4 The consensus estimates of fully diluted EPS for fiscal years 2007, 2008, 2009, 2010, and 2011 were $0.508, $0.888, $1.36, $1.373, and $2.319, respectively (Bloomberg Businessweek 2012). In comparison, the actual fully diluted EPS numbers were $0.53, $0.91, $1.44, $1.36, and $2.22, respectively in 2007 through 2011 (Diamond Foods 2006–2011).

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EXHIBIT 1 (continued)

Panel C: Statements of Cash Flows

Source: Diamond Foods, 10-K reports filed with the SEC.

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FIGURE 1 Diamond Foods

(Source: Annual reports of Diamond Foods and Yahoo Finance)

Panel A: Sales, Gross Profit, Net Income, EPS (2005–2011) of Diamond Foods

Panel B: History of Stock Returns

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Issues in Accounting Education Volume 30, No. 1, 2015

with the SEC in March 2010, Diamond touted its record of beating consensus analyst estimates for 12

consecutive quarters.

Michael Mendes appreciated the strong work ethic at Diamond and dedicated himself to his

job. His attention to detail provided Mendes with a deeper understanding of all aspects of the

Company’s operations. As one former employee said, ‘‘You could talk to Michael about anything

from nut sourcing to the prices being paid by Diamond’s international and retailer customers.

Mendes’ knowledge of what was happening at Diamond was the best of anyone in the Company’’

(Diamond Foods, Inc. 2012, 10).

Steven Neil, who had served as an independent director on Diamond’s board since 2005,

became Diamond’s executive vice president, and chief financial and administrative officer in March

2008 and served in that position until February 2012. Neil was reportedly the type of CFO who

maintained personal oversight of the general operations of the business and looked after several

functions including logistics, IT, treasury, grower relations, and purchasing. Neil visited walnut

growers in the field at least twice a year, usually once during harvest and once during some stage of

the bloom, either at the beginning of or during the middle of the summer (Diamond Foods, Inc.

2012, 174).

Compensation of Diamond’s Senior Management

Mendes and Neil were handsomely rewarded for their contributions to Diamond’s success.

Mendes’ compensation in fiscal 2004 was $1.1 million. Five years later, in 2009, it had more than

tripled to $3.8 million and for the fiscal year 2011, it almost doubled to approximately $7.3 million

(Diamond Foods 2006–2012). The compensation paid to Neil, who became CFO in March 2008,

was approximately eight times that of his predecessor CFO at the time of Diamond’s conversion

from a cooperative.

Consistent with the goal of becoming a performance-driven organization, the compensation of

Diamond’s senior management was tied to the Company’s success. Diamond’s annual bonus

incentives ‘‘were determined by both a corporate financial objective, representing 60 percent of

bonus potential, and individual objectives for each named executive officer, representing 40 percent

of bonus potential’’ (Diamond Foods, Inc. 2012, 179). In 2010 and 2011 Mendes received bonuses

of approximately $1.4 million and incentive compensation of more than $2.6 million, while Neil

received bonuses totaling more than $875,000 and incentive compensation worth more than $1.1

million (Henning 2012). 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

(Huffington Post 2012).

Plans for a More Prosperous Future: Diamond’s Attempts to Acquire Pringlest

On the heels of the past fruitful acquisitions and successful integration of Kettle Brandt Chips

in Diamond’s operations, the Company embarked upon an even more ambitious target, Pringlest.

Beginning in May 2010, Diamond submitted several purchase offers to Proctor & Gamble (P&G) to

purchase Pringlest. The Pringlest acquisition would make Diamond the second-largest snack food

company, only behind PepsiCo’s Frito-Layt.

Although Proctor & Gamble initially rejected Diamond’s offers, negotiations resumed in

February 2011. On April 5, 2011, Diamond reached an agreement to acquire Pringlest by

exchanging $1.5 billion of Diamond’s stock and paying $850 million in cash toward the total

purchase price of $2.35 billion. The transaction had a ‘‘cash collar,’’ such that if the price of

Diamond’s stock dropped, Diamond would increase the cash component to as high as $1.05 billion,

and if the stock price rose, the cash component would be reduced to as low as $700 million. In the

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press release announcing the signing of a definitive agreement for the proposed merger, Diamond

provided the following rationale for acquiring Pringlest:

The largest potato crisp brand in the world with sales in over 140 countries and

manufacturing operations in the U.S., Europe, and Asia, Pringlest had a combination of

proprietary products, unique package design and significant advertising investment. The

acquisition of Pringlest would enable Diamond to gain greater merchandising and

distribution influence, leverage its sales and distribution infrastructure, and obtain a

broader global manufacturing and supply chain platform with access into key growth

markets including Asia, Latin America, and Central Europe. (PR Newswire 2011)

The expected benefits of the merger appeared enticing. In the conference call to announce

Pringlest merger, Mendes stated, ‘‘In fiscal 2012 we expect net sales for the combined company to be approximately $1.8 billion and EPS in the range of $3.00 to $3.10. This reflects EPS accretion of

$0.12 to $0.15 per share’’ (Thompson Reuters Streetevents 2011). In the same conference call, CFO Steven Neil mentioned that although Diamond would incur merger and integration related costs of

approximately $100 million5 over the first two years, ‘‘the financial benefits of improved margins, significant EPS accretion, and free cash flow will make Diamond an even stronger company in the

future, delivering exceptional value to Diamond and P&G shareholders’’ (Thompson Reuters Streetevents 2011). News of the Pringlest acquisition and prospects of resulting improvement in

financial performance took Diamond’s share price to an all-time high of $96.13 in September 2011.

The Specter of Accounting Controversy Appears on Diamond’s Horizon

Everything seemed to be going perfectly well for Diamond until the publication of a report on

September 25, 2011 by Mark Roberts, an analyst with the Off Wall Street Consulting Group (Off

Wall Street 2011). Roberts noted that earnings for 2011 were likely overstated because the

Company made payments this year to pay off growers who were underpaid last year.

Roberts’ report on Diamond’s accounting sparked interest in the media. On September 26,

2011, an article in Reuters Breakingviews discussed the issue of payments to walnut growers

stating that ‘‘Diamond’s long-term contracts gave it great leeway to determine a final price at the end of the crop year. And while walnut prices have been rising thanks to Chinese demand, they are

among the most opaque in the agricultural world and can vary widely’’ (Reuters Breakingviews 2011). Quoting the growers contacted by Breakingviews, Reuters stated that ‘‘Based on a closing payment on August 31 for the previous year’s crop, [Diamond] undercut competitors by at least a

third, a far bigger discount than is typical’’ (Reuters Breakingviews 2011).6 On September 27, 2011, Wall Street Journal quoted that ‘‘Pressure from growers could quickly become an issue for Diamond. After all, growers can go elsewhere when contracts expire’’ (Wall Street Journal 2011).

Walnut Costs and Long-Term Grower Contracts

Walnut growers have long-term walnut purchase agreements with Diamond. Farmers deliver

their crop during the Fall harvest season (September-October-November) and the Company pays

the farmers in installments as per the guidelines issued at the beginning of the season. Typically, the

payments are made in three installments: the delivery payment (10–14 days after delivery); the

5 On September 16, 2011, Diamond announced in its proxy statement an increase of $50 million in the estimated transaction and integration costs of the Pringlest acquisition, raising the figure from $100 million to $150 million (Diamond Foods 2006–2011).

6 The article also reported that ‘‘Based on Diamond’s estimated market share, this makes the company’s costs around $60 million lower than they would be had Diamond paid something closer to rivals’’ (Reuters Breakingviews 2011).

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progress payment (February 15); and the final payment (August 15 of the following year). The

Company’s fiscal year ends July 31.

The final price for the walnuts delivered was not known at the time of delivery. Growers

accepted the price uncertainty in return for Diamond’s willingness to buy their entire crop,

recognition of their longstanding relationship with the Company, and the past experience of

Diamond’s paying a fair price for walnuts, especially in lean years. For example, in 2008, walnut

prices declined to about 60 cents a pound, but Diamond paid its growers more than 70 cents

(Barron’s 2011). The policy for Diamond’s accounting for inventories from its annual report for the fiscal year

ending July 31, 2011 (filed with the Securities and Exchange Commission [SEC] on September 15,

2011) stated:

All inventories are accounted for on a lower of cost (first-in, first-out) or market basis.

We have entered into long-term Walnut Purchase Agreements with growers, under which

they deliver their entire walnut crop to us during the Fall harvest season and we determine

the minimum price for this inventory by March 31, or later, of the following calendar year.

The final price is determined no later than the end of the Company’s fiscal year. This

purchase price will be a price determined by us in good faith, taking into account market

conditions, crop size, quality, and nut varieties, among other relevant factors. Since the

ultimate price to be paid will be determined subsequent to receiving the walnut crop, we

must make an estimate of price for interim financial statements. Those estimates may

subsequently change and the effect of the change could be significant. (Diamond Foods


The ‘‘Unusual’’ Recording of the Payments for the Fall 2009 and Fall 2010 Crops

While the delivery and progress payments for the Fall 2009 crop were made in a customary

fashion, the third and final payment in August 2010 was unusual. Diamond sent a letter to growers,

signed by CEO Mendes, stating that the August 2010 check was intended to ‘‘represent both the final payment of the Fall 2009 crop and a continuity payment reflecting the value of the multi-year supply

arrangement’’ (Diamond Foods, Inc. 2012, 182). The term ‘‘continuity payment’’ was not used before by Diamond, and not mentioned to growers in the annual guidelines for the Fall 2009 crop.7

The payment pattern for the Fall 2010 crop was similar to that for the Fall 2009 crop, except

that the phrase ‘‘momentum payment’’ was substituted for the phrase ‘‘continuity payment.’’ Diamond sent out two checks to each grower toward the final payment, one dated August 31, 2011

and the other dated two days later, September 2, 2011. Neither of these payments used the word

‘‘final payment’’ as Diamond did in the past. In the letter accompanying the September 2011 check, the Company stated that the momentum payment ‘‘is designed to reflect the projected market environment prior to your delivery of the 2011 crop . . . This payment conveys the anticipated value added by our branded walnut retail business during the transitional period prior to delivery and new

crop availability. The momentum payment is independent of and incremental to your upcoming

delivery payment’’ (Diamond Foods, Inc. 2012, 23). There were different views on whether the ‘‘continuity’’ and ‘‘momentum’’ payments made by

Diamond to the walnut growers should be recorded as purchases of the preceding or current fiscal year.

The Company treated them as purchases (and therefore, cost of sales) of the current year. For instance,

with regard to the August/September 2011 payment, Diamond issued a press release on October 3, 2011

7 Even with the continuity payment, Diamond paid less than the market price to farmers for the Fall 2009 crop.

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stating that it had made a ‘‘pre-harvest momentum payment to walnut growers in early September, prior

to the delivery of the Fall walnut crop to reflect the fiscal 2012 projected market environment and the

payment was accounted for in the fiscal year 2012 cost of goods sold’’ (Diamond Foods 2006–2012).

However, several walnut suppliers to Diamond maintained that the payment was for the crop of

the earlier year and hence should have been recorded as purchases (and hence, cost of sales) of the

prior year. Some of the ‘‘momentum’’ payments were puzzling because they were made to farmers

who terminated their relationship with Diamond in the spring following the 2010 crop season. A

supplier of walnuts to Diamond mentioned that she ‘‘knew at least two growers who had already

cancelled their contracts to sell walnuts to Diamond in Fall 2011, but still received the momentum

payment’’ (Diamond Foods, Inc. 2012, 26). Yet, Diamond’s management denied that these

payments were compensation for last year’s crop. Instead, they indicated that the payments were

made ‘‘in an effort to optimize cash flow for growers’’ ( 2011).

Diamond’s independent auditors—Deloitte—did not raise any red flags for Diamond’s

accounting treatment of ‘‘continuity’’ or ‘‘momentum’’ payments. They provided an unqualified

audit opinion on Diamond’s financial statements for fiscal years 2010 and 2011. Deloitte’s audit

opinions stated that Diamond complied with GAAP and maintained effective internal control over

its financial reporting.

Audit Committee Investigation, SEC Investigation, and Class-Action Suit

The September 25, 2011 report by Mark Roberts on Diamond’s questionable accounting and

the subsequent media attention it sparked resulted in an audit committee investigation, an SEC

investigation, and a class-action suit. In Fall 2011, Diamond’s audit committee initiated an internal

probe to investigate whether Diamond’s senior management intentionally adjusted the accounting

for the grower payments to increase profits for a given period. In December 2011, the SEC began a

formal investigation of Diamond’s recording of costs, payables to growers, and payments to them.

This was followed by a class-action suit demanding a jury trial against Diamond, its senior

management, and Deloitte—its auditors.

The plaintiffs in the class-action suit alleged that Diamond and its senior managers were

motivated to inflate share price of Diamond during a period in which Diamond was seeking to use

its stock to acquire Pringlest (Diamond Foods, Inc. 2012, 131). A financial accountant employed at

Diamond from April 2008 to May 2011 testified that he was asked by Diamond’s management to

change commodity costs ‘‘without any business justification for doing so’’ and was asked to prepare

financial reports to determine earnings ‘‘if we dropped commodity prices half a penny or one

penny’’ (Diamond Foods, Inc. 2012). If the executives approved, the change would be accepted and

recorded in a journal entry. Reportedly, at the conclusion of each month, the Company prepared an

Excel spreadsheet detailing the monthly financial statements. Then senior director Debra Donaghy,

controller Jim Tropp, and CFO Neil reviewed those results and ‘‘scrubbed’’ them (Diamond Foods,

Inc. 2012). According to one witness, it ‘‘seemed like every quarter they dropped commodity costs,

to get to EPS goals’’ (Diamond Foods, Inc. 2012). Because Diamond was buying a hundred million

pounds or more of walnuts, a small drop in the walnut cost per pound helped it to achieve a

significant change in earnings.

Prices that Diamond paid to the walnut growers were not disclosed publicly or internally. A

witness said that accounting for grower payments was maintained within a very small circle of people

including controller Jim Tropp, CFO Neil, CEO Mendes, and senior vice president of grower

accounting, Eric Heidman, Mendes’ brother-in-law (Diamond Foods, Inc. 2012, 13). An employee

who managed every price list for every product of Diamond said that he ‘‘knew pricing for everything

but in-shell nut price’’ and that senior management refused to give him that information when asked

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(Diamond Foods, Inc. 2012, 13). Another witness recalled situations where accounting decisions were

discussed in the context of the impact the decision would have on the Diamond share price.

A witness who was an assistant treasurer from 1999 through May 2011 testified that Neil and

other executives decided ‘‘on numerous occasions’’ to accelerate payments or delay recognizing an

expense in order to make their earnings look better. ‘‘If we were making too much money they

would push more costs in. Whenever we couldn’t hit our numbers, [or] if they needed extra money,

it was always commodity costs that got changed’’ (Diamond Foods, Inc. 2012, 18).

Despite the allegations above, Diamond’s management insisted that its accounting for grower

payments was fine. In October 2011, an analyst at RBC Capital Markets, who spoke with

Diamond’s executives, wrote, ‘‘Management insists that this ‘momentum’ payment is viewed and

treated internally as a payment related to this year’s crop, not last year’s, and that attestations to the

contrary are simply misinformed’’ ( 2011).

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