Diamond Foods Inc Case Solution

1. In this case, Diamond Foods was accused of “managing earnings” in an unethical manner. Provide two specific examples of how a company could ethically improve net income.

Earnings management is a technique adopted by many companies to improve the income reported on their financial statements by using accounting techniques to their advantage to either increase revenue or decrease expenses.

An example of decreasing expense to inflate income is seen in momentum payments issued to walnut farmers by Diamond Foods. The company had historically kept the price paid to farmers for walnuts 20 to 15 cents lower than the market price. These low costs led to high-profit margins for the company as the cost of sales decreased or remained constant while net sales and gross profit percentage increased. Diamond Foods was able to achieve this through momentum payments that promised 35 cents a pound to raise 2010 payments to $1.35 pound, however, Diamond declared it to be a loyalty bonus that shouldn’t be applied to 2011 harvest. By deferring these payments to next year, Diamond was able to lower the value of the costs for fiscal year 2011 by charging payments to farmers at only $1 a pound compared to $1.45 a pound in the market, with the 35 cents a pound shifted to next year. Hence costs were lowered while most of these nuts were sold within the year and revenue for them was recorded in fiscal year 2011. This caused the gross margin to increase and the net income was inflated by clever earnings management by Diamond Foods.

Another way to ethically improve net income is by manipulating account receivables to influence the revenue recognized for the year. Bad debts expense that are part of account receivable involves judgment and estimation on part of accountants. They are based on past results and industry standards to be a certain percentage of total credit sales with the percentage being decided by the company itself. By reducing the percentage of uncollectible debts, a company can increase its value of account receivables which will increase revenue and hence inflate net income. 

2. Describe the “fraud triangle.” Discuss the components of the fraud triangle in the context of this case.

Fraud triangle is a framework that is used to analyze a person’s reasons behind committing a fraud. The fraud triangle constitutes of three components, opportunity, pressure and rationalization. Opportunity is the circumstances that enable fraud to occur and can range from weak internal controls to lack of quality control in an organization. Pressure is the incentive or motivation that instigates a person or organization to commit fraud while rationalization is the justification given to one's own self to justify why committing the fraudulent activity is justified.

In the context of Diamond Foods, the opportunity for fraud lies in the payment methods to walnut farmers in the forms of installments that allowed it to defer costs to next year. Board of Director’s members were aware of this nature of payments that could be used to record payments in later years as they have years of experience in the industry. Internal controls of Diamond Foods were not sufficient to detect any such accounting fraud, nor did the tone at top stress on ethical behavior which was an opportunity to commit fraud.