Case Study Analysis: Diamond Foods Recovers from Accounting Scandal 2000 words case study analysis based on the attached case study The Analysis of the Ca

Case Study Analysis: Diamond Foods Recovers from Accounting Scandal 2000 words case study analysis based on the attached case study

The Analysis of the Case Study should follow the following format

A-Introduction(summary of the case study in one paragraph)

B-Case Analysis (body):

The ethical issue/issues present in the case

Identification of alternatives/ options to solve the ethical dilemma

C-Conclusion: Choice of one alternative (Decision Making) and justification

D-Recommendations (Suggested steps/plan of implementation your choice)

References (Using Harvard style referencing)

Appendices (optional, such as graphs,photos, etc)

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Please check attached documents Daniels Fund Ethics Initiative
University of New Mexico
http://danielsethics.mgt.unm.edu
Diamond Foods Recovers from
Accounting Scandal
INTRODUCTION
Diamond Foods, based in Stockton, California, is a premium snack food and culinary nut company
with a diversified and successful portfolio. Diamond Foods has five premium product lines
consisting of potato chips, popcorn, and a variety of nuts. Brands offered by Diamond Foods include
Diamond of California, Pop-Secret, Emerald, and the Kettle Brand; these products are sold in over
100 countries. Diamond Foods has a historical reputation of making bold and expensive
acquisitions. Due to the competition within the snack food industry, Diamond Foods developed an
aggressive company culture that placed high emphasis upon performance. The company was
known for operating according to the phrase “bigger is better,” which was implemented by former
CEO Michael Mendes. However, without strong ethical oversight, questionable behavior began to
persist at Diamond Foods. In 2011, an investigation was launched into the company’s financial
measures and policies in response to multiple allegations of fraud. This investigation led to serious
implications for the company, including major financial losses and the imminent need to
restructure the company’s top leadership. After the investigation, the company began to focus on
rebuilding the company’s image. Diamond’s current president and CEO Brian J. Driscoll has aimed
to develop comprehensive strategic initiatives to advance the company past its ethical dilemmas,
instill trust among investors and consumers, and bounce back from the accounting scandal that
created both financial and reputational losses. Diamond Foods agreed to pay $5 million to settle
fraud charges.
BACKGROUND
Diamond Foods was founded in 1912 under the Diamond of California brand. In 1930, the company
expanded internationally and in 2005 became a publicly traded company. Currently, Diamond
Foods products are distributed globally, and the company has approximately 1,700 full-time
employees. The company has become known for building up its brands and identifying
opportunities to connect products to consumers, thus adding value to the product. It focuses its
efforts on five product lines: 1.) Potato chips, 2.) Snack nuts, 3.) Popcorn, 4.) In-shell nuts, and 5.)
Culinary nuts. In 1997, Diamond foods hired Michael Mendes as the company’s Chief Executive
Officer and President. He became a member of the board in 2005. Mendes was Diamond Foods’ Vice
President of International Sales and Marketing prior to becoming CEO and President. Mendes had
worked for various companies in the competitive snack food industry prior to joining Diamond
Foods, including the Dole Food Company and Hormel Foods Corporation. While at Diamond Foods,
Mendes was known for his competitive nature and for implementing the philosophy “Bigger is
Better.” This viewpoint and the impact it had upon Diamond Foods’ corporate culture will be
discussed later in this case.
This case was prepared by Danielle Jolley, Ericka Avery, Monica Merker, and Kaylyn Peters for and under the direction of O.C. Ferrell and
Linda Ferrell, © 2015. It was prepared for classroom discussion rather than to illustrate either effective or ineffective handling of an
administrative, ethical, or legal decision by management. All sources used for this case were obtained through publicly available material.
Users of this case are prohibited from converting to digital format to email or place on the Internet. Call O.C. Ferrell at 505-277-3468 for
more information.
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Although Diamond Foods looked as if it was progressing rapidly, in truth the firm was engaging in a
number of questionable practices to hide losses and improve its chances of acquiring the Pringles brand
from Procter & Gamble. In 2011, a number of accounting discrepancies revealed that the company was
struggling. A year later Diamond Foods had a net loss of $86,336,000 and earnings (loss) per share
of $3.98. During 2012 the company’s stock price experienced volatility, dropping approximately 42
percent from its peak of about $21.50 in early November to its lowest in six years at $12.50 in late
November. Since this large drop, the stock price has begun to increase once more, hitting a value of
$33.22 in early 2015.
INDUSTRY AND CORPORATE CULTURE
The snack-food business is large and extremely competitive. In fact, the global snack food market is
estimated to be about $374 billion. Diamond Foods competes with both regional and national
companies. This competition also occurs in terms of retail shelf space. With significant competition,
Diamond Foods has faced many pressures to be successful. Diamond’s previous CEO Michael
Mendes had ambitious goals for making the company more competitive, resulting in millions of
dollars in loans for the acquisition of Pop Secret popcorn and loans amounting to $1 billion for the
intended purchase of Pringles. The acquisition of the Pringles brand from Procter & Gamble would
have raised Diamond Foods to become the second largest distributor of snack foods in the United
States, second only to PepsiCo. This significant pressure to increase market share and become one
of the largest snack food distributors, coupled with increasing competition, could have incentivized
unethical behavior within the firm.
The company’s highly ambitious and competitive culture could have also increased organizational
pressures for fraud. Interviews with former employees and board members found that the
company pushed very hard to meet increasingly ambitious earnings targets, allowing executives to
gain large bonuses for meeting these goals. According to regulatory filings, in fiscal years 2009,
2010, and 2011, CEO Michael Mendes received approximately $2.6 million in bonuses for exceeding
the company’s earnings-per-share (EPS) goals. Furthermore, in September 2010, Mr. Mendes boldly
promised 15 to 20 percent EPS growth for the next five years. This highly incentivized and
competitive culture was exacerbated by the fact that Diamond Foods’ culture did not encourage
open communication. Nut suppliers of Diamond Foods were told what appeared to be misleading
information concerning payments for their crops. Such a lack of communication likely increased the
opportunity for unethical behavior.
ETHICAL CHALLENGES
In 2011 suspicion arose regarding Diamond Foods’ accounting practices. Specifically, Mark Roberts,
an analyst with the Off Wall Street Consulting Group, accused Diamond Foods of incorrectly
reporting its payments to suppliers. This accusation claimed that Diamond Foods was issuing
“momentum payments,” in which the company would send payments to growers in September for
walnuts that were delivered in Diamond’s fiscal year 2011, which had already ended in July.
Although it might not seem like a major issue, reporting payments in the wrong pay period
significantly impacted how Diamond Foods’ financial statements were perceived. If done
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intentionally, such conduct could be illegal. When first discovered, Diamond Foods denied any
wrongdoing, arguing that these payments were an advance on the 2012 crop and had nothing to do
with the previous year’s crops.
However, growers quickly contradicted this defense. Some growers were told to cash their checks
even if they were not going to provide crops for 2011. They were reportedly told that the checks
were payments for the previous year. An investigation found that these payments were used by
Diamond Foods to inflate the fiscal 2011 results by shifting costs into the upcoming year. This
caused stakeholders to question whether the company was representing its finances and
performance accurately. An internal investigation found that the company, specifically CEO Michael
Mendes and CFO Steven Neil, had improperly accounted for these previously mentioned payments
to walnut growers, thus skewing Diamond Foods’ financial results. In addition, “continuity”
payments to growers in August 2010 of approximately $20 million were also accounted for in the
wrong period. The company improperly moved about $60 million in payments to walnut growers
from the fourth quarter of fiscal year 2011 into the first quarter of fiscal year 2012.
Diamond Foods’ “momentum payments” improved the full-year 2011 earnings per share from
$1.14 to $2.61. These greater earnings allowed top managers to take home millions in additional
compensation. It has also been speculated that the fraud was intended to encourage the sale of the
Pringles brand of potato chips from Procter & Gamble. These increased earnings per share would
incentivize Procter & Gamble’s shareholders, as they were to be paid in Diamond’s stock.
There were several factors which encouraged unethical behavior at Diamond Foods. Not only is the
snack food industry very competitive, but so was the company’s culture. The “bigger is better”
ideology supported by then-CEO Michael Mendes placed significant pressures on Diamond Foods’
attempted acquisition of Pringles, which would have greatly expanded Diamond Foods’ growth.
This ideology led to large debts, as the company was required to take out loans to make these
acquisitions possible. Because of the loans, Diamond had debt agreements, which required certain
performance standards to be met. The company also had a debt-to-earnings covenant in one of its
debt agreements, requiring the company to have higher earnings. The debt-to-earnings covenant,
increased compensation for stakeholders for meeting higher performance standards, and the
pressures to acquire Pringles likely played a major role in Diamond Foods’ inaccurate financial
reporting.
Another major red flag is the fact that Diamond Foods’ CFO had a seat on the company’s board. This
could have created a significant conflict of interest in Diamond Foods’ corporate governance
structure. A board member who directly receives compensation from the firm could sway the board
into exerting less oversight over operations or making decisions that would not be in the best longterm interest of the firm.
The company was externally investigated for criminal fraud and an audit was completed. The
investigation made stakeholders uneasy and prevented the company’s acquisition of Pringles. As a
result of the investigation, Diamond Foods had difficulty meeting the deadlines for filing financial
results. Nut growers began complaining that Diamond Foods was paying them 10 cents a pound
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less than they could get from independent buyers, which began causing dissatisfaction among the
firm’s suppliers. Diamond Foods was quickly gaining the attention of both investors and regulators.
RAMIFICATIONS OF UNETHICAL CHOICES
Manipulating accounting results qualifies as a type of fraud that misleads stakeholders. The three
points of the fraud triangle are opportunity, motivation, and rationalization. Using this model, it
becomes clearer how the accounting fraud at Diamond Foods was allowed to take place. For
instance, employees were given the opportunity to conduct fraud as internal controls were clearly
not being implemented. Furthermore, top management did not set an ethical tone at the top, giving
employees even more opportunity for unethical behavior. Indeed, investigations appear to show
that top management itself was likely responsible for some of the unethical behavior.
There was also much motivation for Diamond Foods to improve its performance at any cost.
Improving its EPS would help the company acquire the Pringles brand and allow Diamond Foods to
meet its required debt-to-earnings ratio in its debt covenant. Furthermore, executives would
personally gain large bonuses. In addition, the company faced both internal and external pressures
to succeed at any cost. The nature of the industry, as well as Diamond Foods’ highly competitive
culture, provided the motivation to commit accounting fraud.
Finally, Diamond Foods likely rationalized its actions by denying that the momentum payments
were illegal. After the payment irregularities were discovered, Diamond Foods’ management
denied that the payments were for the previous year’s crops. The company instead stated that the
payments were made to “optimize cash flow for growers.” Diamond Foods claimed that the
previous year’s payments occurred and were accounted for in the previous year. It also appeared
that the company’s improper reporting and control environment may have dispersed these issues
across the organization, limiting accountability. This could prevent any one person from fully
understanding what was going on, allowing employees to rationalize their actions through denial.
As seen in Diamond Foods’ six-year low stock price of $12.50, the company faced financial
difficulties. This low stock price was the result of the company’s restated financial results and
update of the current year’s performance. The restatement of Diamond Foods’ financial results
removed a previously reported $56.5 million in profits due to the accounting fraud. This issue was
exacerbated by a 2011 SEC investigation into the company. Billionaire investor and activist David
Einhorn was believed to be shorting the stock, leading to loss of trust and uncertainty from
investors in the company.
In addition to its plummet in stock price, Diamond Foods lost its deal to purchase Pringles from
Procter & Gamble. Additionally, the resulting audit found that significant weaknesses existed in the
firm’s internal controls for financial reporting, and these weaknesses breached the company’s loan
agreements with its creditors. Breaking these agreements could have led Diamond Foods into
bankruptcy because creditors could have required Diamond Foods to repay all of its outstanding
loans. Diamond Foods could have also faced increased interest rates in the company’s outstanding
loans.
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Immediately after discovering the errors, CEO Michael Mendes and CFO Steven Neil were placed on
administrative leave. Eventually, on November 19, 2012, Mendes resigned and Neil was removed
from Diamond Foods. In accordance with Mendes’s employment agreement, he did not receive his
insurance benefits as his resignation was considered to be a violation of his duty as CEO. Diamond
Foods entered into a Separation and Clawback Agreement with Mendes that required him to repay
his fiscal 2010 and 2011 bonuses totaling $2,743,400. He also was required to pay back all of the
common stock shares he had received from fiscal year 2010, amounting to 6,665 shares of Diamond
Foods common stock. However, this amount was taken from his Retirement Restoration Plan, and
he still received payment of $2,696,600. The company also announced that it would restate its
financial reports for the two years involved in the incorrect payments.
The immediate aftermath of the scandal resulted in financial losses and reputational damage. In
response to Diamond Foods’ accounting blunders, the company faced risks of litigation, regulatory
proceedings, government enforcement, and insurance claims. The company ended up paying $5
million to the Securities & Exchange Commission to settle fraud allegations. The SEC had also
charged former CFO Steven Neil for his participation in falsifying walnut costs as well as former
CEO Michael Mendes for his role in the misleading financial statements. Mendes forfeited $4 million
in bonuses and benefits and paid a penalty of $125,000. While it was not proven that Mendes
participated in the scheme, regulatory authorities believed he should have known about Diamond
Foods’ incorrect financial statements. Steven Neil initially fought the SEC charges but eventually
settled by paying a $125,000 civil penalty. Investors also filed lawsuits against Diamond Foods,
stating that the company misrepresented its financial standing. The company settled with investors
for $100 million.
DIAMOND FOODS’ RESPONSE
In a December 2012 letter to shareholders, Diamond Foods’ new president and CEO, Brian Driscoll,
outlined a number of comprehensive strategic initiatives aimed to advance the company past its
ethical mistakes. These initiatives started with the company’s remediation steps to improve the
internal controls of financial statements. Six new directors were appointed to strengthen the board.
Driscoll also emphasized the importance of open communication with stakeholders, specifically
walnut growers.
In making strides to become a more ethical company and return from the accounting scandal,
Diamond Foods has issued a forward looking statement of risks. This statement aimed to identify
any possible problems that may arise in the future to prevent similar ethical wrongdoing. Within
this statement, Diamond Foods identified three primary areas in which it needs to improve that the
company felt led to the accounting scandal. These three specific areas included 1.) Control
Environment, 2.) Walnut Grower Accounting, and 3.) Accounts Payable and Accrued Expenses. With
this discovery, the company found its internal controls to have been ineffective.
The control environment includes the Company’s Code of Conduct and Ethics Policy. It is top
management’s responsibility to set the tone of the organization as well as the foundation for an
ethical culture and internal controls over financial reporting. Diamond Foods’ former CEO Michael
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Mendes did not create a culture in which there was open communication. This prevented a strong
control environment. Although Mendes was an innovative leader, he made a number of ethical
missteps in attempting to achieve his vision. Because ethical leaders are able to distribute and
monitor the organization’s values, they are able to contribute more meaningfully to the company’s
culture. Rather than relaying an ethical message, Mendes focused on competition and quick growth.
Mendes’s actions harmed the firm, as he did not provide ethical leadership or an environment in
which employees followed acceptable behavior.
To rectify this issue, the company replaced the former CFO as well. Additionally, it improved
financial and operational reporting packages in which managerial approval is needed for material
and non-routine transactions. The company implemented ethics training led by the CFO to reinforce
proper accounting procedures. This training attempts to help employees gain a greater
understanding of financial reporting integrity and the company’s ethical expectations. By placing
the CFO and other top management in charge of training, the company demonstrates the
importance of proper accounting procedures as well as an ethical tone at the top.
Previous leadership did not document accounting policies or design the process for which walnut
grower payments and the walnut cost estimates were determined. This was exacerbated by the fact
that management did not communicate the intent of the payments effectively. In this area, Diamond
Foods modified its walnut cost estimation policy. This revision included adding a greater variety of
inputs each quarter required to be reviewed and signed off by cross-functional management.
Additionally, the company improved documentation and oversight of accounting procedures and
supplier communication. Diamond also created a Grower Advisory Board to receive input from
growers and enhance communication between growers and the company. Finally, in order to
ensure compliance, Diamond Foods revised the Sarbanes-Oxley internal control policies involved
with grower accounting procedures.
Diamond Foods deduced that its accounts payable and accrued expense controls of invoice
processing were inadequately designed, leading to costs that were recorded in the incorrect
accounting periods. Using a third party report entitled “Internal Control – Integrated Framework,”
Diamond Foods evaluated the effectiveness of its internal controls. The company found that
processes intending to increase…
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