Late last week, Diamond Foods (NASDAQ:DMND) agreed to pay $5 million to settle charges brought by the SEC. The SEC alleged that "Diamond's then-chief financial officer Steven Neil directed the effort to fraudulently underreport money paid to walnut growers by delaying the recording of payments into later fiscal periods." Specifically, Diamond allegedly managed earnings in 2010 and 2011 quarterly filings.
News of trouble at Diamond first came on November 1, 2011. The Company issued a press release announcing that the Audit Committee had initiated an investigation into its accounting for payments made to walnut farmers. Then, on February 8, 2012, the company issued an 8-K with an Item 4.02: Non-Reliance on Previously Issued Financial Statements. The accounting scandal caused Diamond's stock to plummet, and their audit fees jumped from $1.6 million in 2011 to $16.5 million in 2012.
As seen in the chart below, Diamond's stock took a major hit after the November 1st announcement.
Were there any signals in Diamond's previous financial statements that something might have been amiss? Some flags were indeed raised before the announcement, notably by the consulting firm Off Wall Street, which questioned whether a strange "momentum payment" made to walnut farmers in FY11 was included in the FY11 financial results.
Interestingly, in Diamond's 4/30/11 10-Q, they made the following opaque disclosure:
(7) Balance Sheet Items
In the three months ended April 30, 2011, the Company revised its estimate for expected commodity costs which resulted in a pre-tax decrease in cost of sales of approximately $1.5 million for sales recognized in the first six months of fiscal year 2011. In the three months ended April 30, 2010, the Company revised its estimate for expected commodity costs which resulted in a pre-tax decrease in cost of sales of approximately $1.1 million for sales recognized in the first six months of fiscal year 2010.
That pre-tax decrease in cost of sales of $1.5 million could have affected EPS by up to $0.04, compared to diluted EPS for the quarter of $0.34.
Similar disclosures were made in the quarters ended 1/31/11, 4/30/10, and 1/31/10, but no more detailed information was given aside from that basic statement. Considering the events that subsequently unfolded, perhaps these changes in estimates were worth further investigation?
Indeed, in its amended 10-K for the year ending July 31, 2011, the company noted a material weakness in its internal controls over financial reporting (ICFRs). In the assessment, failures in the process of estimating walnut costs were specifically noted as contributing to the material weakness.
• Walnut Grower Accounting - Senior management did not document the accounting policies or sufficiently design the processes for walnut grower payments and determination of walnut cost estimates. Further… the controls that were in place were not designed to ensure that the annual walnut costs and the quarterly walnut cost estimates and changes in such estimates were sufficiently supported and based on consideration of all relevant information…. These factors caused our controls related to accounting for walnut grower payments and quarterly walnut cost estimates to be ineffective for ensuring that walnut costs were recorded correctly within the appropriate period.
We have noted before that changes in accounting estimates could be a relatively easy source of earnings management. With Diamond Foods, it looks like a case in point. Unusual or opaque changes in accounting estimates should capture the attention of users of financial statements.
Additional disclosure: Audit Analytics is a team of Research Analysts from Audit Analytics, an independent provider of audit, regulatory and disclosure intelligence. This article was written by John Pakaluk, one of our Research Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.