Diamond Foods Fraud Illustrates the Danger of overly-optimistic Earnings Projections

Management does it all the time – set overly optimistic earnings and earnings per share projections to motivate financial analysts to give positive recommendations to current and potential investors with respect to stock holdings. It was the fuel that engineered the accounting frauds at Enron, WorldCom, et al. A recent example is 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 fiscal 2011 to $29.7 million and by 46 percent for fiscal 2010 to $23.2 million. By December 7, 2012, Diamond’s share price had declined 54 percent during 2012.

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 a 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 pre-payment 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 he had sent Diamond in 2010. Heidman told Barnhill that the payment was for the 2010 crop, part of fiscal 2011, 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 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 does not seem that the auditors lived up to their professional responsibilities in detecting and/or reporting the fraud.

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’ cash clawback was deducted from his retirement payout of $5.4 million. Former chief financial officer Steven Neil was fired on November 19, 2012 and did not receive any severance.

An interesting aspect of the case is the 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 fiscal 2006 to more than 5 percent in fiscal 2011. According to Feakins, “no competitors were improving like that; even with rising Asian demand…it just doesn’t make sense.” 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 fiscal 2010 when earnings were strong. This raises questions about the quality of earnings. Also, in September 2010 Mendes had promised earnings per share growth of 15 percent to 20 percent per year for the next five years. 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.

The ethical issues in this case are fairly obvious: misleading financial results; improper accounting; and a corporate governance system that did not work. The earnings projections raise questions whether auditors should include these projections in their audit work. In accounting, they are referred to as “forward-looking” statements and cautionary language is assigned to the amounts. However, this is insufficient to protect the public in an environment of capitalism run amok.

Blog posted by Steven Mintz, aka Ethics Sage, on February 18, 2013