, when earnings
were strong. This raises questions about the quality of earnings.
Also, in September 2010, Mendes had promised EPS
growth of 15 percent to 20 percent per year for the next
five years. In FY2009, FY2010, and FY2011, $2.6 million
of Mendes’s $4.1 million in annual bonus was paid because
Diamond beat its EPS goal, according to regulatory filings.
It was expected that the company would likely face a civil
enforcement action by the SEC for not maintaining accurate
books and records and failing to maintain adequate internal
controls to report the payments properly, both of which are
required for public companies. If the SEC decides to bring
1 Available at www.investor.diamondfoods.com/phoenix.zhtml?c=
189398&p=irol-newsArticle&id=1758849 .
2 Available at www.reuters.com/article/2012/03/19/us-diamondtax-
idUSBRE82I0AQ20120319 .
Chapter 7 Earnings Management and the Quality of Financial Reporting 469
a civil fraud case against any individuals at Diamond Foods,
the Dodd-Frank Act gives it the option of filing either an
administrative case or a civil injunctive action in Federal
District Court. An administrative proceeding is generally
considered a friendlier venue for the SEC.
Questions
1. One of the red flags identified in the case was that operating
cash flow increases did not seem to match the level of
increase in net income. Explain the relationship between
these two measures and why it raised questions about the
quality of earnings at Diamond Foods.
2. Why were the actions of Diamond Foods with respect to its
‘accounting for nuts’ unethical?
3. The role of Deloitte & Touche is unclear in the case. We
do not know whether the firm approved the accounting
for the payments to walnut growers and periods used to
record these amounts. Assume that the firm identified
the improper payments and discussed the matter with
management (i.e., CFO and CEO). What levers might
Deloitte use to convince top management to correct the
materially misstated financial statements?

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