Analysis of a Young CPA 1

Analysis of a Young CPA Stands His Ground

Cheryl Deberry, Rebecca Fleming, Bobbie Haggans,

Carina Hernandez, Kenneth McGuire, Irma Oke,

Jodi Schmidt and Chris Walker

University of Maryland University College

Accounting 422

Professor Eric Sumners

April 7, 2010
 Analysis of a Young CPA 2

Abstract

Startup companies face many risks and most of them can mean success or failure. We

look at Advance Tech Inc in this article and we show you some of the risks that they are facing.

Financial risk is one that Advance Tech Inc. is having issues with. In order to receive more

funding they had to meet goals provided by the venture capital partners. As the last day of the

accounting period came they were short of their goals. Right before close of business on that last

day of the period an order comes through that will help meet the goals. Newly appointed

controller, Manual Gonzales, has to use his judgment on when the accounting period ends so that

the correct information for the order received is recorded in the correct period. The estimates

and judgments accountants have to make affect financial reporting and in Advance Tech Inc’s

situation those decisions can mean additional funding for the company. That is why proper

consideration is needed by Manual to make the judgment so that Advance Tech Inc’s financial

situation is properly documented.

Introduction

All companies and their affiliates (i.e. accountants and auditors) have a lot of issues and

risk factors they face day to day. How they deal with these issues and risk factors will determine

the success of their company. When dealing with a company that is well established these issues

may only mean a slight difference in profit or loss. On the other hand, when you talk about a

startup company every decision can mean the end of your business. According to the Small

Business Administration, 24% of businesses close within the first year, 53% are closed within

the fourth year of operation and 62% are closed after the fifth year of operation (Headd, Brian).

So by looking at those numbers you can see how important it is for companies and their affiliates

to understand the issues and risk factors facing their day to day operations. In this paper, we will
 Analysis of a Young CPA 3

discuss risks start-up companies face, how these risks affect Advance Tech Inc., why accountants

must make estimates and judgments when recording financial information, and how Advance

Tech Inc.’s auditors and accountants are affected by this estimates and judgments.

Risks Facing Start-up and How These Risks Affect Advance Tech

Start-up businesses face many challenges in the early years of their operations. These

challenges are risks that include business, financial, management, and organizational risks. As

an inexperienced entity, a start-up business must start everything from the ground up and as well

as face competition, despite its weak position. The business risks are associated with the overall

success or failure of the company. Due to the lack of reputation and well known products or

services, a start-up business is normally dependent on outside venture capital to fund the

business. According to Investopedia (2010), “venture capital is money provided by investors to

startup firms and small businesses with perceived, long-term growth potential. This is a very

important source of funding for startups that do not have access to capital markets. It typically

entails high-risk for the investor, but it has the potential for above-average returns.

Venture capital can also include managerial and technical expertise. Most venture capital comes

from a group of wealthy investors, investment banks and other financial institutions that pool

such investments or partnerships. This form of raising capital is popular among new companies,

or ventures, with limited operating history, which cannot raise funds through a debt issue. The

downside for entrepreneurs is that venture capitalists usually get a say in company decisions, in

addition to a portion of the equity (Investopedia ULC, 2010).”

 Analysis of a Young CPA 4

In addition, start-up companies often fail to attract experienced workers, adequate

leadership, and have high employee turnover. Moreover, this kind of company does not operate

efficiently because the organization process is fairly new; the accounting and internal control

system might not be well structured leaving a lot of flaws they may lead to fraud or manipulation

of financial information. Consequently, the managers and the team must be faithful and work

diligently to ensure the company’s growth and success.

Just like all start-up companies, Advance Tech. is affected by the above risks. The

company is struggling financially, and depends completely on the funds provided by the venture

capitals. The company barely made their sales goal to qualify for the next year’s funding. The

last order that came in will allow them to meet their goal, if it is not a “bogus” order. Because of

inexperienced personal, there is uncertainty about the application of GAAP accounting rules, and

a lot of opinions generated from managers. Luckily, the controller was able to make a decision

about the cutoff time of the last order. The CPA himself was hesitant when applying for the job,

and has a plan “B” in case the start-up fails to deliver. This proves that many qualified

employees might not apply to start-up position because of the risks that it represents. Advanced

Tech. needs to develop a strong market for its products in order to meet its sales goals, and

assure future financing of its activities.

Why Accountants Must Make Estimates and Judgments

AU Section 342 defines an accounting estimate as “an approximation of a financial

statement element, item, or account”1. Estimates are often included in financial statements for

two reasons.

1
 Analysis of a Young CPA 5

• The measurement of some amounts or the valuation of some accounts is

uncertain, pending the outcome of future events. (AU Section 342)

• Relevant data concerning events that have already occurred cannot be

accumulated on a timely, cost-effective basis. (AU Section 342)

Public companies must disclose the use of accounting estimates. The SEC has made the

following statement regarding the use of estimates and judgments in financial statements.

“When preparing disclosure under the current requirements, companies should

consider whether they have made accounting estimates or assumptions where:

the nature of the estimates or assumptions is material due to the levels of

subjectivity and judgment necessary to account for highly uncertain matters or

the susceptibility of such matters to change; and the impact of the estimates and

assumptions on financial condition or operating performance is material. If so,

companies should provide disclosure about those critical accounting estimates or

assumptions in their MD&A.”(17 CFR Parts 211, 231 and 241)

Estimates and judgments are essential because we have incomplete information. We

must make estimates for such items as the net realizable value of inventories, uncollectable

accounts receivable, sales returns and warranty expenses. These judgments are made based on

our experiences, and the course of actions we plan to take. Auditors are responsible to determine

the reasonableness of accounting estimates made by management.

The case study gives an example of a judgment made regarding the timing of revenues.

A key issue is whether or not the sale can be counted in the current period. According to Staff
 Analysis of a Young CPA 6

Accounting Bulletin No. 101, revenue can be recognized when the following criteria are met

(17 CFR Part 211)

Persuasive evidence of an arrangement exists,

• Delivery has occurred or services have been rendered,

• The seller's price to the buyer is fixed or determinable, and

• Collectability is reasonably assured

The accountant in the case had to determine whether or not the shipment (delivery) had

occurred in the current period. The result of this judgment would have significant impact on the

future of Advanced Tech.

How Advance Tech Inc.’s Auditors and Accountants are Affected by Estimates and
Judgments

As changes in accounting estimations and judgments are made regularly, Manuel’s new

role as interim controller, in addition to the associated accountants and auditors, had a large

impact on Advance Tech, Inc. “Matters that relate to typical business operations and the

outcomes of which depend on the actions of management should be susceptible to reasonable

estimation; therefore estimates are inherent in the accounting process (1992).” An accounting

estimate can be defined as “an approximation of a financial statement, item, or account in the

absence of exact measurement (SAS No. 57).” This auditing standard defines the responsibility

of management and the auditor with respect to accounting estimates; management develops the

estimates, and the auditor evaluates those estimates (Greenawalt 1988). SAS No. 61 further

states that “management judgments and accounting estimates” that are significant to their

financial statements should be communicated to the auditor. The referenced auditing standards
 Analysis of a Young CPA 7

also emphasize that the auditor should evaluate whether management has identified all material

accounting estimates which are needed. As a result, SAS No. 57 was issued due to the

determination that a need for guidance existed in the area of estimates because many felt that

accounting approximations were based on subjective judgments, as well as objective facts, and

that controls over the process of developing those estimates were difficult to establish (Harsha

1989).

In addition to estimates, professional judgment, as previously referenced in SAS No. 61,

is an increasingly important aspect of the independent audit function. Audit risk standards have

identified the general types of information an auditor should acquire during an audit: “The

auditor must employ judgment in using that information to identify the risks of material

misstatements and develop an appropriate audit response (Schmutte 2009).” GAAS further

states, in AU Section 150, that the nature of the auditing standards requires auditors to “exercise

professional judgment in applying them.” In accordance, professional judgment helps to

determine the type of information to collect and the resulting conclusions (Schmutte 2009).

Advance Tech’s auditors and accountants, as well as the young CPA, Manuel Gonzales,

are affected by estimates and judgments in that they have an obligation to determine if the

numbers and information that has been provided to them by management has occurred, is

accurate and complete, and reflects the proper cut-off dates. Before being promoted to interim

controller, it was stated that Manuel “realized his responsibility to be truthful and fair when

reporting the monthly results. This was troublesome at times, especially when he changed his

method of estimating. Judgment was the only guiding light. Manuel took comfort in knowing

that the controller reviewed all estimates and had ultimate responsibility for the financial

statements (Arens 2010).” As a result, his promotion gave him the opportunity to take on the
 Analysis of a Young CPA 8

challenging responsibilities of making estimations and judgments that would serve as a

managing decision of Advanced Tech.

A major area of concern for Advanced Tech, Inc. auditors and accountants should be the

receipt of a critical order that occurred on the last day of the business month. This order is

critical in that it will help the company’s venture capital owners to determine if a new round of

funding will be provided to the struggling new technology start up. The auditors and accountants

will need to verify that the order is indeed a legitimate order and that the shipment of this order is

within the realms of the proper cut-off date, in order to properly book the revenue. Because

revenue recognition will play an important role in determining whether the venture capital

owners will continue to fund Advanced Tech operations, the accountants and auditors will be

liable to them, as well as other third party stakeholders such as employees, customers, vendors,

stockholders, etc., if a loss is incurred due to misleading financial statements. Therefore, it is

imperative that the judgments and estimates of the auditors and accountants on the authenticity

of the order, as well as the proper cut-off date for shipment are accurate. Likewise, the controls

and analytical procedures used to determine if revenue needs have been properly generated and

booked, should be identified as logical, appropriate, and well documented. As a result, this

places a lot of pressure on the auditors and accountants of Advanced Tech, as well as the newly

promoted interim controller, Manuel.

Conclusion

Through careful research and auditing by the controller, Manual Gonzales, it is

determined that the order received on the last day of the month was a legitimate order. Though

many aspects of the order seemed questionable, the order met all the qualifications of legitimate

order: (1) delivery has occurred or services have been rendered, (2) the seller's price to the buyer
 Analysis of a Young CPA 9

is fixed or determinable, and (3) collectability is reasonably assured. So after reading this paper

you should have a better understanding of the risks that small business face day to day, the

reasons why accountants must make estimates and judgments, and how the risk, estimates, and

judgments affect Advance Tech Inc. After looking at all these issues you can see that even

though Manual Gonzales felt he was out of his league, he still was able to do a great job.
 Analysis of a Young CPA 10

REFERENCES

Headd, Brian. "Redefining Business Success: Distinguishing Between Closure and Failure."
Small Business Administration, 22 Mar. 2002. Web. 21 Feb. 2010.
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17 CFR Part 211, SEC Staff Accounting Bulletin: No. 101 – Revenue Recognition in Financial
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17 CFR Parts 211, 231 and 241, Interpretation:Commission Guidance Regarding Management's
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(1992). General Update on Economic, Industry, Regulatory and Accounting and Auditing
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