Diamond Foods Accounting Scandal Stems From Years of Bad Practices

Snack maker, Diamond Foods’ accounting scandal may have surprised many in recent months but some accounting and industry experts claim they have already spotted red flags some time before the scandal was revealed to the public.

The warning signs found in a close examination of business practices at the nation’s largest walnut processor and maker of Emerald nuts including unusual timing of payments to growers, a jump in profit margins, and volatile inventories and cash flows.
Per interviews with former employees, board members, rivals, and suppliers, the company has for years seemed to push hard on every lever to meet increasingly ambitious earning targets and allowed top executives to pull in big bonuses.

Among those who noticed the early red flags at Diamond is Nick Feakins who teaches forensic accounting at San Jose State University and does some work for Bevmark, a food and beverage consultant that was monitoring Diamond for its client, PepsiCo’s Frito Lay.

Per the Huffington Post report, Feakins said the relentless climb in Diamond’s profit margins looked suspicious to him. Boosted in part by purchasing of two high-margin snack brands, net income of Diamond rose to more than five percent in fiscal 2011 from 1.5 percent in fiscal 2006. He said, even with rising Asian demand, no competitors were improving in such rate.

As early as last April, Bevmark raised concerns about Diamond in reports to clients, based on questions from Feakins and others at Bevmark about Diamond’s board and management, its rapid expansion, and dissatisfaction among growers.

All the Wrong Signs

Douglas Barnhill, an accountant and a farmer of 75 acres of California walnut groves, received a mysterious check for $46,000 from Diamond, prompting him to question the reason for the payment. He said he has spoken with Eric Heidman, Diamond’s director of field operations twice to figure out if the check was a final payment for his 2010 crop or pre-payment of 2011 harvest.

Diamond growers are paid in installments, with final pay for the prior fall’s crop coming late the following year. Though it was September of 2011, Barnhill was still waiting for full payment of his 2010 crop. Barnhill then saw news stories quoting analysts and the company saying it was an advance payment for the next crop but Heidman told him the opposite.

Inventory swings were also a problem at Diamond. Barnhill saw a pattern in which year after year, Diamond, citing industry figures, would initially predict sizeable year-end inventories. But after payments were made to growers, Diamond would report significantly lower actual inventories, leaving Barnhill suspicious.

Following an investigation on February 8 this year, an audit committee said it had 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. A delay in booking payments from one fiscal year to the next could artificially reduce costs and boost earnings in that period.

The company will restate its earnings for the two years, but no one knows by how much. The company has so far replaced its chief executive, Michael Mendes, chief financial officer, Steven Neil, and has appointed two new directors to its audit committee. More accounting issues may yet surface.

Cash flow trends of the company are among areas that may still raise questions. Net income growth is generally reflected in operating cash flow increases but at Diamond, cash generation was sluggish in fiscal 2010 when earnings were strong.

Bonuses to executives raised more concerns on Diamond’s ledger. In September 2010, Mendes boldly promised earnings per share growth of 15 percent to 20 percent annually for the next five years. From 2009 to 2010, $2.6 million of Mendes’ $4.1 million annual bonus was paid because Diamond beat its EPS goal, according to regulatory filings.

Mendes also used predictions of further growth to drive up stock price, which helped to finance its acquisition of other snack foods businesses and diversify beyond the Emerald nuts business. Pop Secret popcorn was acquired in 2008, Kettle potato chips in 2010, and barely a year later, Diamond agreed to buy Pringles potato chips from Procter & Gamble for $2.35 billion, of which $1.5 billion came in the form of Diamond stock.
The deal was postponed following the board’s accounting inquiry. The deal fell apart later.

Per one famous quote from my accounting professor at grad school, creativity has no place in accounting. If you do not know the source of the numbers you are looking at, it is probably an accounting scandal in the making.

Reese Darragh is a contributing writer for CompliancEX and Wall Street Job Report. She is an experienced business news writer with expertise in macroeconomics topic, the financial industry, rules and regulations including the Dodd-Frank Act and the Sarbanes-Oxley Act as well as rules from other federal regulators. She has a Master Degree in International Economics and Finance from Brandeis University.

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