Why were the actions of Diamond Foods with respect to its ‘accounting for nuts’ unethical?

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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