Case Analysis: Diamond Foods, Inc.

Terry Knox
Jose Ixchu
LaKisha Woods

Measurements I 632
Professor Lavelle Lemonier
March 24, 2014

Diamond Foods, Inc.

Problem Statement
With a goal of becoming a major competitor at any cost, Diamond Foods engaged in
unethical and questionable behavior as company leadership attempted to monopolize the market,
implement deceitful accounting practices, and defraud investors resulting in falsified annual
growth rates and earnings from 2006-2011.
Key Issues

The monopolization of the walnut market

1. Momentum payments
2. Unfair pricing
3. Guaranteed future production
Use of deceitful accounting practices
1. Financial statements
2. Momentum payment reporting times
3. Reported annual growth
Purposely defrauding investors
1. Increased credit availability
2. Increase stock sales
3. Annual growth rate

Diamond Foods, Inc.

Analysis
The confusion with momentum payment, unfair pricing, and guaranteed future
production were just a few of the many underlining problems that existed with the relationship
between the contracted walnut growers and Diamond Foods. A momentum payment according to
the investigating analyst was a new accounting term. There was also confusion about what a
momentum payment was to the farmers. But, even before the momentum payment was an issue,
there were other factors that led to the farmers unhappiness and frustration with Diamond
Foods. For example, some farmers were upset because they believed they were underpaid by
nearly $50 million for the years 2005 and 2006 harvest and they also believed that they had been
underpaid for several years. As the contracts ended, the last momentum payment made to the
farmers was 35 cents per pound versus the $1.50 per pound they previously received (Srinivasan
& Gray, 2013). The farmers clearly felt slighted by Diamond Foods.
Unfair pricing among Diamond Foods was also concern. The company had a no price
guarantee but was willing to buy all walnuts from the farmers leading to a monopoly. The
farmers did not receive fair market value for their goods. However, by the 1990s, consumer taste
had changed and walnuts were not as popular as they previously were in the past (Srinivasan &
Gray, 2013), yet farmers were on contracts as they received fluctuating payments. The payment
received by the farmers was said to be based on quality and other factors yet farmers received no
price guarantee for their crops (Srinivasan & Gray, 2013).
Guaranteed future production of walnuts gave Diamond Foods exactly the edge they
needed to compete in different snack industry markets. The walnut industry catapulted the
company into a new direction where it was able to capitalize on potential opportunities to
increase market presence and grow sales and profits. As market shares increased, Diamond Food
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Diamond Foods, Inc.

was able to obtain better shelf locations and presence to the consumer which in turn has the
ability to drive sales and profits even more.
The loyalty bonus was given to the farmers in order to shift cost and boost profits. There
were some corrupt business practices present. Lack of communication and trust began to prevail
as the relationship deteriorated between the two organizations. Materiality does exist because the
company failed to report correctly in its financial statements (Schmidt).
Because the farmers accepted the contract, no matter how many walnuts were produced,
diamonds gave the farmers what they wanted them to have leaving the farmers in a nonnegotiating position. Moreover, there was just a small amount of farmers that was dissatisfied
with the contract resulting in the company disregarded their opinions. The walnut industry began
to decline and Diamonds Food paid the farmers even less overtime which had the potential to
lead to poor relationships.
Diamond Foods was able to venture into other markets which led them into the snack
industry, it was through unfair practices the walnut farmers. It is important that the farmers put
themselves in a position to negotiate. A small amount of the farmers believed they were being
underpaid for a long time and had done nothing about it. Diamond Foods influenced the stock
market by making the financial statements look stronger than they were; as a result this drove
investors to purchase stock.

Diamond Foods utilized multiple less-than-ethical methods to ensure that their stock
prices were of a high enough level that they could secure a substantial loan. The amount credited
to them would allow for the acquisition of Pringles from Proctor & Gamble (P&G). With a
growing loss in the market share of their core product, walnuts, and a declining market for their
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Diamond Foods, Inc.

previously purchased Kettle Foods and Pop Secret companies, a boost from the iconic brand was
seen as the path to a dominating role in the snack food industry. To that end, CEO Michael
Mendes likely had given approval for creative accounting tactics to guarantee Diamonds
success.
In 2011, Diamond Foods sent momentum payments to their walnut farmers. These
payments were to pre-purchase the entire walnut harvest of the farmers and lock them into multiyear contract for their walnuts. The practice was not uncommon for Diamond, though they used
different names for the payments each year. The true problem with the momentum payments
was the manner in which they were reported in the financial statements. This would be the
catalyst for the implementation of the companys creative accounting scandal.
Typically, Diamond would send payments to the farmers for their walnuts throughout the
harvesting process each fiscal year. In this case, the payments for the 2010 harvest started in
November 2010 and ended in August 2011. Instead of being paid for the walnuts collected for
the FY12 harvest, Diamond Foods stated that the momentum payment was for the harvest that
would begin in FY11. In their income statement, however, Diamond Foods would have the
payment count toward the 2011 statements instead of 2010. This act of mispricing effectively
improved their earnings outlook and provided the push needed to impress investors and creditors.
Some transactions require firms to make commitments to provided future resources that are
casually related to economic events that occur (Healy & Choudhary, 2001), however, it is not
ethical nor legal to pay in a later fiscal year for goods of a past fiscal year. What Diamond Foods
was doing was committing accounting fraud.

Diamond Foods, Inc.

Another problem plaguing the accounting practices of Diamond Foods was the time in
which they were distributed the momentum payments. In this particular dissemination of
payments to the farmers, Diamond was looking to obtain the credit worthiness to buy Pringles
from P&G. So, they provided payments to their walnut growers at the time that they were
expecting payment for the previous harvest. As stated earlier, they did not, however, report it in
that manner. The momentum payment might have been a way to make the company to look
more profitable, and less risky, than it really was (Srinivasan & Gray, 2013). Diamond was able
to proceed further into the deal with P&G for the acquisition of Pringle, making them one step
closer to securing the number two position within the snack food industry. However, had they
continued submitting payments to the farmers as they had normally done in the previous years,
their earnings for the 2011 income statement would have stated that the earning were less than
half of what was reported.
Diamond Foods continued their practice of inaccurate financial reporting by inflating
their compound annual growth rate (CAGR). They reported that between FY06 and FY11,
revenue increase by a margin of 15%. They go on to state that the rapid grown was due to the
assimilation of Kettle Foods and Pop Secret. Had the two companies been in the growth phase
of the market cycle, the percentage fabricated by Diamond would look a little more convincing.
As it was, however, the companies were actually in a mature or even a declining stage.
Documentation would go on to show that both Kettle Foods and Pop Secret were suffering from
major losses in revenue during their time with Diamond Foods. As for the CAGR, the 15%
stated was actually closer to 3.5% (Srinivasan & Gray, 2013). Again, this form of inaccurate
financial status reporting was intended bolster investor confidence in the company and drive up
the price of their stock through fraud.
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Diamond Foods, Inc.

Diamond Food competed in several markets, both regional and national.

Competition was really focused on market share, specifically the retail shelf space at the local
supermarket. The competition and pressure to be successful led the company to make several
bold and expensive acquisitions (Diamond Foods Accounting Scandal Seeds Sown Years Ago,
2012). CEO Michael Mendes goal of making the company more competitive resulted in
entering into billions of dollars in debt to acquire Pop Secret, Kettle Foods, and Pringles. The
goal of bigger is better became the driving force in the very competitive market, creating an
environment where unethical behavior and lack of oversight ultimately resulted in increased
availability to credit, higher stock prices, and better than actual annual growth rate by defrauding
investors.
Diamond Foods deliberately misrepresented their financial statements in order to
represent a stronger economic position in violation of accrual accounting practices. As a result,
the company was able to enter into negotiated loans, increasing their available credit from
lending institutions. The end result of these questionable practices was to hide losses and
improved its chance of acquiring product lines like Pringles from Proctor & Gamble and other
products (Diamond Foods Accounting Scandal Seeds Sown Years Ago, 2012). The main
accusation was incorrectly reporting its payment to suppliers which skewed its fiscal financial
results. For example, the momentum payments were said to be an advance on the next years
crop, and the company insisted they had nothing to do with previous years production. The
payments were reported in September which was after the fiscal year ended in July. Reporting
these payments in the wrong period basically impacted how financial statements were perceived
by investors, shareholders and the industry in general. (Diamond Foods Accounting Scandal
Seeds Sown Years Ago, 2012) There were many reasons why these types of irregularities were
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Diamond Foods, Inc.

allowed, or even encourage by leadership. The employees and many of the managers were
reacting to the ambitious earning targets set by their CEO, Michael Mendes. Additionally, there
was confusion about the meaning of the payments, what price the company was actually paying
for the crops and the lack of open communications that contributed to the fraud environment.
These actions also led to an artificially inflated stock price.
In an extremely competitive market, there are many driving forces which create an
incentive to twist financial reports. As stated, the company entered into various debt obligations
requiring increased performance in order to generate enough income and ensure they were able
to keep a low interest coverage ratio. Additionally, their primary business needed to generate
income through any business cycle. The debt obligations carried very restrictive covenants
requiring low debt on their balance sheets from 4.75 to 3.25 to 1 by the end of April 2014.
Additionally, the company was required to satisfy fixed interest financing expenses a minimum
of 1 to 1.1 through October 2012 (Srinivasan & Gray, 2013). The additional pressures resulted in
unethical and criminal misreporting in order to increase stock prices and investors. The company
offered $181 million in stocks at an elevated price resulting in increased income from the sale of
the stock offering (Srinivasan & Gray, 2013). If the information leaked, creditors would have
concerns with the internal controls and could choose to call in all the loans and force Diamond
Foods into bankruptcy (Michael Mendes' Dream for Diamond Foods Shattered, 2012).
The main culprit, the momentum payments, resulted in improved earnings per share
(EPS) from $1.14 to $2.61 as the companys operating costs were transfer to a different reporting
period. These actions were put in place to misrepresent their financial status which would have
the intended outcome of incentivizing P&G shareholders when paid in Diamonds stock.
Company projections identified a $100 million merger cost, however shareholders would be left
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Diamond Foods, Inc.

with 43% of the new company. Michael Mendes enthusiasm even led many industry analysts to
recommend their stock and contributed to their growth (Srinivasan & Gray, 2013). The
momentum payments seemed to do more than increase EPS, it also elevated the CEOs public
persona to somewhat of a financial celebrity. Reports noted Diamond Foods snack food focused
acquisitions would result in higher revenues as the company could use the Pringles brand as a
jump off to introduce other snacks. As a result, investors poured money into the company and
top managers enjoyed millions in additional compensation (Darragh, 2012). On September of
2011, the company stock rose to new $92.47 high.
When does loyalty lead to corruption? There were different reasons for the problems.
The biggest, however, were the leaderships character flaws. The drive for success in a
competitive market clouded their decision making processes, leading to an environment where
opportunity, motivation, and rationalization allowed illegal activities to influence the processes
of an up and coming snack food giant. Many in the industry saw the warning signs like unusual
timing of payments, jump in profit margins and volatile inventories and cash flows (Darragh,
2012). As noted, employees did not have clear guidance and internal controls were not
implemented. Top leadership and managers did not set ethical examples giving more reasons to
violate guidelines (Diamond Foods Accounting Scandal Seeds Sown Years Ago, 2012). Because
of the drive to succeed at any cost, showing improved EPS would allow a twofold strategy; meet
debt to earnings ratios and help qualify for debt covenants, assisting in the Pringles acquisition.
These factors also had a beneficial effect resulting in large executive bonuses. Money was a very
persuasive motivator, especially when accompanied by the power of a position. Industry experts
considered Diamond Foods leadership an example of creative marketing and product
development/enhancement (Srinivasan & Gray, 2013). The last factor, rationalization focused on
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Diamond Foods, Inc.

the momentum, or loyalty, payments. These were reported in the wrong reporting period and
when confronted, leadership denied the wrong doing (Davidoff, 2011). While denying these
payments, the companys reporting procedures also allowed leadership ability to deny the illegal
actions because of the complexity and no one person really understood the illegal actions. As a
result of the payments, stock price plunged to the lowest point since 2006 (Diamond Foods
Shares Plunge Following Restatement, 2012).
Recommendation
The company should implement several corrective measures including, improving the
internal controls environment to include ethics training, proper accounting for Walnut growers
ensuring the company meet all legally required guidelines, robust accrual accounting practices
and defined procedures with different level of approvals. These actions should be put in place
immediately and documented with annual employee training modules.
Along with training, internal auditors should be mindful of and more diligent in their
efforts to ensure the integrity of reported financial statements. Rather than constantly rename the
payments provided to the walnut farmers, a single term should be decided upon for their
payments. Also, in concern with the payments, Diamond Foods should resort back to the
previous method of paying installments for the current fiscal years walnut harvest to prevent any
additional mispricing on financial statements.

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Diamond Foods, Inc.

References
Diamond Foods Accounting Scandal Seeds Sown Years Ago. (2012, March 19). Retrieved March
24, 2014, from Huffington Post: [Link]
Diamond Foods Shares Plunge Following Restatement. (2012, November 15). Retrieved March
24, 2014, from Businessweek: [Link]
Michael Mendes' Dream for Diamond Foods Shattered. (2012, February 12). Retrieved March
24, 2014, from SFGate: [Link]
Darragh, R. (2012, March 20). Diamond Foods Accounting Scandal Stems From Years of Bad
Practices. Retrieved March 24, 2014, from CompliancEX:
[Link]
Davidoff, S. M. (2011, November 29). At Diamond Foods, Accounting Weighs on Pringles Deal.
Retrieved March 24, 2014, from The New York Times:
[Link]
Healy, P. M., & Choudhary, P. (2001). Expense Recognition. Boston: Harvard Business School.
Schmidt, M. (n.d.). Materiality Concept in Accounting Explained. Retrieved Marxh 24, 2014,
from Building the Business Case: [Link]
Srinivasan, S., & Gray, T. (2013). Diamond Foods, Inc. Boston: Harvard Business School.

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