Audit Program Design Part II March 26, 2012

Larry Lancaster Chairman, President and CEO Apollo Shoes Inc., 123 Shoestring Lane Shoetown, ME 00001

Dear Mr. Lancaster: Anderson, Olds, and Watershed CPAs want to again thank the management of Apollo Shoes Inc. for allowing us to continue with the necessary auditing activities. AOW will work diligently to ensure the trust placed in our services is well-founded, and results in a desire for an ongoing auditing partnership for future needs. As requested, we have provided information on designing tests of controls, substantive tests of transactions, and analytical procedures for the sales and collection cycle, payroll and personnel cycle, and acquisition and payment cycle. Sales and Collection Cycle Based on previously conducted research, it is evident the controls over the sales and collection cycle at Apollo Shoes Inc. are greatly ineffective. Some of the research results found, to name a few, improperly recorded sales transactions because of missing bill of ladings, the lack of proper approvals causing issues with collection activities, and incorrect billing to customers due to overcharges and undercharges (University of Phoenix, 2007). In an effort to prevent these same errors from occurring in the future, AOW will need to design tests of controls, substantive tests of transactions, and analytical procedures for the sales and collection cycle. These tests and procedures will help strengthen the current system of internal controls used at Apollo Shoes Inc. According to Arens, Elder, and Beasley (2006), A typical approach for sales is to study the clients flowcharts, prepare an internal control questionnaire, and perform walkthrough tests of sales. The internal controls currently in place provide information for assessing the control risks involved. Once the controls and deficiencies are determined, AOW will proceed with the tests and procedures. Some of the deficiencies found include inadequate separation of duties, improper authorization, inadequate documents and records, and duplicated documents. For audits of public companies, the auditor must perform tests of key controls, and evaluate the impact of the

noted deficiencies on the auditors report on internal control over financial reporting (Arens et al., 2006, p. 419). After gathering information on the volume of testing controls, AOW will proceed by designing the tests of controls. According to Arens et al. (2006), For each key control, one or more tests of controls must be designed to verify its effectiveness. One internal control of Apollo Shoes Inc. requires credit approvals for sales. To test this internal control, we will examine all sales transactions for the proper credit approvals. Another test of control involves examining all sales invoices for supporting bill of ladings. These are just two of many tests of controls used in auditing Apollo Shoes Inc.s internal controls. The design of substantive tests of transactions for sales may sometimes depend on the results from the tests of controls. Some of the objectives used for this part of the audit include recorded sales that exist, recorded sales for which there were no shipments, sales recorded more than once, and shipments made to nonexistent customers. AOW will also check to ensure the sales transactions were accurately recorded in the proper accounts. It is important to note that the same methodology used for designing tests of controls and substantive tests of transactions for sales is used for collections (Arens, Elder, & Beasley, 2006). Payroll and Personnel Cycle The process for testing the payroll and personnel cycle consists of several steps. Tests of controls and substantive tests of transaction are, according to Arens, Elder, and Beasley (2006), the most important means of verifying account balances in the payroll and personnel cycle (p. 565). Apollo Shoes is a publicly traded company, so the tests of internal controls must provide sufficient evidence to express an opinion on the effectiveness of internal control in addition to ensuring control risk is below the maximum. Substantive tests of transactions will focus on determining if the audit objectives are met for transactions. Analytical procedures will help detect misstatements through comparison to previous period expenses. The characteristics of the payroll and personnel cycle generally result in effective internal control. The federal and state governments enforce payroll regulations with harsh penalties, and employees are vocal when paychecks are incorrect or late (Arens et al., 2006). The tests of controls begin with inquiring of management whether Apollo Shoes employs an outside company for processing payroll and if Apollo Shoes maintains a separate bank account for processing payroll payments. The frequency and regularity of transactions in this business cycle support the use of third-party processing companies for payroll, and the consistency of payroll transactions encourages the use of computer systems (Arens et al., 2006). If Apollo Shoes uses an outside company for payroll, the auditors report of the payroll company may express an opinion on the effectiveness of its internal control. Other tests of controls will coincide with substantive tests of transactions.

Substantive tests of transactions will require an examination of the payroll journal, general ledger, bank statements, and samples of personnel files, time cards, and canceled payroll checks. Matching canceled checks with time cards, personnel files, bank statements, and the payroll journal will verify multiple objectives: Payroll payments on record are only for work done, and by existing employees;

All payroll transactions are on record;

Payroll transactions are for the correct amount of time, at the proper rate, and calculated accurately;

Dating of transactions is correct (Arens et al., 2006).

Reviewing the chart of accounts will determine if classification is proper. Tracing payroll journal entries to the general ledger will reveal if posting and summarization are correct. Assessing the control risk for the payroll and personnel cycle includes addressing all relevant key controls within Apollo Shoes. An examination of these items will test two key controls: the adequacy of documents and records and the level of physical control over assets and records (Arens et al., 2006). Additional tests will review other key controls. Observation and inquiry of personnel will reveal if an adequate separation of duties are present, and indicators of internal verification show proper authorization and whether checks on performance are independent or not (Arens et al., 2006). Payroll taxes and withholdings are another area of concern for the audit of the payroll and personnel cycle. Recalculating samples of payments for multiple payroll periods and comparing the payroll journal with bank statements will cover these control areas. Analytical procedures for this cycle compare payroll-related expenses with prior periods to examine current payroll accounts for potential misstatements. Several useful analytical procedures are as follows: Comparing the payroll expense account with previous years requires adjusting for changes in the number of employees and any alterations in pay rates;

Comparing direct labor as a percentage of sales is another useful comparison;

 The comparison of payroll tax expense as a percentage of payroll, including adjustments for changes in the tax rates;

Comparing accrued payroll tax accounts (Arens et al., 2006).

The comparison of these items to previous years may detect the potential for misstatements in payroll expense and payroll tax accounts.

References Arens, A. A., Elder, R. J., & Beasley, M. S. (2006). Auditing and assurance services: An integrated approach (11th ed.). New York, NY: Pearson. University of Phoenix. (2007). Apollo Shoes case. Retrieved from University of Phoenix, ACC546 website. ----------------------[pic] Anderson, Olds, and Watershed (AOW) CPAs One Audit Drive Shoetown, ME 00001