Apollo shoes case study solution

An Audit Case to Accompany

AUDITING AND ASSURANCE SERVICES
Prepared by
Timothy J. Louwers

James Madison University

J. Kenneth Reynolds

Louisiana State University

Acknowledgements

We would like to gratefully acknowledge the following individuals for their assistance in preparing and completing this case. Sincere appreciation is due to Reagan McDougall, Meghan Peters, Denise Patterson, Bob Ramsay, and several classes of Louisiana State University students. Their suggestions greatly enhanced several portions of the case. However, we remain responsible for all errors of commission and omission.

Introduction

Apollo Shoes, Inc. is an audit case designed to introduce you to the entire audit process, from planning the engagement to drafting the final report. You are asked to assume the role of a veteran of two-to-three “busy” seasons, “in-charging” for the first time.

While Apollo Shoes’ growth has been phenomenal (there has been a dramatic growth in unaudited net income over the past year), there are some concerns: the client doesn’t want your firm (Anderson, Olds, and Watershed (AOW)) to talk with the predecessor auditor, a labor strike is looming, and one of Apollo Shoes’ largest customers is suffering some financial difficulties.

Because of busy season, there is little help, other than from an untrained intern. While the intern can do “grunt work,” such as vouching and gathering information for you, he appears incapable of preparing workpapers, making adjusting entries, or even getting good coffee and doughnuts. Assistance does come in the form of an objective, competent internal audit staff. Communication between client personnel and other firm members takes the form of e-mail messages from the engagement partner (Arnold Anderson), the engagement manager (Darlene Wardlaw), the intern (Bradley Crumpler), and the director of Apollo’s internal audit department (Karina Ramirez). Required assignments and memos are in bold print. Page indexing suggestions are given, but feel free to adjust page numbering as you see fit.

The AOW intranet website ( http:// www.mhhe.com/louwers3e / ) has many useful resources such as a repository of electronic documents (so that you won’t need to input data or retype documents) and an archive of e-mail messages and their attachments, all filed by account group.

While we tried to make the case as realistic as possible, limitations remain. Since you are unable to follow up directly with client personnel, you may need to rely on some evidence with which you may be uncomfortable. In an actual audit, you would be able to inquire, observe, and otherwise follow-up on any questions that you have until you feel comfortable relying on the evidence. To make sure that the case can be completed in a reasonable amount of time, we cut some corners with respect to audit sampling. Understand that audit sampling plays a large role in actual audit practice.

The information is sequential in nature. In other words, pay close attention to information disclosed early in the audit (for example, in the Board of Director’s minutes) as it may play a role in subsequent audit work. Similarly, the bank cutoff statement in the cash workpapers and invoices used for valuing inventory may be useful later in the search for unrecorded liabilities. Similarly, the bank confirmation contains information about long-term liabilities.

Lastly, while it is difficult for us to believe that not everyone enjoys auditing as much as we do, we have tried to make the case both interesting and enjoyable (in a perverse sort of way). You can think of the project as a puzzle, in which you have to fill in all the pieces. Alternatively, you could look at the project as a murder mystery that needs a solution. In either case, have fun!

Tim Louwers J. Kenneth Reynolds

Harrisonburg, VA Baton Rouge, LA

Table of Contents

Introduction 1

Table of Contents 2

Planning 3

Internal Control Evaluation 49

Substantive Testing: Cash 62

Substantive Testing: Accounts Receivable 72

Substantive Testing: Inventory 83

Substantive Testing: Prepaids and Other Assets 107

Substantive Testing: Fixed Assets 113

Substantive Testing: Liabilities 117

Substantive Testing: Payroll 123

Audit Wrap-up 130

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Date: Thu, 25 OCT 2007 00:42:35 +0000 From: "Darlene Wardlaw" < DW@aow.cpa > Subject: Upcoming Apollo Shoes Engagement Attachment: <>

Well, first let me congratulate you on your recent promotion. Although we have not worked on an engagement together before, I have heard many good things about you. I look forward to working with you on the new Apollo Shoes engagement.

I understand that this is your first engagement to in-charge. Arnold Anderson (aka “Uncle Arnie”) will be the engagement partner; he is pretty sharp so you’ll have to stay on your toes. As engagement manager, I’ll try to help out as much as I can. Understand, however, that I am managing four other busy season engagements, so my interaction time with you will be limited. For now, I want you familiarize yourself with Apollo Shoes and help me out by doing the following:

1. SEC Filing : I have asked Larry Lancaster, President and chairman of the Apollo Shoes board of directors, to send you a copy of last year’s (2006) 10-K filing with the SEC. Review the information when you receive it, as it is one of the most important sources of information about a company.

2. Audit Committee Meeting : I have attached the minutes of an audit committee meeting that occurred last week. Please review the minutes of the meeting and draft an appropriate engagement letter (label it GA-1 , for General and Administrative, page 1) addressed to Mr. Lancaster. (Since this is our first year on the engagement, you might want to check one of your old auditing textbooks for an example.) I’ll review the letter before getting Arnold to sign it.

3. Audit Team: Based upon the information that you glean from 1 and 2 above, do you see any need for special business knowledge in regard to the basic type of business and products Apollo manages? Do you see any need for special audit or accounting expertise for any of the work that we have agreed to perform? In other words, since you’ll be in the trenches, what kind of expertise do you want on your audit team? Just write a brief audit staffing memo (GA-2) telling me what expertise you need to complete the audit and I’ll see if I can get them assigned to the audit team.

4. Scheduling: We are going to have to work around your other engagements, but we have you tentatively scheduled for one week in October (next week) for bringing you up to speed on Apollo and its industry, and five straight weeks beginning the last week in December for engagement planning, internal control evaluation, and substantive testing.

Finally, since most of our interaction will be by e-mail, please forgive me if I give you too much detail. Since we haven’t worked together before, I’d rather give you too much than too little until we get used to working together.

DW

Minutes of the Audit Committee, Apollo Shoes

October 18, 2007

Present at Meeting: Arnold Anderson, CPA (partner in charge of the audit); Darlene Wardlaw, CPA (engagement manager); Eric Unum (Apollo ’s vice president of finance); Mary Costain (Apollo ’s treasurer); Samuel Carboy (Apollo ’s controller); and Karina Ramirez (Apollo ’s director of internal audit). The three members of the audit committee of the board and the corporate secretary also were present, but they did not enter into the conversation.

Mr. Unum (VP finance): Well, I want to welcome the auditing firm of Anderson, Olds, and Watershed, CPAs to what we call the “Apollo Shoes Experience.” After our old auditors, Smith & Smith, CPAs, unexpectedly withdrew from the engagement, we were very happy to have a firm of your quality to come aboard.

Mr. Anderson (partner on the audit): Well, we are always looking for high quality clients. By the way, why did your previous auditors resign?

Mr. Unum (VP finance): I’d rather not talk about it. Arnold, will Darlene be in charge?

Mr. Anderson (partner on the audit): Yes, and she will be assisted by several of our best staff, including a tax specialist and an information systems auditor. We need to keep up to date on your computer systems. Back to your previous auditors, with your permission, we would like to contact them.

Mr. Unum (VP finance): Well, we’d rather you didn’t. There may be some litigation since they withdrew from the engagement with so little notice. Is it necessary for you to speak with them to accept the engagement?

Mr. Anderson (partner on the audit): No, not really, but it does raise some concerns for our firm.

Ms. Costain (treasurer): In the past, we have never had any unpleasant discoveries of embezzlement or theft, but we always want to be vigilant. Will you plan enough in-depth auditing to give us assurances about errors and frauds in the accounts?

Ms. Wardlaw (manager on the audit): We will follow audit standards and base our audit work on samples of transactions. We plan the work to look for major errors and frauds in the accounts, but cleverly hidden schemes might not be discovered. According to the Sarbanes-Oxley Act of 2002, we will need to test the effectiveness of Apollo’s internal controls, as well as provide you the usual separate management letter on related findings.

Ms. Ramirez (internal auditor): Darlene, I agree, it’s hard to uncover clever schemes. While I am new to Apollo, none of the projects that I have undertaken this year shows anything amiss, other than normal human error types or mistakes.

Ms. Costain (treasurer): This year, we want to add some work to the audit. I am short on staff time and need to have you prepare the state franchise tax return as well as the federal tax returns.

Ms. Wardlaw (manager on the audit): Our tax staffperson can do the state and federal returns, and I will have them reviewed by Maria Olds, our tax partner. In order to perform the tax work, Sarbanes-Oxley requires that we get prior approval from the audit committee to perform both the tax work as well as the audit.

Mr. Anderson (partner on the audit): I assume you also want us to review the 10-K filing material?

Mr. Unum (VP finance): Yes. Will you need any staff help from us?

Ms. Ramirez (internal auditor): Last year, Apollo was able to save on audit fees when my staff prepared a stack of schedules and analyses that our previous auditors needed.

Mr. Wardlaw (manager on the audit): Yes, Karina, I will give you a list of schedules for various accounts. I will appreciate your having them ready when we start fieldwork in mid January.

Mr. Carboy (controller): Speaking of being ready, we will be able to give you a trial balance the day after December 31.

Mr. Unum (VP finance): How much is this going to cost us?

Mr. Anderson (partner on the audit): It is difficult to give you a fixed fee deal, but my estimate, considering the additional work, is $750,000. Darlene will let you know immediately if problems arise to cause the work to be more extensive.

Mr. Unum (VP finance): Thank you. This has been a productive meeting of the minds. We look forward to your getting started next month.

Meeting ended 5:30 p.m. /s/ Jeff Chesnut, Secretary

C:/AudComMins—101807.doc/

Date: Fri, 26 OCT 2007 4:43:17 +0000 From: "Larry Lancaster" < LLancaster@ApolloShoes.com > Subject: Attached 10-K Filing

Attachments: <>, <<10K.doc>>, <>

I am sorry that you were unable to attend the audit meeting last week, but Darlene Wardlaw said that you were busy with another client. She asked that I forward a copy of our 10-K directly to you. I’ve attached one that we sent out to all shareholders with the Letter to Shareholders attached.

I’ve attached a copy of Apollo’s organizational table. Please let me know what my staff or I can do to help the audit go smoothly for you. I will have Karina Ramirez, our Director of Internal Audit, contact you to provide you with any other information that you need.

Larry

P.S. Do you play golf?

This Apollo message (including any attachments) contains confidential information intended for a specific individual and purpose, and is protected by law. If you are not the intended recipient, you should delete this message and are hereby notified that any disclosure, copying, or distribution of this message, or the taking of any action based on it, is strictly prohibited.

Letter to Fellow Shareholders

Dear Fellow Shareholders,

You may have noticed our competitor's focus on earth-bound activities and athletes. Our focus is in exactly the opposite direction. In actuality, the technological superiority of our products is at the point where our sales are limited only by the technological inferiority of other scientific fields (specifically, current transportation means). As space exploration continues, we intend to be among the first to market our products in new worlds. It is there that our technological advances in light and sound can combine with our rugged footwear to propel all galactic sports participants to their fullest potential.

Back here on earth, the past year has been one of the most dynamic and exciting years since I began my tenure at Apollo Shoes. From the beginning, Apollo Shoes, Inc. has adapted itself to meet the needs of all its galactic customers and to take advantage of all opportunities supplied by exploration of new frontiers. After a record year when most companies may have wanted to relax and play it safe, we have decided to use this excitement to reach out further in our continuing mission: to make a difference in this galaxy.

Our product lines, led by the flagship products SPOTLIGHT (for athletes who like to compete at night) and SIREN (designed specifically for police officers working the graveyard shifts in our nation's most dangerous cities) have met widespread acceptance. We have signed with some of this world's premier athletes as spokespersons for our products, including a recent winner of the grueling Alaska Iditarod who used his SPOTLIGHTs to guide his dogs to a late night finish line. We are currently negotiating with a soccer league to exclusively use our SIRENs ; the shoe's flashing lights are designed to go off after every team goal!

Our strategic management plans have allowed us to maintain a positive trend in income over the past several years, and this was no easy task, given the state of the galactic economy. Our net income for the year has been the best since we began operations four years ago. Next year appears even better!

The strength of our results for the past year should not be confused with the truth of the times. This was a uniformly difficult year for all businesses. Due to the conflicts in foreign countries, and uncertainty with the Federal Reserve's adjustments of interest rates, consumer confidence has been negatively affected; therefore, fewer earth consumers are buying our state-of-the-art athletic equipment. All of our operating divisions were severely tested. I am proud of their responses. Although sales were not as strong as we had anticipated, our marketing plans will allow us to bounce back next year.

With the advent of significant new breakthrough technology by Apollo Shoes, Inc.'s research and development team, Apollo Shoes, Inc. now has the possibility to take a leadership role in the galactic athletic footwear market. Apollo Shoes, Inc. has always been known for its leadership position in electronic shoe technology, but we are now committed to expanding our marketing focus. With new applied technologies, Apollo Shoes, Inc. can maintain its tradition of high tech electronic performance and style. We continue to work on and improve the SPEAKERSHOE , an athletic shoe with an amplified loudspeaker, originally designed for the international recording group "Mythic Meathook." We are hard at work on new ideas, such as the PHONESHOE , the sneaker with a cellular phone for those executives who like to simultaneously combine exercise with work. We anticipate that the PHONESHOE will capture a significant piece of this quickly expanding market.

At Apollo Shoes, Inc., we like to briefly acknowledge achievement and then proceed to new challenges. This year was great only because it provided us with resources to expand operations and further technological progress. As we continue into this century of "more, faster, better," it is critical to continue this tradition because production, speed, and quality are critical elements for future success. We look forward to the challenge.

Larry Lancaster
Chairman, President and CEO

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--------------------------------

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

------------------------

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2006

COMMISSION FILE NUMBER 1-9Z40

APOLLO SHOES INC.

(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

MAINE X8-061325

(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER

INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)

SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:

TITLE OF EACH CLASS NAME OF EACH EXCHANGE

ON WHICH REGISTERED

------------------- -----------------------------------------

COMMON STOCK, PAR VALUE, $1.00 PER SHARE STUDS

SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: NONE

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this

Form 10-K. [X]

As of March 8, 2007, the aggregate market value of the registrant's voting stock held by non-affiliates of the registrant was approximately $24,315,000.

As of March 8, 2007, 8,105,000 shares of the registrant's Common Stock were issued and outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Definitive Proxy Statement dated December 12, 2006 for the Annual Meeting of Shareholders to be held on Tuesday, February 27, 2007 at the End of the Universe Restaurant in downtown Shoetown.

APOLLO SHOES INC.

ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

Item 1. Business i

Item 2. Properties ii

Item 3. Legal Proceedings iii

Item 4. Submission of Matters to a Vote of Security Holders. iii

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters. iii

Item 6. Selected Financial Data iv

Item 7. Management's Discussion and Analysis of Financial

Condition and Results of Operations v

Item 8. Financial Statements and Supplementary Data vi

Item 9. Changes in and Disagreements with Accountants xix

Item 10. Directors and Executive Officers of the Registrant xix

Item 11. Executive Compensation xix

Item 12. Security Ownership of Certain Beneficial Owners and Management. xix

Item 13. Certain Relationships and Related Transactions. xix

Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K xx

This Annual Report on Form 10-K contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, including statements with regard to the Company's revenues, earnings, spending, margins, cash flow, orders, inventory, products, actions, plans, strategies and objectives. Forward-looking statements include, without limitation, any statement that may predict, forecast, indicate or imply future results, performance or achievements, and may contain the words "believe," "anticipate," "expect," "estimate," "intend," "plan," "project," "will be," "will continue," "will result," "could," "may," "might," or any variations of such words or other words with similar meanings. Any such statements are subject to risks and uncertainties that could cause the Company's actual results to differ materially from those discussed in such forward-looking statements. Prospective information is based on management's then current expectations or forecasts. Such information is subject to the risk that such expectations or forecasts, or the assumptions underlying such expectations or forecasts, become inaccurate. For a description of such risks, see the section below entitled "ISSUES AND UNCERTAINTIES."

ITEM 1. BUSINESS.

Apollo Shoes, Inc. is a planetary distributor specializing in technologically superior athletic podiatric products. The Company’s brands-- SIREN , SPOTLIGHT , and SPEAKERSHOE -- are used extensively in many athletic competitions, such as the Switzerland Watersports Games in Zurich. The Company is excited about this annual event that exhibits to the entire world the skills and spirit of outstanding Swiss aquatic athletes.

The Company’s products are shipped to large and small retail outlets in a six-state area. The company stocks a wide range of shoe products and has a large base of retail store customers. Apollo operates from a large office, operations, and warehouse facility in the Shoetown, Maine area.

Apollo Shoes, incorporated in the state of Delaware, is a public corporation. Its stock is traded in the over-the-counter market. No one presently owns more than 4 percent of the outstanding common stock. The company is subject to the reporting requirements of the Securities and Exchange Act of 1934.

Organization and Personnel

Apollo Shoes is a medium-sized corporation. It has over 100 employees organized in five departments headed by vice presidents.

Marketing

The marketing department handles advertising and direct contact with customers. The marketing department vice president supervises the sales staff, the advertising staff, and the customer relations staff.

i

Finance

The finance department has two subordinate offices—the treasurer and the controller. The treasurer supervises the cashiers and the cash management professionals. The controller’s office has the following departments and personnel: billing department, accounts receivable/cash receipts department, accounts payable/cash disbursements department, inventory records department, payroll department, general ledger department, and financial statement department.

Information Systems

An information systems department was created this past year. At present, the staff consists of a Director of IS (information systems), a systems development project manager and two programmer/analysts, an operations manager (who also serves as the librarian and control clerk), and two machine operators.

When the information systems department became active, the director was promoted to vice president. Apollo obtained a wireless local area network (LAN) multiserver soon after and began testing the hardware and software. Since the new computer system was designed and customized to Apollo’s needs, every effort was made to keep as many as possible of the procedures and business documents used in the manual system. This made the transition to the computer system easy on the employees, thus reducing training and employee objections to the computer.

Operations

The operations department contains production planning specialists and some production control professionals, who assist the marketing department in technical matters and assist customers with product specifications. Operations supervisors supervise hourly workers who move products from receiving, inventory, and shipping to serve customer demand. The department also supervises the timekeepers, who maintain the workers’ time clocks and collect payroll time cards. The operations department contains the critical functions of purchasing, receiving, and shipping. Inventory storekeeping responsibility is also in this department, with some inventory managers. For reasons lost to history, the department also has the mailroom and the personnel department.

ITEM 2. PROPERTIES.

Until February of 2004, the Company leased most of the properties that were used in its business. Its corporate headquarters relocated at that time to office facilities in Shoetown, Maine. At its corporate headquarters, the Company occupies approximately 10,000 square feet of space. A lease on an operations facility expires on June 30, 2007. This warehouse and distribution center is located approximately one mile from the Company headquarters and contains approximately 450,000 total square feet of usable space.

ii

ITEM 3. LEGAL PROCEEDINGS.

On September 15, 2006, the Company agreed to settlement of a suit brought against the Company by a competitor for patent infringement for the Company's use of the Siren. While the Company denies any wrongdoing, the Company felt that the settlement would be preferable to a long litigation process. The final settlement totaled $11,695,000 ($19,172,000, net of a tax benefit of $7,477,000).

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

No matter was submitted during 2006 to a vote of security holders, through the solicitation of proxies or otherwise.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.

The Company's common stock is quoted on the Security Traders, Underwriters, and Dealers System (STUDS) under the symbol APLS. The following table, derived from data supplied by STUDS, sets forth the quarterly high and low sale prices during 2006 and 2005.

PRIVATE

2006

2005

High

Low

High

Low

First

14 5/8

3 3/8

4

3 1/2

Second

11

2 5/8

4 5/8

4 1/4

Third

8 1/4

3 1/4

8 1/8

4

Fourth

5 5/8

3 1/8

11 1/2

5

The stock price at closing on December 31, 2006, was $3 1/4 per share.

As of December 31, 2006, there were approximately 15,342 holders of record of the Company's Common Stock including those shares held in "street name". The Company believes that it has in excess of 16,000 shareholders.

The Company has never paid cash dividends on its Common Stock and the Board of Directors intends to retain all of its earnings to finance the development and expansion of its business. However, there can be no assurance that the Company can successfully expand its operations, or that such expansion will prove profitable. Future dividend policy will depend upon the Company's earnings, capital requirements, financial condition, and other factors considered relevant by the Company's Board of Directors.

iii

ITEM 6. SELECTED FINANCIAL DATA.

APOLLO SHOES, INC.

in thousands (except per share data)

Income Statement Data

PRIVATE

Year Ended December 31

2006

2005

2004

2003

Net Sales

$240,575

$236,299

$182,209

$138,920

Income Before Taxes

$26,337

$54,680

$2,226

$1,757

Income Taxes

$10,271

$21,634

$636

$502

Net Income

$4,371

$1,745

$1,590

$1,255

Earnings Per Share

$0.54

$0.22

$0.55

$0.44

Balance Sheet Data

PRIVATE

As of December 31,

2006

2005

2004

2003

Working Capital

$20,482

$16,866

($1,951)

($2,356)

Total Assets

$36,794

$21,304

$6,754

$6,062

Long‑Term Debt

$0

$0

$0

$0

Shareholders' Equity

$22,119

$17,748

$5,470

$3,880

iv

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

2006 Financial Results

Net sales for the year ended December 31, 2006 increased 2% to $240,575,000, when compared to the same period in 2005. The sales growth was primarily due to new products introduced during the 2006 fiscal year. The average selling price per product in the year ended December 31, 2006 increased approximately 2% from the year ended December 31, 2005.

Gross profit for the year ended December 31, 2006 was 41% of sales compared with 49% for the year ended December 31, 2005. The decrease was primarily due to higher prices charged by our suppliers for raw materials.

Selling, general and administrative expense for the year ended December 31, 2006 was 30% of net sales as compared to 26% for the year ended December 31, 2005. The increase of 16% to $71,998,000 was primarily the result of increases in staffing and increased professional expenses. The increased professional fees were primarily related to the settlement of litigation brought against us by a competitor. Rather than face a costly, lengthy litigation process, the Company decided to settle out of court. The Company vehemently denies any wrongdoing in the matter.

Total research and development expenses for the year ended December 31, 2006 were 5% of net sales and increased by 10% when compared to the year ended December 31, 2005. The increase was primarily due to the addition of engineering personnel. Research and development activities were focused on continued development of PHONESHOE and SPEAKERSHOE technology.

Liquidity and Capital Resources

The Company's principal source of operating funds has been from proceeds from short-term borrowing against a $50 million line of credit. While the credit facility must be renewed each year, the Company foresees no problems with renewal for the foreseeable future.

The Company intends to use its capital resources to expand its operations facilities and to increase research and development in order to maintain its competitive advantage in podiatric technology. There are no other significant capital requirements identified at this time.

Management believes that the effect of inflation on the business of the Company for the past three years has been minimal.

The Company believes that its current working capital of $20,482 million and anticipated working capital to be generated by future operations will be sufficient to support the Company's working capital requirements for the foreseeable future.

v

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

STATEMENTS OF INCOME

APOLLO SHOES, INC.

in thousands (except per share data)

For year ended, December 31,

2006

2005

Net Sales (Note 2)

$240,575

$236,299

Cost of Sales

$141,569

$120,880

Gross Profit

$99,006

$115,419

Selling, General and Administrative Expenses

$71,998

$61,949

Interest Expense (Note 7)

$875

0

Other Expense (Income)

($204)

($1,210)

Earnings from Continuing Operations Before Taxes

$26,337

$54,680

Income Tax Expense (Note 10)

$10,271

$21,634

Earnings from Continuing Operations

$16,066

$33,046

Discontinued Operations, Net of tax benefit

($31,301)

Extraordinary Item, Net of tax benefit (Note 11)

($11,695)

Net Income

$4,371

$1,745

Earnings Per Common Share

From Continuing Operations

$1.98

$4.08

Other

($1.44)

($3.86)

Net Income

$0.54

$0.22

Weighted shares of common stock outstanding

8,105

8,105

The accompanying notes are an integral part of the consolidated financial statements.

vi

STATEMENT OF FINANCIAL CONDITION

APOLLO SHOES, INC.

in thousands

As of December 31

2006

2005

Assets

Cash

$3,245

$3,509

Accounts Receivable (Net of Allowances of $1,263 and 210, respectively) (Note 3)

15,148

2,738

Inventory (Note 4)

15,813

13,823

Prepaid Expenses

951

352

Current Assets

$35,157

$20,422

Property, Plant, and Equipment (Note 5)

1,174

300

Less Accumulated Depreciation

(164)

(31)

$1,010

$269

Investments (Note 6)

613

613

Other Assets

14

0

Total Assets

$36,794

$21,304

Liabilities and Shareholder's Equity

Accounts Payable and Accrued Expenses

$4,675

$3,556

Short-Term Liabilities (Note 7)

10,000

0

Current Liabilities

$14,675

3,556

Long-Term Debt (Note 7)

0

0

Total Liabilities

$14,675

3,556

Common Stock

8,105

8,105

Additional Paid-in Capital

7,743

7,743

Retained Earnings

6,271

1,900

Total Shareholders' Equity

$22,119

$17,748

Total Liabilities and Shareholders' Equity

$36,794

$21,304

The accompanying notes are an integral part of the consolidated financial statements.

vii

STATEMENTS OF SHAREHOLDERS' EQUITY

APOLLO SHOES, INC.

in thousands

PRIVATE

Shares

Par Value

($1 per share)

Additional Paid-in Capital

Retained

Earnings

Other

Total

Balance, December 31, 2004

2,873

$2,873

$2,442

$155

$0

$5,470

Net Income

$1,745

$1,745

Exercise of Stock Options

232

$232

$301

$533

Other

5,000

$5,000

$5,000

$10,000

Balance, December 31, 2005

8,105

$8,105

$7,743

$1,900

$0

$17,748

Net Income

$4,371

$4,371

Exercise of Stock Options

0

$0

$0

Other

$0

Balance, December 31, 2006

8,105

$8,105

$7,743

$6,271

$0

$22,119

The accompanying notes are an integral part of the consolidated financial statements.

viii

CONSOLIDATED STATEMENTS OF CASH FLOWS

APOLLO SHOES, INC.

in thousands

For the year ended December 31,

2006

2005

Cash Flows from Operating Activities

Net Income

$4,371

$1,745

Adjustments to Reconcile Net Income to Net Cash Provided

Depreciation and Amortization

$133

$26

Changes in Operating Assets and Liabilities

Decrease (Increase) in Current Assets

Accounts Receivable

($12,410)

($2,073)

Inventory

($1,990)

($11,861)

Prepaid Expenses

($599)

($123)

Increase (Decrease) in Current Liabilities

Accounts Payable and Accrued Expenses

$1,119

$5,504

Total Adjustments

($13,747)

($8,527)

Net Cash Provided by Operating Activities

($9,376)

($6,782)

Cash Flows from Investing Activities

Capital Expenditures

($874)

($255)

Purchase of Other Assets

($14)

Net Cash Provided by Investing Activities

($888)

($255)

Cash Flows from Financing Activities

Proceeds from the Issuance of Debt

$10,000

Proceeds from the Issuance of Common Stock

$10,533

Net Cash Provided by Financing Activities

$10,000

$10,533

Net Increase (Decrease) in Cash

($264)

$3,496

Cash at Beginning of Year

$3,509

$13

Cash at End of Year

$3,245

$3,509

The accompanying notes are an integral part of the consolidated financial statements.

ix

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

APOLLO SHOES, INC.

1. Summary of Significant Accounting Policies

Business activity The Company develops and markets technologically superior podiatric athletic products under various trademarks, including SIREN, SPOTLIGHT, and SPEAKERSHOE.

Marketable Securities Investments are valued using the market value method for investments of less than 20%, and by the equity method for investments greater than 20% but less than 50%.

Cash equivalents Cash equivalents are defined as highly liquid investments with original maturities of three months or less at date of purchase.

Inventory valuation Inventories are stated at the lower of First-in, First-out (FIFO) or market.

Property and equipment and depreciation Property and equip​ment are stated at cost. The Company uses the straight-line method of depreciation for all additions to property, plant and equipment.

Intangibles Intangibles are amortized on the straight-line method over periods benefited.

Net Sales Sales for 2006 and 2005 are presented net of sales returns and allowances of $4.5 million, and $0.9 million, respectively, and net of warranty expenses of $1.1 million, and $0.9 million, respectively.

Income taxes Deferred income taxes are provided for the tax effects of timing differences in reporting the results of operations for financial statements and income tax purposes, and relate principally to valuation reserves for accounts receivable and inventory, accelerated depreciation and unearned compensation.

Net income per common share Net income per common share is computed based on the weighted average number of common and common equivalent shares outstanding for the period.

Reclassification Certain amounts have been reclassified to con​form to the 2006 presentation.

2. Significant Customers

Approximately 15%, and 11% of sales are to one customer for years ended December 31, 2006 and 2005, respectively.

x

3. Accounts Receivable

Accounts Receivable consists of the following at December 31:

PRIVATE in thousands

2006

Trade Receivables

$16,411

Employee and Officer Receivables

0

16,411

Less Allowance for Doubtful Accounts

(1,263)

Net Accounts Receivable

$ 15,148

Amount charged to bad debt expense for the year ended December 31, 2006 was 1,622,000. Writeoffs for the year were approximately the same.

4. Inventories

Inventories consist of the following at December 31:

PRIVATE in thousands

2006

Siren

$3,098

Speaker

9,571

Spotlight

6,156

18,825

Less Reserve for Inventory Obsolescence

(3,012)

Ending Inventory

$15,813

5. Property and equipment

Property is stated at cost net of accumulated depreciation. Property and Equipment at December 31 was as follows:

PRIVATE in thousands

2006

Land

$117

Buildings and Land Improvements

624

Machinery, Equipment and Office Furniture

433

Total Land, plant and equipment

1,174

Less Accumulated depreciation

(164)

Net Land, Plant and Equipment

$1,010

xi

6. Investments

In order to receive a higher rate of return on its excess liquid assets, the Company invested approximately $0.6 million in stock for a 25% share in the SHOCK-PROOF SOCKS Company in 2004. This investment is valued in the financial statements using the Equity method. SHOCK-PROOF SOCKS did not recognize any income and did not pay any dividends in 2005 and 2006. In addition, the Company incurred approximately $14,000 in legal fees to register the patent for the PHONESHOE. The asset will be amortized over its useful life of 17 years.

7. Debt

At December 31, 2006, the Company had $10,000,000 outstanding in short-term borrowings under a $50 million secured revolving credit line with a local financial institution. The line of credit is secured by the Company’s inventory. The interest rate charged on this agreement is the Prime Rate plus 3%. This credit line is evaluated annually on June 30 by the lending institution.

Annual maturities of debt obligations are as follows:

2007 $10,000,000

2008 0

Total Debt $10,000,000

8. Commitments

Annual obligations under non‑cancelable operating leases are as follows:

2007 $1,200,000

Thereafter 0

Rent expense charged to operations for the years ended December 31, 2006 and 2005 was $2.6 million and $3.7 million, respectively.

xii

10. Income taxes

The provision (benefit) for income taxes consists of the following for the years ended December 31:

2006 2005

Current:

Federal $ 2,025 $ 873

State 365 154

$ 2,390 $ 1,027

Deferred:

Federal $ 340 $ (42)

State 64 (7)

$ 404 $ (49)

$ 2,794 $ 978

Deferred income taxes are provided for the tax effects of timing differences in reporting the results of operations for financial statements and income tax purposes, and relate principally to valuation reserves for accounts receivable and inventory, accelerated depreciation and unearned compensation. A reconciliation of the statutory federal income tax provision to the actual provision follows for the years ended December 31:

2006 2005

Federal Statutory Rate 34.0% 34.0%

State taxes, less federal benefit 6.0% 6.0%

Research and experimentation credit (2.0%) (1.4%)

Other 1.0% 1.0%

Effective Tax Rate 39.0% 39.6%

11. Litigation

On September 15, 2006, the Company agreed to settlement of a suit brought against the Company by a competitor for patent infringement for the Company's use of the Siren. While the Company denies any wrongdoing, the Company felt that the settlement would be preferable to a long litigation process. The final settlement totaled $11,695,000 ($19,172,000, net of a tax benefit of $7,477,000).

12. Related-party transactions

On February 1, 2006, the Company purchased its operating facility and equipment from a company controlled by two previous directors and shareholders of the Company for $623,905.92. Currently, the Company leases a second facility and equipment from the same company for approximately $200,000 per month. The Company’s lease ends in June 2007 at which time all operations will be moved to the central headquarters building.

xiii

13. Employee benefit plans

The Company sponsors a defined-contribution retirement plan covering substantially all of its earth employees. Contributions are deter​mined at the discretion of the Board of Directors. Aggregate contribu​tions made by the Company to the plans and charged to operations in 2006, 2005 and 2004 were $3 million, $3 million and $3 million, respectively.

14. Concentrations of credit risk

Financial instruments which potentially subject the Company to credit risk consist principally of trade receivables and interest-bearing investments. The Company sells a significant amount of its product to one retail distributor with sales operations located throughout North America, Europe and Asia Pacific. The Company is currently negotiating to increase its sales to that company, as well as enter into long-term relationships with two other large retail distributors. The Company performs on‑going credit evaluations of all of its customers and generally does not require collateral. The Company maintains adequate reserves for potential losses and such losses, which have been minimal, have been included in management's estimates.

The Company places substantially all its interest-bearing investments with several major financial institutions. Corporate policy limits the amount of credit exposure to any one financial institution.

xiv

CERTIFICATIONS

We, Larry Lancaster and Joe Bootwell, certify that:

1. We have reviewed this annual report on Form 10-K of Apollo Shoes, Inc.;

2. Based on our knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on our knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. We are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

c) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. We have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent functions):

a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: February 4, 2007

Larry Lancaster
Joe Bootwell
Larry Lancaster

Joe Bootwell

Chairman of the Board of Directors,

President and CEO

Executive Senior Vice-President and CFO

xv

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of APOLLO SHOES, INC.

We have audited the accompanying balance sheets of APOLLO SHOES, INC. as of December 31, 2006 and 2005 and the related statements of income, comprehensive income, shareholders’ equity, and cash flows for the two years in the period ended December 31, 2006. We have also audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that APOLLO SHOES, INC. maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control ​– Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO criteria). APOLLO SHOES’ management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of internal control over financial reporting. Our responsibility is to express an opinion on these financial statements, an opinion on management’s assessment, and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audit of the financial statements including examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of APOLLO SHOES, INC. as of December 31, 2006 and 2005 and the results of its operations and cash flows for each of the three years in the period ended December 31, 2006 in conformity with U.S. generally accepted accounting principles. Also in our opinion, management’s assessment that APOLLO SHOES, INC. maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Furthermore, in our opinion, APOLLO SHOES, INC. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.

Smith & Smith, CPA's
Shoetown, Maine

January 29, 2007 xvi

CORPORATE INFORMATION

Auditors

Smith & Smith, CPA's

31rst Financial Avenue

Shoetown, ME 00002

Transfer Agent and Registrar

The Twenty-First National Bank of Maine is the Transfer Agent and Registrar for the Company's common stock and maintains shareholder accounting records. The Transfer Agent should be contacted on ques​tions of changes in address, name or ownership; lost certificates and consolidation of accounts.

The Twenty-First National Bank of Maine

Shareholder Correspondence

Post Office Box 1

Shoetown, ME 00002

Form 10‑K

For a copy of the Form 10‑K Annual Report, filed with the Securities and Exchange Commission write to:

Office of Investor Relations

Apollo Shoes Inc.

100 Shoe Plaza

Shoetown, ME 00001

Annual Meeting

The Annual Meeting of Shareholders was held at 10:00 a.m., local time, on Tuesday, February 28, 2006 at the End of the Universe Restaurant in downtown Shoetown. Shareholders of record on February 14, 2006 were entitled to vote at the meeting.

The PHONESHOE, SIREN, SPEAKERSHOE, and the SPOTLIGHT Designs are registered trademarks of Apollo Shoes, Inc.

xvii

BOARD OF DIRECTORS

Larry Lancaster

Chairman, President and CEO

APOLLO SHOES, INC.

Eric. P. Unum

Vice-President - Finance

*Fritz Brenner

President

The Widget Corporation

*Ivan Gorr

President

Far More Drugs, Inc.

*Harry Baker
Executive Vice President and Treasurer

Iguana Growers of America Inc.

*Theodore Horstmann

Minister of Commerce

Anglonesia

*Josephine Mandeville, PH.D., CPA

Professor of Accountancy and Typing

Graduate School of Business and Clerical Skills

* External Directors

CORPORATE OFFICERS

Larry Lancaster

Chairman, President and CEO

Joe Bootwell

Executive Senior Vice President and CFO

Fred Durkin
Vice-President - Marketing

Daisy Gardner

Vice-President - Operations

Eric. P. Unum

Vice-President - Finance

Sue D. Fultz

Vice-President - Legal Affairs

Mary Costain

Treasurer

Jeff Chesnut
Secretary

xviii

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS

Smith and Smith, CPAs, withdrew as the Company’s auditors after completing the 2006 audit. The auditors expressed concerns about “mutually incongruent goals.”

The Company is considering legal action against the firm.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The president, Larry Lancaster, is both chairman of the board of directors and President and chief executive officer (CEO). Eric Unum (Vice-President – Finance) is also a member of the board, along with five outside (independent) directors who never worked for the Apollo organization. Three outside board members constitute the audit committee of the board.

ITEM 11. EXECUTIVE COMPENSATION

(Approximate amounts expressed in thousands)

Larry Lancaster, Chairman, President and CEO 2,500

Sue D. Fultz, Vice-President - Legal Affairs 1,500

Joe Bootwell, Executive Senior Vice President and CFO 1,200

Fred Durkin, Vice-President – Marketing 1,000
Eric. P. Unum, Vice-President – Finance 590

Daisy Gardner, Vice-President – Operations 410

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.

Currently, no management personnel hold stock ownership in the Company

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

On February 1, 2006, the Company purchased its operating facility and equipment from a company controlled by two previous directors and shareholders of the Company for $623,905.92. Currently, the Company leases a second facility and equipment from the same company for approximately $200,000 per month. The Company’s lease ends in June 2007 at which time all operations will be moved to the central headquarters building. The two previous directors are no longer associated with Apollo Shoes.

xix

ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

QUARTERLY RESULTS OF OPERATIONS (Unaudited)

2006

March 31

June 30

September 30

December 31

Total

Net Sales

$58,236

$59,759

$60,239

$62,341

$240,575

Gross Profit

$24,372

$24,996

$24,356

$25,282

$99,006

S,G, & A Expenses

$16,478

$17,695

$17,347

$20,478

$71,998

Net Income

$4,815

$4,454

($7,785)

$2,887

$4,371

Earnings Per Share

$0.59

$0.55

($0.96)

$0.36

$0.54

The Company filed one 8-K dealing with the withdrawal of its auditor on January 30, 2007. It is incorporated in this document by reference.

<<10-K.Doc>>

xx

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<> Date: Mon, 29 OCT 2007 07:14:35 +0000 From: "Karina Ramirez" < Kramirez@ApolloShoes.com > Subject: Upcoming Apollo Shoes Engagement Attachment: <>

Per your request, I have attached a copy of our accounting and procedures manual. We look forward to your upcoming fieldwork. Please let us know if there is anything else we can provide you to make your job easier.

Karina

Karina Ramirez

Director, Internal Audit

Apollo Shoes, Inc.

This Apollo message (including any attachments) contains confidential information intended for a specific individual and purpose, and is protected by law. If you are not the intended recipient, you should delete this message and are hereby notified that any disclosure, copying, or distribution of this message, or the taking of any action based on it, is strictly prohibited.

Apollo Shoes

Accounting and Control Procedure Manual

Sales and Accounts Receivable

Daily batches of sales invoices shall be analyzed by sales totals in the athletic shoes product lines. Sales credits are coded to three product line sales revenue accounts.

Charges to customer accounts should be dated the date of shipment.

When sales invoices are recorded, the numerical sequence shall be checked by an accounts receivable clerk, and missing invoices must be located and explained. The items shipped shall be compared to the items billed for proper quantity, price, and other sales order terms.

The general ledger supervisor shall compare the copy 2 daily batch total with the copy 4 individual accounts posting total sent from the accounts receivable department.

Discrepancies shall be investigated to help assure that the customer subsidiary accounts are posted for the same total amount posted to the control account.

At the end of each month, the total of the trial balance of customer account balances (prepared by the accounts receivable department) shall be reconciled to the general ledger control account by the general ledger supervisor.

Sales invoice batches shall be dated with the date of shipment, and totals of batches (including product line sales for athletic shoes) shall be accumulated each month and recorded in the accounts receivable control and sales revenue accounts. The general ledger supervisor shall approve all monthly summary entries before they are posted to the general ledger.

The treasurer shall approve all cash refunds and allowance credit memos for sales returns, after initiation by customer relations personnel.

The marketing vice president shall periodically analyze sales activity by product lines in comparison to budgets and forecasts and prior years’ activity.