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 Felix I. Lessambo
Financial Statements
Analysis and Reporting
Financial Statements
 Felix I. Lessambo

Financial Statements
Analysis and Reporting
Felix I. Lessambo
Central Connecticut State University
New Britain, CT, USA

ISBN 978-3-319-99983-8 ISBN 978-3-319-99984-5 (eBook)

https://doi.org/10.1007/978-3-319-99984-5

Library of Congress Control Number: 2018957071

© The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer
Nature Switzerland AG, part of Springer Nature 2018
This work is subject to copyright. All rights are solely and exclusively licensed by the
Publisher, whether the whole or part of the material is concerned, specifically the rights
of translation, reprinting, reuse of illustrations, recitation, broadcasting, reproduction
on microfilms or in any other physical way, and transmission or information storage and
retrieval, electronic adaptation, computer software, or by similar or dissimilar methodology
now known or hereafter developed.
The use of general descriptive names, registered names, trademarks, service marks, etc. in this
publication does not imply, even in the absence of a specific statement, that such names are
exempt from the relevant protective laws and regulations and therefore free for general use.
The publisher, the authors and the editors are safe to assume that the advice and
information in this book are believed to be true and accurate at the date of publication.
Neither the publisher nor the authors or the editors give a warranty, express or implied,
with respect to the material contained herein or for any errors or omissions that may have
been made. The publisher remains neutral with regard to jurisdictional claims in published
maps and institutional affiliations.

Cover credit: MirageC/Getty Images

Cover design by Ran Shauli

This Palgrave Macmillan imprint is published by the registered company Springer Nature
Switzerland AG
The registered company address is: Gewerbestrasse 11, 6330 Cham, Switzerland
 Acknowledgements

Writing a book is always a challenge. But writing a book on Financial

Statements: Analysis and Reporting, geared to M.B.A. students, a more
daring intellectual exercise for twofold reasons: (i) because of the hard
choice of topics to cover, and (ii) financial analysis is part science and
part art.
I would like to express my gratitude to those who motivated me all
along the project, knowing my dedication to the subject, and thought
I am more than able to complete this project: Dr. Gordon Marsha, Dr.
Linda Sama, Fouad Sayegh, Esq., Jerry Izouele.
Several good friends provided me with needed guidance and materi-
als to complete this book, while others took from their busiest time to
review and comb the manuscript: Reverend Pastor Roland Dalo, Aline
Kabongo.

v
 Contents

Part I Overview of Financial Statements and the Statement

of Financial Position

1 Overview of Financial Statements 3

1.1 General 3
1.2 The International Accounting Standard Board: IFRS 4
1.3 European Financial Reporting Advisory Group
(EFRAG) 4
1.4 The USA: The FASB 5
1.5 The UK: Financial Reporting Council (FRC) 9
1.6 Japan: The Accounting Standard Board of Japan 11
1.7 Australia: The Australian Accounting Standard
Board 13
1.8 New Zealand: The New Zealand Accounting
Standards Board (NZASB) 15
1.9 India: The Council of the Institute of Chartered
Accountants of India (ICAI) 15
1.10 China: Accounting Standard for Business Enterprises 16
1.11 The Financial Statement Materials 16
1.11.1 The Proxy Statement 17
1.11.2 The Management Discussion & Analysis
(MD&A) 17

vii
viii    Contents

1.12 Interim Statements and Subsequent & Adjusting

Events 18
1.12.1 Interim Financial Statements 18
1.12.2 Subsequent Events 18
1.12.3 Adjusting Events 18
1.13 Users of Financial Statements 21

2 Cash and Cash Equivalents 23

2.1 General 23
2.2 Cash and Cash Equivalents 24
2.2.1 Bank Reconciliation 25
2.2.2 Bank Overdraft 27
2.2.3 Petty Cash 29
2.3 Marketable Equity Securities and Fair Value
Measurement 30
2.4 Accounting for Financial Instruments 32
2.5 Accounting for Derivatives 35
2.6 Accounting for Hedging 37

3 Short-Term Assets: Inventories 41

3.1 General 41
3.2 Inventory Methods 42
3.2.1 The Perpetual Inventory System 42
3.2.2 The Periodic Inventory System 43
3.3 Ownership Issues 46
3.4 Valuation of Inventory 46
3.5 The LIFO Reserve 47
3.6 LIFO Liquidation 48
3.7 Comprehensive Example 49
3.8 Restrictions on the Use of LIFO 51

4 Account Receivables 53
4.1 General 53
4.2 Cash Discount on Sales 54
4.2.1 The Gross Method 54
4.2.2 The Net Method 54
4.3 Bad Debts Concept 55
4.3.1 Rebates 55
 Contents    ix

4.3.2 Doubtful Accounts 56

4.3.3 Accounting for Bad Debts 56
4.4 Accounts Receivable Aging Method 57
4.5 Assignment of Accounts Receivable 58
4.6 Factoring of Accounts Receivable 60
4.6.1 Recourse vs Non-recourse Factoring 60
4.6.2 Factoring vs Loan 60
4.6.3 Factoring vs Assignment of Receivables 62
4.7 Securitization of Receivables 63
4.7.1 Sale Accounting Criteria 63
4.7.2 Secured Borrowing 66
4.8 Receivables—Troubled Debt Restructurings by
Creditors 66

5 Prepaid Expenses, Unearned Income,

and Other Current Assets 69
5.1 General 69
5.2 Prepaid Expenses 69
5.3 Unearned Income 72
5.4 Other Current Assets 73

6 Short-Term Liabilities and Working Capital 75

6.1 General 75
6.2 Accounts Payable 75
6.3 Notes Payable 76
6.4 Current Maturities of Long-Term Debt 77
6.5 Other Current Liabilities 77
6.6 Working Capital 77
6.6.1 Determinants of Working Capital 78
6.6.2 Financing of Working Capital 78
6.6.3 Computation of Working Capital: Example 79

7 Long-Term Assets: Plant, Property, and Equipment 81

7.1 General 81
7.2 Property, Plant, and Equipment 81
7.2.1 Acquisition of Property, Plant, and
Equipment 82
7.2.2 Cost of Land 83
x    Contents

7.2.3 Cost of Buildings 84

7.2.4 Cost of Equipment 84
7.3 Valuation of Property, Plant, and Equipment 84
7.4 Amortization, Depreciation, and Depletion 85
7.4.1 Straight-Line Method of Depreciation 85
7.4.2 Declining Balance Method of Depreciation 86
7.4.3 Double Declining Balance Depreciation
Method 87
7.4.4 Units of Production Method of Depreciation 88
7.4.5 Sum of the Years’ Digits Method of
Depreciation 89
7.5 Disposition of Property, Plant, and Equipment 91
7.5.1 Sale of Plant Assets 91
7.5.2 Involuntary Conversion 91
7.5.3 Miscellaneous Problems 92

8 Long-Term Assets: Intangibles 95

8.1 General 95
8.2 The Goodwill 96
8.2.1 Goodwill Impairment 97
8.3 Computer Software 101
8.3.1 Research and Development Costs of
Computer Software 101
8.3.2 Production Costs of Computer Software 101
8.3.3 Purchased Computer Software 102
8.3.4 Amortization of Capitalized Software Costs 102
8.3.5 Presentation and Disclosure
of Software Costs 103
8.3.6 Software Purchased Before Technological
Feasibility Established 103
8.3.7 Disclosure of Risks and Uncertainties
Related to Capitalized Software Costs 104

9 Long-Term Liabilities: Leases 105

9.1 General 105
9.2 Lease 105
9.2.1 Legal Definition of a Lease 105
9.2.2 Advantages and Disadvantages of Leasing 107
 Contents    xi

9.3 Types of Leases 107

9.3.1 Finance Lease 107
9.3.2 Operating Lease 109
9.4 Sale–Leaseback 110
9.4.1 Sale–Leaseback Advantages 111
9.4.2 Accounting Analysis 111
9.5 Short-Term Lease 113
9.6 Lease Disclosure 114
9.6.1 In the Balance Sheet 114
9.6.2 In the Statement of Cash Flows 114

10 Long-Term Liabilities: Pension and Postretirement

Liabilities 117
10.1 General 117
10.2 Types of Pension Plans 118
10.2.1 Defined Contribution Plan 118
10.2.2 Defined Benefit Plan 120
10.3 Net Pension Asset/Liability 120
10.4 Projected Benefit Obligations 121
10.5 Plan Assets 121
10.6 Reporting Pensions Plans on Financial Statements 122
10.6.1 In the Statement of Income 122
10.6.2 In the Balance Sheet 124
10.7 Funded Status 124
10.8 Postretirement Benefits Other Than Pensions 126

11 Shareholders’ Equity 127

11.1 General 127
11.2 Common Stock 129
11.2.1 Par Value of Common Stock 130
11.2.2 Stated Value of a Common Stock 130
11.2.3 Authorized Capital 130
11.2.4 Issued Capital 130
11.2.5 Outstanding Capital 130
11.3 Issuance of Shares of Stock 131
11.3.1 Issuance of Par Value Stock 131
11.3.2 Issuance of No Par Stock 132
xii    Contents

11.4 Issuance of Shares for Non-cash Items 133

11.5 Lump-Sum Stock Issuance 134
11.6 Treasury Stock—Cost Method 135
11.7 Treasury Stock—Par Value Method 136
11.8 Stock Dividends 138
11.8.1 Small Stock Dividend 138
11.8.2 Large Stock Dividend 138
11.9 Employee Stock Options 139
11.9.1 Legal Understanding 139
11.9.2 Statement of Financial Accounting
Standard No. 123 140
11.9.3 Illustration 141
11.10 Stock Splits 142
11.11 Retained Earnings 143

Part II The Statement of Income

12 Analysis of the Statement of Income 149

12.1 General 149
12.2 The Single-Step Income Statement 149
12.3 Multiple-Step Income Statement 150
12.3.1 Analysis of the Multiple-Step Components 151
12.3.2 Format and Example 154
12.4 Holding Equity 155
12.5 Income from Discontinued Operations 157

13 Other Comprehensive Income 159

13.1 General 159
13.2 Presentation of the OCI 160
13.3 Accumulated OCI 161
13.3.1 Foreign Currency Accounting 161
13.3.2 Discontinued Operations 162
13.4 Reclassification Out of Accumulated Other
Comprehensive Income 165
13.4.1 Presentation on the Face of the Statement—
In Net Income 166
13.4.2 Presentation as a Separate Disclosure
in the Notes 167
 Contents    xiii

13.5 Earnings Per Share 169

13.5.1 The Computation of the Simple EPS 169
13.5.2 The Computation of the Diluted EPS 171

14 The Sub-Statement of Retained Earnings 175

14.1 General 175
14.2 Steps in Preparing the Statement
of Retained Earnings 175
14.3 Retained Earnings Formula 176
14.4 Changes in Retained Earnings 177
14.4.1 Accounting Changes
and Retained Earnings 177
14.4.2 Accounting Errors and Retained Earnings 179

15 The Computation of the Taxable Income 181

15.1 General 181
15.2 Differed Taxes and Assets 181
15.2.1 Temporary Differences for Revenue
and Expenses 182
15.2.2 Permanent Differences 184
15.3 Net Operating Losses 185
15.4 Undistributed Profits of Foreign Subsidiaries 186
15.5 APB 23 and Indefinitely Reinvested Earnings 188
15.6 ASC 740: Accounting for Uncertainty in Income
Taxes (Formerly FIN 48) 189
15.7 Financial Statement Reporting 191
15.7.1 Statement Reporting 191
15.7.2 Presentation 191
15.7.3 Disclosure 191

Part III The Statements of Cash Flows and Financial Ratios

16 Analysis of the Statements of Cash Flows 195

16.1 General 195
16.2 Classification of Cash Flows 196
16.2.1 Cash Flows from Operating Activities 196
16.2.2 Cash Flows from Investing Activities 197
16.2.3 Cash Flows from Financing Activities 198
xiv    Contents

16.3 Content and Form of the Statement of Cash Flows 200

16.3.1 Reporting Cash Flows from Operating
Activities 200
16.3.2 Quick Analysis of the Operating Cash Flows 203
16.4 Examples 203
16.4.1 Example of Operating Cash Flows 203
16.4.2 Example with Investing Cash Flows 204
16.4.3 Example with Financing Cash Flow
Activities 205
16.5 Noncash Investing and Financing Activities 205

17 Financial Ratios Analysis 207

17.1 General 207
17.2 Liquidity Measurement Ratios 207
17.3 Solvency Ratios 214
17.4 Profitability Indicator Ratios 217
17.5 Efficiency Ratios 223
17.6 Debt Ratios 227
17.7 Operating Performance Ratios 229
17.8 Cash Flow Indicator Ratios 232
17.9 Investment Valuation Ratios 234
17.10 Strategic Financial Ratios 238
17.11 Bankruptcy Ratios 244
17.11.1 Working Capital/Total Assets 244
17.11.2 Retained Earnings/Total Assets 245
17.11.3 Earnings Before Interest and Taxes/Total
Assets 245
17.11.4 Market Value of Equity/Book Value
of Total Debt 246
17.11.5 Sales/Total Assets 246
17.12 Limitations 247

Part IV Pro-Forma Financial Statements

18 Forecasting Financial Statements’ Analysis 251

18.1 General 251
18.2 The Forecasted Statement of Income 251
18.2.1 Sales Forecasting 252
 Contents    xv

18.2.2 Production and COGS Forecasting 252

18.2.3 Expenses’ Forecasting 252
18.3 The Forecasted Statement of Position 252
18.3.1 Making Assumptions 253
18.4 The Forecasted Statements of Cash Flows 255
18.4.1 Forecasting Operating Cash Flows 255
18.4.2 Forecasting Financing Cash Flow 256
18.4.3 Forecasting Investing Cash Flow 258

Part V Consolidated Financial Statements

19 Foreign Currency Accounting 261

19.1 General 261
19.2 Determination of the Functional Currency of the
Foreign Entity 261
19.2.1 Factors to Be Considered 262
19.2.2 Changing the Functional Currency 264
19.3 Translation Methods 264
19.3.1 Current/Noncurrent Method 264
19.3.2 Monetary/Nonmonetary Method 265
19.3.3 Temporal Method 265
19.3.4 Current Rate Method 266
19.4 Re-measurement into the Functional Currency 266
19.4.1 The Foreign Entity Does Not Book
or Record in Functional Currency 267
19.4.2 Highly Inflationary Economies—US GAAP 267
19.5 Hedging Balance Sheet and Forecasted Exposure 268

20 Consolidated Financial Statements 269

20.1 Overview 269
20.2 Purpose of Consolidation 270
20.3 Consolidation Methods 271
20.4 Consolidation Theories 272
20.4.1 Parent Company Theory 272
20.4.2 Contemporary/Entity Theory 272
20.4.3 Traditional/Hybrid Theory 272
20.5 The Consolidation Process 273
20.6 Pushdown Accounting 274
xvi    Contents

21 Segment and Intermediary Financial Statements 277

21.1 General 277
21.2 Segment Statements 277
21.2.1 Reportable Segments 278
21.2.2 Identification of Additional Segment 280
21.2.3 Disclosure Requirements 282
21.2.4 Measurement 283
21.2.5 Entity-Wide Information 286
21.2.6 Goodwill Considerations 289
21.3 Intermediary Statements 289
21.3.1 Accounting Principles and Practices 289
21.3.2 Revenue 289
21.3.3 Costs and Expenses 290
21.3.4 Costs Associated with Revenue 290
21.3.5 All Other Costs and Expenses 291
21.3.6 Seasonal Revenue, Costs, or Expenses 292
21.3.7 Extraordinary Items, Unusual and
Infrequent Items, and Disposals of
Components 293
21.3.8 Accounting Changes in Interim Periods 293
21.3.9 Adjustments Related to Prior Interim
Periods of the Current Fiscal Year 294
21.3.10 Guidelines for Preparing Interim
Statements 294
21.3.11 SEC Materials: Regulation S-X Rule 10-01,
Interim Financial Statements 297

22 IFRS and GAAP 299

22.1 General 299
22.2 Principles-Based vs Rules-Based 300
22.3 Selected International Accounting Standards 301
22.3.1 IAS 1—Presentation of Financial Statement 301
22.3.2 IAS 2—Inventories 303
22.3.3 IAS 5—Non-Current Assets Held for Sale
and Discontinued Operations 303
22.3.4 IAS 7-Statements of Cash Flows 304
22.3.5 IAS16—Leases 307
22.3.6 IAS 24 Related Disclosures 309
22.3.7 IAS 27—Consolidated Financial Statements 311
 Contents    xvii

22.3.8 IAS 32, Financial Instrument—

Presentation 316
22.3.9 IAS 33—Earnings Per Shares 318
22.3.10 IAS 34—Interim Financial Reporting 320

Part VI Case Study

23 Apple and Microsoft Case Study 331

23.1 Industry Analysis 331
23.2 Apple 332
23.2.1 Overview 332
23.2.2 Business Strategy 333
23.2.3 Financial Statements 334
23.3 Microsoft 337
23.3.1 Overview 337
23.3.2 Business Strategy 340
23.3.3 Microsoft Financial Statements 340
23.4 Financial Analysis 342
23.4.1 Common-Size Income Statement Analysis 342
23.4.2 Common-Size Balance Sheet Analysis 345
23.4.3 Comparative Common-Size Analysis 347
23.4.4 Financial Ratio Analysis 347
23.4.5 Comparative Financial Ratio Analysis 351

Glossary 353

Bibliography 361

Index 365
 Abbreviations

ABS Asset-Backed Security

AIA American Institute of Accountants
AICPA American Institute of Certified Public Accountants
ARM Accrual Reversal Method
ASC Accounting Standard Committee
ASU Accounting Standard Update
COGS Cost of Goods Sold
EBITDA Earnings Before Interest Tax Depreciation and Amortization
EFRAG European Financial Reporting Advisory Group
EITF Emerging Issues Task Force
EPS Earnings per Share
ESOs Employee Stock Options
FASB Financial Accounting Standard Board
FIFO First-in, First-out
FRC Financial Reporting Council
GAAP Generally Accepted Accounting Principles
GASB Governmental Accounting Standards Board
IAS International Accounting Standard
ICAI Institute of Chartered Accountant of India
IFRS International Financial Reporting Standards
ISOs Incentive Stock Options
LIFO Last-in, First-out
MBS Mortgage-Backed Security
MD&A Management Discussion & Analysis
NZASB New Zealand Accounting Standards Board
OCI Other Comprehensive Income

xix
xx    Abbreviations

PBO Projected Benefit Obligation

PCAOB Public Company Accounting Oversight Board
PPE Plants, Property, Equipment
ROA Return on Assets
ROI Return on Investment
SEC Securities and Exchange Commission
SFAS Statement of Financial Accounting Standard
 List of Tables

Table 8.1 Starbucks (2014): Changes in the carrying amount

of goodwill 98
Table 13.1 Walmart (2014): Currency translation 161
Table 13.2 Walmart (2014): Basic and Diluted Income
per Common Share 174
Table 15.1 Starbucks (2014): Tax effect of temporary
differences and carryforward 192
Table 16.1 PepsiCo (2014): Consolidated statements of cash flows 199
Table 23.1 Apple—Consolidated statement of income 335
Table 23.2 Apple—Consolidated balance sheet 335
Table 23.3 Apple—Consolidated statement of shareholders’ equity 336
Table 23.4 Apple—Consolidated statement of cash flows 337
Table 23.5 Microsoft—Consolidated statement of income 341
Table 23.6 Microsoft—Consolidated balance sheet 342
Table 23.7 Microsoft—Consolidated statement of shareholders’ equity 343
Table 23.8 Microsoft—Consolidated statement of cash flows 344
Table 23.9 Apple—Common-sized income statement 345
Table 23.10 Microsoft—Common-sized income statement 345
Table 23.11 Apple—Common-sized balance sheet 346
Table 23.12 Microsoft—Common-sized balance sheet 347

xxi
 Disclaimer

While the author has made every effort to ensure that the information in
this book is correct at the time of publication, he does not assume and
hereby disclaims any liability to any party for any loss, damage, or dis-
ruption caused by errors or omissions, whether such errors or omissions
result from negligence, accident, or any other cause.
This publication is designed to provide accurate and authoritative
information in regard to the subject matter covered. It is sold on the
understanding that the publisher is not engaged in rendering profes-
sional services. If professional advice or other expert assistance is needed,
the services of a competent professional should be sought.

xxiii
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 There was no doubt but that the miners had once followed a vein
of quartz through this passage, and had reached what they believed
to be its termination here.
The result of this dampening discovery upon Barney and Frank
was disheartening in the extreme.
“No chance,” said Frank, gloomily. “We are in for it, Barney.”
“Bejabers, that’s so, Misther Frank,” acknowledged the Celt. “Yet,
on me worrud, I hate to give it up.”
“So do I,” agreed Frank. “But what can we do?”
“Shure, I don’t know.”
The pocket lantern burned brightly and illumined the passage.
There was plainly no way to go further. To attempt to dig a way out
would be the height of folly.
A horrible death by starvation seemed to be inevitable.
It was much drier and cleaner however in this passage than at the
bottom of the pit. So it was decided to remain here.
“We are thirty feet nearer the surface,” said Frank. “Oh, if there
was only some way to go the rest of the way.”
“Bejabers, I’m not sure but there is,” cried Barney, as he picked up
the rope. “Av yez only remimber there’s beams acrost the shaft at
intervals all the way up.”
“Yes, but they are beyond our reach.”
“Shure, mebbe I cud get the rope over thim in some way or other.”
The Celt started for the mouth of the passage imbued with this
wild hope.
Frank lighted the way with the pocket lantern.
 In a few moments they had reached the mouth of the passage,
and Barney measured the distance to the beam above.
It was not more than twenty feet.
“Whurroo!” he cried, exultantly. “I tell yez I kin jest do it an’ don’t ye
fergit it. Luk out fer ye’silf.”
Balancing himself upon the beam at the mouth of the passage
Barney made a throw with the coil of rope.
It passed over the upper beam and came down so that the Celt
could grasp the other end of it.
With a cry of triumph he made the two ends fast.
“Shure, Misther Frank!” cried the brave Irishman, “whin I reach the
mouth av the shaft I’ll let the rope down an’ draw yez up.”
Frank’s heart leaped with a wild thrill of hope.
It was not impossible that Barney might succeed in his enterprise.
It was a frightful distance to overcome, but the Celt had full
confidence and any amount of pluck.
Up he went, hand over hand upon the rope.
He stood upon the beam above a moment later.
Frank shot the rays of the lantern up through the darkness of the
shaft.
Barney had overcome over fifty feet of the thousand. But it was
hard to say what obstacles might not be before him.
Yet the plucky Irishman realized that any chance of the sort was
better than lying down to die at the bottom of the shaft.
“Whurroo! Misther Frank!” he cried, with exultation. “Shure, I’m
makin’ out foinely. There’s another beam jist over me head.”
 Frank murmured an inward prayer for the success of his faithful
servitor.
But a moment later all the hopeful plans were dashed.
An end of the rope came tumbling down. A moment later Barney
came down and swung into the passage.
“Shure, Misther Frank, it’s the ind av us!” he said, dismally.
“What?” cried Frank, “couldn’t you go any further?”
“I cudn’t, Misther Frank. Shure the nixt beam was more nor eighty
feet above me head an’ I cudn’t throw the rope over it nohow.”
The last straw seemed to have given way.
Death in its most hideous form certainly seemed to confront the
two prisoners.
A groan of despair escaped Frank’s lips. He covered his face with
his hands.
“I am not a coward,” he said, earnestly, “but truly, Barney, it seems
hard, indeed, to die in this manner.”
“Shure it’s all av that, Misther Frank,” said the brave Celt. “Av it
was not so far, I think we cud dig our way out av the place.”
With an instinctive feeling that this might be possible, they
retreated to the far end of the passage.
But the sober reflection that there were many hundred feet of earth
between them and the outer air, and that they had no tools to dig
with, dispersed this theory like mist.
Both sank down on the ground, overcome with despair.
Frank’s head was near the wall of the passage, and suddenly he
experienced a strange thrill.
An odd sound came from beyond the wall of the passage.
 It was not far distant, either, and as the young inventor listened, he
heard very distinctly the ring of pickaxes and the low hum of voices.
It was an astounding discovery, and caused him to apply his ear
closely to the passage wall.
 CHAPTER XI.
INTO THE GREASERS’ DEN.

There was no disputing the fact.

The sounds which came to Frank’s hearing were plain and
unmistakable.
The ring of pickaxes was quite audible, and could not have been
twenty feet distant through the wall of earth.
The young inventor was dazed with the force of this realization.
Barney had heard the sounds also, and both sat silently gazing at
each other.
What did it mean?
Startling queries and theories flashed through the minds of each.
Was some one coming to their rescue through the earth? Or was it
all a delusion?
The former theory was at once dispelled. If any friends knew of
their presence there they would scarcely go to the trouble of
rescuing them by means of digging through a thousand feet of earth.
A few moments’ pulling at the mouth of the shaft would have
brought them both out of their difficulty.
As for the latter possibility it was at once dismissed.
“Begorra, Misther Frank,” said Barney, in a mystified way,
“phwativer do yez call that?”
“Somebody is digging their way toward us,” said Frank.
 “Shure yez don’t suppose it is fairies?” whispered the superstitious
Celt.
“Nonsense!”
Frank had hit upon what he believed to be the truth in his own
mind.
It had occurred to him that the greasers were conducting mining
operations in these hills.
Might it not be that in their shaft sinking they had followed a vein
dangerously near the old shaft?
In fact, it was not impossible that in a few hours they might not dig
their way actually through into the old mine.
The thought gave Frank a deep thrill of hope.
“Barney,” he said, earnestly, “upon my soul, I believe that we are
bound to make our escape.”
“Shure, Misther Frank, phwat do yez mean?” cried Barney, in
surprise.
“Hush! let us wait and watch.”
For some time the two prisoners listened to the sounds of the
pickaxes, and the voices of the workmen could almost be
distinguished.
Suddenly, however, the sounds ceased.
All was quiet beyond the wall of earth.
What did it mean?
Without doubt the miners had ceased work.
Then Frank recollected the hour, and that without doubt they had
retired for the purpose of gaining sleep.
With an inspiration the young inventor sprang up.
 “Barney!” he cried. “Our time has come!”
The Celt was astonished.
“Shure, phwat do yez mean, Misther Frank?”
“I mean that we must dig our way through and meet that passage.
It will be deserted, and though it will lead us into the camp of the
greasers, we will stand a chance to escape.”
Barney caught the inspiration.
“Bejabers, ye’re right!” he cried. “But how will we do it? Shure, we
’aven’t any pick nor shovel.”
“Somewhere in this mine there must be some old ones!” cried
Frank. “Let us search.”
“It will likely be in the ould mine below, sor.”
“All right.”
“Shall we go down, sor?”
“Yes.”
Barney quickly adjusted the rope and slid down into the old shaft.
Frank followed him.
Then with the pocket lantern they began an exploration of the
place, and with most gratifying results.
In one corner they found part of an old spade and an iron bar.
The bar could be used in lieu of a pickaxe. They quickly returned
to the upper level.
First making sure that they were not likely to be heard, work was
begun.
Frank wielded the bar and Barney the shovel.
 For hours they kept at work in a lively manner.
A deep hole had been excavated.
They had made a distance of full fifteen feet into the solid earth.
Frank guessed from the hollow sounds that they were now not
many feet from the inner mine.
His theory proved correct.
In less than twenty minutes later his bar went through the wall of
earth and he lost it.
But, fortunately, with the shovel they were able to enlarge the
aperture sufficiently to enable him to pass through.
Barney followed quickly.
They were now in the new mine.
All was darkness, but Frank cautiously opened the slide of his
lantern.
The tools of the miners lay about, but none of the latter were in
sight.
The coast was clear apparently, and they moved forward, not,
however, without great caution.
The passage seemed to extend a great ways through the earth.
They followed it for what seemed a good while and yet there was
presented no sign of the main shaft.
“That is curious!” exclaimed Frank, in surprise. “There certainly is
a main shaft somewhere. We must soon find it.”
“Begorra, maybe there’s none at all,” said Barney, logically.
“Perhaps it leads into some koind av a cave or the loikes.”
There was more in Barney’s remark of a pertinent sort than
seemed at the moment likely.
 Suddenly Frank came to a stop.
“Goodness gracious!” he exclaimed. “What does that mean?”
“Pwhat?” asked Barney.
“Why, don’t you see?”
“Begorra, it’s a loight.”
“Certainly.”
Far down the passage the faint gleam of light was seen.
It was not daylight as the prisoners well knew at that hour.
They paused and watched it intently for some time.
At first Frank had been inclined to believe it a lantern carried by
some of the greasers, who were coming back into the mine to work.
But a few moments’ study convinced him that this was not so.
“That is at the end of this passage,” he declared. “Come on,
Barney. Let’s get out of here as quickly as possible.”
They pressed forward at a rapid pace.
Every moment the light grew larger and plainer.
Then Frank saw that it occupied the whole size of the passage
and at once understood that it was a chamber beyond illuminated.
This theory was borne out perfectly well, when, a few moments
later, they came to the mouth of the passage.
A wonderful scene was spread before them.
They came out upon a sort of circular gallery about a deep
amphitheater which lay below them.
The passage was only one of many leading into this gallery, and
there were other galleries of similar sort.
 It was far from being a new mine, as Frank saw at a glance.
Indeed, it might have been older than the mine they had just
escaped from.
The light which illuminated the amphitheater, which was of large
dimensions, was created by a large pitchwood fire burning in the
center of the mine floor below.
Frank looked up and saw patches of the night sky through
apertures in the roof of the mine, which was not far above their
heads.
The fact was, a cave had originally occupied the spot and the
galleries and passages had been added by man.
It was certainly a wonderful spectacle. The floor was full fifty feet
below, and as our adventurers looked down from the gallery they
saw a large number of the greasers lounging about the place.
Many were rolled in blankets and sound asleep.
Others were playing dice or talking and smoking their cheroots,
and the hum of conversation came upon the air.
“By Jove!” exclaimed Frank, with a thrill, “I tell you, Barney, we
have found the den of Costello and his gang.”
“Begorra, that’s thrue,” agreed Barney.
“It is certainly a place well suited for the purpose.”
“I should say so, sor. But however will we get out of here?”
“That is a question.”
“Shure, sor, I think we’d betther get out as soon as possible.”
“Right you are, Barney. If those miners return and discover our
escape from the shaft they will be quickly after us.”
“Shure enough, sor.”
 “Let us move cautiously along and see where this gallery goes to.”
Frank led the way along the gallery.
It terminated in a flight of steps cut in solid rock.
There were none of the greasers, apparently, in any of the
galleries or passages above the floor.
So Frank felt safe in descending these steps.
He went down them until a gallery below was reached.
They were now quite near to the floor. Frank and Barney here
paused.
It was, of course, decidedly unsafe to venture down within the
circle of the firelight.
“If they would only all go to sleep,” said the young inventor, “then
we could be sure of slipping by them.”
But the greasers seemed to have no such idea in view.
There was no doubt but that many of them would remain up all
night. What was to be done?
Frank pondered the question seriously and long.
He saw what he believed was the passage which led out of the
mine.
But men were constantly passing in and out, and it would be
utterly impossible to escape in that direction.
Meanwhile, the risk was great in staying where they were.
At any moment some one of the greasers might come upon them.
It was clear that desperate action had got to be taken at once.
Frank considered every daring move which he could think of.
 He even thought of a break for liberty through the outer passage.
But second thought showed that this was suicidal.
But he noted that there was a line of shadow under the galleries.
Perhaps by keeping in this he could find another outward passage.
It was a terrible risk to take, but Frank did not hesitate.
“Come, Barney!” he said, “let us go down below.”
The Celt, without a word, followed Frank. But they had not
descended three steps when the young inventor came to a startled
halt.
A thrilled exclamation escaped his lips.
 CHAPTER XII.
THE PURSUIT UNDERGROUND.

“Heavens!” he gasped. “We cannot go down now. Back for your

life, Barney.”
The Celt, who would have followed his master anywhere, obeyed
this command.
Back up the stairs they sprang.
They were just in time.
Two of the Mexicans came up the stone steps into the gallery.
They paused by the landing and stood for some time engaged in
conversation.
Of course while they should remain there the way was blocked for
Frank and Barney.
The two fugitives were dismayed.
They knew that at any moment the miners might return to their
work and then their escape from the old shaft would be discovered.
Even as this fear was upon them, Frank heard a commotion in the
gallery above.
A loud cry in the Mexican tongue came down from above.
The effect was startling.
Instantly the greasers below sprang up with loud cries, and made
a rush for the galleries.
Frank turned to Barney.
 The truth had burst upon him with horrible force.
“My God!” he gasped. “We are lost, Barney. They have discovered
our escape!”
“Begorra, that’s thrue enough,” agreed the Celt. “Phwat shall we
do, sor?”
For a moment Frank was in a quandary.
But there was no time to lose.
The Mexicans were swarming up into the galleries.
To retreat into the shaft from which they had emerged would be
folly.
But where else could they go?
It was a serious question.
There was no time to lose.
Suddenly, at that moment, Frank saw a narrow opening in the
gallery wall.
He rushed into it and found that he was in one of the many
passages which made a honeycomb of the hill.
All was darkness, but the young inventor did not care for this, so
long as safety was assured.
Barney was close behind.
They were just in time to avoid being seen by the foe.
Fortunately not one of the Mexicans turned into this passage.
“Thank Heaven, we have given them the slip for a moment,” Frank
breathed.
“Bejabers, I’ve an idea!” exclaimed Barney, with eagerness.
 “Indeed!” said Frank. “What is it, Barney?”
“Shure, sor, let us stay here by the opening. Pretty quick the
blathershites will all be gone by. Shure, thin, we kin slip out av here,
an’ p’r’aps foinde our way out through the main passage. Do yez
see?”
“There is logic in your plan, Barney,” declared Frank. “I think we
will try it.”
Accordingly the two fugitives waited for their pursuers to pass.
Soon they were heard in the upper gallery, and it seemed as if the
coast was clear.
“Bejabers, now’s our toime,” cried Barney.
“All right,” agreed Frank. “Let us try the game.”
“Will yez lead the way, and I’ll folly, if it is to perdition?”
“I will.”
Frank crept out into the gallery.
He cast a glance up the gallery and saw nobody.
But as he looked in the other direction he was given a mighty thrill
of horror and dismay.
There, not twenty feet below, stood half a dozen of the greasers.
They blocked the passage, and what was worse at that moment,
they saw Frank Reade, Jr., and gave a yell of discovery.
It was echoed in the gallery above, and then exciting scenes
followed.
Frank darted back into the passage.
He was not a moment too quick.
 The crack of rifles was heard, and bullets flattened against the
gallery wall.
“My soul! we are discovered!” he cried, wildly. “Come, Barney, we
must follow this passage somewhere—anywhere.”
“That’s the divil’s luck!” cried Barney, in dismay. “But sure, sir, I’m
wid yez foriver. We’ll give the omadhouns the slip yet, or me name
ain’t O’Shea.”
Into the passage they darted.
The sounds of pursuit came in their rear.
All was dense blackness in the shaft and they were obliged to rush
on blindly.
Lights were seen in their rear, and at times it seemed as if their
pursuers must surely overtake them.
But Frank was possessed of a deadly resolution.
He knew that if he was caught it would be certain death.
Of course in the darkness there was imminent danger at any
moment of falling into some dangerous pit or hole.
But the young inventor preferred such a fate to certain capture.
Barney kept at his heels closely.
Thus they rushed on at full speed.
Every moment new passages were encountered. Frank adopted
the tactics of dodging into every one he could come to and keeping
to the right.
In this way he had soon distanced his pursuers.
The sounds of pursuit died out in the rear.
Satisfied of their safety for the moment they came to a halt.
 Both were quite exhausted, and Barney was particularly so. The
Celt flung himself flat upon the floor of the cavern.
“Och hone, Misther Frank,” he cried, in a panting manner, “shure,
it’s all done out I am wid the exertion av the run. But we’ve
disthanced the divils anyhow.”
“That’s true,” agreed Frank, “but in my opinion we are a long ways
from being out of the scrape.”
“Shure, that’s right.”
“I’ve no idea where we are or how we’ll ever get out of this place.”
“Bejabers, I’m sthuck intoirely mesilf an that.”
“But I still cling to a hope that we will yet get out of here all right.”
“I hope so, sor.”
“Of course the greasers are familiar with the passages in this
mine.”
“Yis, sor.”
“They probably will make a very thorough search. In that case they
will be likely to run us down.”
“Shure, I fear that, sor.”
Lying upon the hard floor of the shaft the two fugitives listened
fearfully for sounds of the pursuit.
But none came, and after awhile they felt a renewal of hope.
But to remain where they were was out of the question.
Where to go or what to do was a problem.
Finally Frank decided that the best move was to cautiously work
their way if possible back to the main body of the mine.
 But in the fearful darkness this did not seem likely to be an easy
bit of work.
One passage could not be told from another.
Yet Frank decided upon this as the only feasible move.
He went in advance and Barney followed slowly.
In this manner they crept along in a cautious way. What seemed
an age passed, when a startling incident occurred.
Suddenly Frank heard a muffled voice in what seemed like a long
distance away.
“Misther Frank! Shure, where have yez gone?”
“Barney!” cried Frank, in surprise, “where are you?”
“Shure, I don’t know, sor.”
“Well, that is odd!” exclaimed the young inventor, with a laugh, in
spite of the possible seriousness of the situation. “How did you get
there?”
“I don’t know that, sor.”
Frank was puzzled.
The voice of the Celt seemed to be within a few yards of him, and
yet was dull and muffled.
It occurred to Frank of a sudden that Barney had wandered into a
parallel passage and was now opposite him, beyond a thick wall of
stone.
Satisfied of this, Frank said:
“I thought you were right behind me, Barney.”
“Shure, so I was.”
 “But you are in another passage. You must have deviated back
here a ways.”
“Very loikely, sor. Pwhat shall I do about it?”
“Why, go back, of course, and get into the right passage and come
along with me.”
“All roight, sor.”
“Be sure and take the first turn to the right. Then keep straight
along the wall until you reach me.”
“Will yez wait, sor?”
“Of course I will.”
“All roight. Here goes thin.”
Frank heard a distant shuffling sound and then all was still.
What seemed like an age passed.
Barney did not appear.
Frank listened in vain for some sound of his approach.
All was tomb-like stillness.
“Well,” muttered the young inventor, “that is queer.”
Finally Frank raised his voice and shouted:
“Barney! Where are you?”
Again and again he shouted.
No answer came back. Now Frank was really alarmed. Cold
perspiration burst out upon him.
“My soul!” he gasped. “It cannot be that he is lost.”
Fearful that this was the case Frank lost no time, but started to
retrace his steps.
 He kept carefully and closely to the wall of the passage and at
intervals shouted loudly.
But each time no answer came.
Only the dull, muffled echoes. It was certainly an alarming matter.
Frank did not credit any assumption that Barney had fallen into the
hands of the greasers.
He reckoned, correctly enough, that the Celt had been misled
further away into other passages and was lost.
Indeed, the mine was a veritable labyrinth, akin to the fabled one
of Crete.
Frank was not sure that he would ever find his way out of the
place, and was oppressed with dismay.
On for some distance he went.
It was easy enough to follow the passage wall.
It seemed certain that it must sooner or later bring him into the one
in which Barney had gone astray.
But the darkness was so very thick that any course was rendered
deceptive.
It was almost impossible to tell, with any degree of certainty, just
where any one would come up. For that matter, it would be easy to
keep up a perpetual circuit until death from sheer exhaustion should
come to end the struggle. It was a situation not without grim terrors.