Accounting and Ethics Guidance
In the first enforcement action of its kind, the U.S. Securities and Exchange Commission says The Cheesecake Factory falsely claimed its restaurants were "operating sustainably" during the pandemic and it failed to disclose the whole truth about the impact on its business. According to the SEC, Cheesecake Factory’s regulatory filings on March 23, 2020 and April 2, 2020 were materially false and misleading because the company failed to disclose that it was losing about $6 million a week and hemorrhaging cash. It is the first time the SEC has charged a public company over misleading disclosures related to the pandemic. To settle the charges, The Cheesecake Factory agreed to pay a $125,000 fine.
Operating and financial disclosures are a key part of ensuring that the financial statements are accurate and reliable and do not contain any material misstatements. The failure to disclose all the information that an investor and creditor needs to make their decisions is wrong. Earnings guidance for investors and financial analysts should meet similar standards. From an ethical perspective, honesty is about what you don’t disclose as well as what is disclosed.
The SEC’s administrative action says The Cheesecake Factory in mid-March faced “an unprecedent challenge to its business model as a result of the health crisis and issued several disclosures regarding the effect of, and its response to, the pandemic. Some of those disclosures failed to adequately inform investors of the extent of the pandemic’s impact on the company’s operations and financial condition in the period from late-March to mid-April 2020, when the company secured additional financing,” the Commission says.
During this period, the SEC says, The Cheesecake Factory began taking steps to conserve cash and increase short-term liquidity by, for example, informing its landlords that it would not be paying April rent due to the “severe decrease in restaurant traffic [due to Covid-19 that] has severely decreased our cash flow and inflicted a tremendous financial blow to our business,” noting that it hope[d] to resume our rent payments as soon as reasonably possible.”
The SEC further states on March 2, The Cheesecake Factory filed a Form 8K and a press release disclosing that it was “withdrawing previously issued financial guidance due to economic conditions caused by the pandemic and that it was transitioning to an ‘off-premise model’ – to go and delivery services – that was ‘enabling the company’s restaurants to operate sustainably at present under this this current model’”. The press release further disclosed a $90 million draw down on its revolving credit facility, that it curtailed planned growth, and that it was “evaluating additional measures to further preserve financial flexibility.”
The company disclosed that, effective as of April 1, 2020, it had reduced compensation for executive officers, its Board of Directors, and certain employees. The company also announced that it had furloughed approximately 41,000 employees but allowed them to retain their benefits and insurance until June and provided them with a daily complimentary meal from their restaurant.
Since the pandemic began, the SEC has encouraged companies to provide disclosures that allow investors to evaluate the current and future expected impact of Covid-19 through the eyes of management and to proactively revise and update disclosures as facts and circumstances change. These disclosures should enable an investor to understand how management and the Board of Directors are analyzing the current and expected impact of the pandemic on the company’s operations and financial condition, including liquidity and capital resources.
The disclosure involves a contingent event that, under generally accepted accounting principles, should be evaluated whether it is probable that a liability or loss will be incurred and the estimated amount of loss (record a journal entry), it’s only reasonably possible that a future liability exists (footnote disclosure to the financial statements), or its highly unlikely that any liability exists at the time the disclosure is made (ignore).
Auditors also have to determine what, if anything, these disclosures mean to audit firms’ ability to render an unmodified (unqualified) opinion about The Cheesecake Factory’s results of operations. At a minimum, it would seem that a going concern alert should be given by the auditors.
The SEC’s actions send a clear message that Covid-19 disclosures will be carefully scrutinized to ensure that they meet established standards for disclosures. Companies that fall short of the mark expose themselves to SEC action that could include fines and other penalties. The failure to disclose adequate information about material events, such as the impact of Covid-19 on current and future business, violates the rights of users of the financial statements to receive full and fair operating and financial information about any material events including:
- Whether disclosures are made on a timely basis
- The ability of the company to continue operating as planned (i.e., going concern).
- The effects of Covid-19 on current and future cash flows including the ability to pay off debts when due.
- The role of management and the audit committee in dealing with current and future effects of Covid-19 on operations.
Kant’s Categorical Imperative establishes the duties and obligations we have to each other. Simply stated, it says, that you should act only in ways that you could establish a universal law that to call something morally just it can be turned into a universal maxim, on which everybody should uphold in a similar situation.
There is no doubt that the public interest requires that a complete picture of the current and future impact of Covid-19 and its after-effects on the financial position and operating results should be made to accomplish the proper accounting response to the pandemic. Like anything else concerning disclosures, the devil is in the details. More guidance is needed by accounting standards setters to ensure the profession meets its ethical obligations to the public.
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Posted by Dr. Steven Mintz, aka Ethics Sage, on December 28, 2020. You can sign up for his newsletter and learn more about his activities at: https://www.stevenmintzethics.com/. Follow him on Facebook at: https://www.facebook.com/StevenMintzEthics and on Twitter at: https://twitter.com/ethicssage.