ACCOUNTING

EPILOGUE

On November 2, 2011, Dayton Business Journal published an article stating that P&G delayed the sale of Pringlest to Diamond Foods until the end of June 2012 because of Diamond’s internal

accounting investigation (Dayton Business Journal 2011). Diamond’s shares, which were trading at more than $90 in September 2011, were trading below $28 by December 2011.

On February 8, 2012, Diamond disclosed the following in its 8-K filing (Report of

Unscheduled Material Events or Corporate Event) to the SEC:

The Audit Committee has substantially completed its investigation of the Company’s

accounting for certain crop payments to walnut growers. The Committee has identified

material weaknesses in the Company’s internal control over financial reporting and

concluded that a ‘‘continuity’’ payment made to growers in August 2010 of approximately $20 million and a ‘‘momentum’’ payment made to growers in September 2011 of

approximately $60 million were not accounted for in the correct periods. The Audit

Committee concluded that the Company’s financial statements for the fiscal years 2010

and 2011 will need to be restated. (Diamond Foods 2006–2012)

Diamond placed Michael Mendes and Steven Neil on administrative leave effective February 8,

2012 for their alleged involvement in the accounting scandal. Subsequently, they both resigned from

their positions in November 2012. In a separate agreement, Mendes agreed to pay the Company a

$2.74 million cash clawback, representing the total value of his 2010 and 2011 bonuses, and return

6,665 shares of Diamond stock awarded to him after fiscal 2010 (San Francisco Business Times 2012). On February 15, 2012, Diamond Foods and P&G mutually terminated the deal to acquire

Pringlest. Diamond did not have to pay any break-up fees to P&G. Pringlest was acquired by Kellogg Company for $2.7 billion cash.

In its annual report for fiscal year 2012, filed with the SEC on December 7, 2012, Diamond

reported sales of $981 million, a 1.55 percent increase over the 2011 sales of $966 million. The

Company stated that its gross margin percentage (18.3 percent in 2012 compared to 22.4 percent in

the prior year) contracted primarily due to the decline in walnut volume, increase in walnut

commodity costs, and heavy promotional spending on snack brands. Diamond reported a negative

EPS of $3.98 and suspended dividend payments.

On August 21, 2013, Diamond agreed pay about $100 million to settle the shareholder lawsuit.

The Company said that it would pay $11 million in cash and issue 4.45 million common shares to a

fund to settle the lawsuit relating to the accounting scandal (Reuters 2013).

On January 9, 2014, the SEC reached a settlement with the Company in which Diamond

agreed to pay $5 million (SEC v. Diamond Foods, Inc. 2014). Accounting Today (2014) stated, ‘‘By

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disguising the fact that the payments were related to prior crop deliveries, Diamond was able to

manipulate walnut costs in its accounting to hit quarterly targets for earnings per share and exceed

analyst estimates.’’ The SEC also reached a settlement with Michael Mendes who agreed to pay a $125,000 penalty to settle the charges without admitting or denying the allegations (SEC v. Michael Mendes 2014). The SEC’s litigation is continuing against Steven Neil (SEC v. Steven Neil 2014).

REQUIREMENTS8

Requirement 1

Does Diamond’s recording of the August 2010 ‘‘continuity’’ payments and August/September 2011 ‘‘momentum’’ payments as the purchases of fiscal 2010 and fiscal 2011, respectively, comply with the U.S. GAAP (Generally Accepted Accounting Principles)? Why or why not? Provide support

from the accounting literature, including the FASB Concept Statements, in support of your argument.

Requirement 2

Diamond’s audit committee concluded that a ‘‘continuity’’ payment made to growers in August 2010 of approximately $20 million and a ‘‘momentum’’ payment made to growers in August/ September 2011 of approximately $60 million were not accounted for in the correct periods. Calculate

the effect of Diamond’s incorrect recording of the August 2010 and August/September 2011

payments on the pretax income for the years ending July 31, 2010 and July 31, 2011, respectively.

Explain and provide supporting calculations, if any. For this requirement, assume that Diamond sold

all the walnuts purchased during a fiscal year in that year itself (i.e., there is no inventory brought

forward from the previous fiscal year or carried forward to the subsequent fiscal year).

Requirement 3

(a) What were plausible motivations for Diamond’s management to misstate financial results

for fiscal 2010 and 2011?

(b) What would the management of a company such as Diamond, that was reportedly growing

fast in sales and profits each year, need to do in subsequent years if it wants to manage

income the same way as it did in fiscal 2010 and 2011? Would it be possible?

Requirement 4

(This requirement and the data therein are independent of other case requirements.)

(a) Assume that a walnut farmer agrees to supply 100,000 pounds of walnuts to Diamond

Foods during the Fall 2009 crop season. The walnuts are delivered on September 15, 2009

when the estimated price is $0.80/pound. Diamond agrees to make payments according to

the following schedule:

Date Payment

October 12, 2009 35 percent of the estimated price. Estimated price is $0.80/pound.

February 15, 2010 85 percent of the total payment based on the latest estimated price will be paid by this

date. Estimated price on this date is $0.90/pound.

August 15, 2010 The remaining payment is made.

8 An Excel file containing the data in the Case Exhibits is available as a downloadable file, see Appendix A.

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On April 15, 2010, Diamond announces to all the walnut suppliers that the final price for

the Fall 2009 crop will be $1.00/pound. On May 15, 2010, Diamond sells 88 percent of the

walnuts purchased from the farmer for cash at the rate of $1.20/pound. The remaining 12

percent of the walnuts is carried in inventory to the following fiscal year.

Prepare the necessary journal entries in the books of Diamond Foods on (1) September 15,

2009, (2) October 15, 2009, (3) February 15, 2010, (4) April 15, 2010, (5) May 15, 2010,

and (6) August 15, 2010. Also, present the necessary adjusting entries, if any, at the end of

Diamond’s fiscal year on July 31, 2010. Closing entries need not be presented. Assume that

Diamond follows a periodic inventory system.

(b) Assume that Diamond would like to manage income by manipulating the recorded cost of

walnuts acquired from the farmer. It chooses to record the payment of August 15, 2010 as

purchases of the following fiscal year ending July 31, 2011. How would the journal entries

in Requirement 4 (a), including adjusting entries, if any, on July 31, 2010 be different?

(c) What would be the effect on the financial statement items in the table below of the incorrect

recording of the August 15, 2010 payment as purchases of the following year (ending July

31, 2011)? Assume that Diamond follows the periodic inventory system. Indicate the

direction (O/S ¼ Overstatement, U/S ¼ Understatement, NE ¼ No effect) as well as the amounts.

(d) If the error in recording the August 15, 2010 payment is discovered on September 15, 2011

(before the books are closed for the fiscal year ending July 31, 2011), what would be the journal entry necessary to correct the error? Ignore the tax effects.

(e) Continue with 4(d) above. Assume that the tax rate is 35 percent and that Diamond follows

the accrual method for tax reporting. What would be the journal entry to record the income

tax effects of the misstatement?

(f ) If the error in recording the August 15, 2010 payment is discovered on September 25, 2011

(after the books are closed for the fiscal year ending July 31, 2011), what journal entry, if any, would be necessary to correct the error? Ignore the income tax effects.

(g) Continue with 4(f ) above. Assume that the tax rate is 35 percent and that Diamond Foods

follows the accrual method for tax reporting. What journal entry, if any, would be

necessary to record the income tax effects of the misstatement?

Requirement 5

(a) The audit committee of Diamond reported that payments to walnut growers of about $20

million in August 2010 and about $60 million in August/September 2011 were not booked

in the correct periods. Present the effect of correcting the grower accounting errors on the

comparative balance sheets and comparative statements of operations of Diamond. Provide

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your answers in the formats provided at the end of the case in Exhibit 2, Panel A—Balance

Sheets, and Exhibit 2, Panel B—Statements of Operations. An Excel file containing the

Case data is available from your instructor.

Assume that the weighted average number of common shares outstanding is approxi-

mately 22 million and 18.7 million for the years ending July 31, 2011 and July 31, 2010,

respectively. For the changes resulting from this error, please assume the following:

(i ) Income tax rate¼ 33 percent. Diamond follows the accrual method of accounting for financial reporting, as well as income tax purposes.

EXHIBIT 2 Format for Requirement 5

Panel A: Balance Sheets

(continued on next page)

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(ii ) Approximately 88 percent of the inventory purchased by Diamond is sold in the year of

purchase, the remaining 12 percent being carried in inventory to the following fiscal year.

(b) Continue with Requirement 5(a) above. Assume that the accounting errors are discovered

on September 15, 2011, before Diamond’s books for fiscal 2011 are closed for SEC filing

purposes. Present a journal entry to record the error correction.

(c) Continue with Requirement 5(a) above. Assume that the accounting errors are discovered

on September 25, 2011, after Diamond’s books for fiscal 2011 are closed. Present a journal

entry to record the error correction.

(d) An article in the Wall Street Journal of September 27, 2011 stated, ‘‘Anytime companies

make extraordinary payments to suppliers, there is an increased likelihood of financial

shenanigans being used to shift expenses and cash flows between periods to manipulate the

appearance of the company’s financial statements’’ (Wall Street Journal 2011). Do you

EXHIBIT 2 (continued)

Panel B: Statements of Operations

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believe that Diamond shifted its cash flows between periods? Explain in the context of the

effect on Diamond’s statement of cash flows for the fiscal years ending July 31, 2010 and

2011.

Requirement 6

What is a clawback provision? In the presence of the clawback provision, what might have

been the incentives for the senior management of Diamond to manipulate the Company’s earnings?

Requirement 7

Companies influence reported earnings via accruals earnings management, or real earnings

management. In accruals earnings management, managers influence earnings through discretionary

accrual choices either within or outside of GAAP (accelerated revenue recognition, for instance). In

real earnings management, managers influence earnings through choices about real business

activities that impact cash flows (reducing discretionary spending such as research and

development, for example). Which of these techniques of earnings management do you think

were used by the senior management of Diamond Foods during fiscal years 2010 and 2011? Note

that this is not an either/or question. If you determine that there are instances of both types of

earnings management, list specific examples of both. What are the implications of earnings

management for Diamond Foods and its stakeholders?

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