Here is a good case study to go through.
Diamond Foods (DMND) is being investigated by the SEC and DoJ for potential accounting fraud.
I will go through a few methods to detect earnings quality, manipulation and aggressive accounting or accounting fraud to see how well it comes up against DMND.
So as we go through this, the question is, could you have identified DMND’s accounting shenanigans in advance by using such methods?
Accounting Fraud Accusation against DMND
From the Forbes article,
“Allegedly, the company delivered so-called “momentum payments” to walnut farmers in order cook their earnings filings.”
Momentum payments mean that DMND paid their suppliers in advance. Future expenses is shifted to an earlier period which will inflate earnings.
If the audit proves to be true, then based on a Bloomberg magazine article (no link sorry), DMND’s 2011 earnings will be reinstated from $2.22 to $1.14. That’s close to 50%. Ouch!
In Financial Shenanigans, shifting expenses to another period is clearly defined as one of the shenanigans used to manipulate earnings in accounting fraud cases. Now in the Bloomberg article, Mendes, the CEO, is portrayed as a very ambitious and business aggressive man. If the article is true, that “could” explain the aggressiveness in the accounting.
If you have read The Art of Short Selling, you will know that there have been many companies throughout history where such CEO characteristics have led to accounting fraud.
Balance Sheet Check
Let’s get down to the numbers.
Take a quick glance at the balance sheet. Even though a company like Diamond Foods is all about the brand of its products, the balance sheet is very unattractive. Just looking at the total intangibles should immediately raise red flags.
66% of total assets is made up of intangibles.
Previously I went through examples of how to analyze accruals. One of the examples featured Dolby (DLB) where accruals were consistently above 25% for 4 years, yet DLB increased cash and reduced debt. DLB’s Sloan ratio was higher than the recommended 8%, but nothing jumped out and the result was inconclusive.
However, take a look at DMND below. (These numbers are from my stock analyzer and the model will be included in the next update.)
Accounting Fraud by the numbers
Cash balance is close to zero, debt has sky rocketed with all the acquisitions, net income is increasing but cash flow from operations is erratic. Dangerous signs already.
The accruals for 2009 and 2010 is shocking. In 2010 and 2011, there is a very good chance that DMND’s growth in EPS came from accruals. In other words, low quality and cookie jar type earnings.
Beneish M (Manipulation) Score
A score greater than -2.22 indicates a strong likelihood of a firm being a manipulator.
Coincidentally, the 2009 and 2010 numbers are red flagged.
By checking the balance sheet, accruals and M score, warnings are flashing everywhere. DMND is innocent until proven guilty, but by my definition, shifting expenses to inflate earnings is fraud.
Summing up, do you:
- check the financial shenanigans checklist?
- look at the construction of the balance sheet ?
- analyze the accruals?
- calculate the Beneish M score?
No position in DMND