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HOW TO READ A FINANCIAL REPORT

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H OW TO R E A D A W R I N G I N G V I T A L S I G N S O U T O F

Eighth Edition

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F I N A N C I A L R E P O RTT H E N U M B E R S

JOHN A. TRACY AND TAGE C. TRACY

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Cover Design: WileyCover Illustration: Wiley

Copyright © 2014 by John A. Tracy and Tage C. Tracy All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

The Seventh Edition of How to Read a Financial Report: Wringing Vital Signs Out of the Numbers was published by John Wiley & Sons, Inc, in 2009.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifi cally disclaim any implied warranties of merchantability or fi tness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profi t or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

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Library of Congress Cataloging-in-Publication Data:

Tracy, John A. How to read a fi nancial report: wringing vital signs out of the numbers / John A. Tracy, CPA, Tage Tracy. — 8th ed. pages cm Includes index. ISBN 978-1-118-73584-8 (pbk.); ISBN 978-1-118-73558-9 (ebk); ISBN 978-1-118-73592-3 (ebk) 1. Financial statements. I. Tracy, Tage C. II. Title. HF5681.B2T733 2014 657'.3—dc23 2013035597

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

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CONTENTS

List of Exhibits ixPreface to the Eighth Edition xiii

Part One—Fundamentals

1 Starting with Cash Flows 3 2 Three Financial Statements 11 3 Profi t Accounting 23 4 Profi t Isn’t Everything 33

Part Two—Connections

5 Sales Revenue and Accounts Receivable 43 6 Cost of Goods Sold Expense and Inventory 49 7 Inventory and Accounts Payable 55 8 Operating Expenses and Accounts Payable 61

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vi Contents

9 Operating Expenses and Prepaid Expenses 6710 Depreciation Expense and Property, Plant, and

Equipment; Intangible Assets 7311 Accruing the Liability for Unpaid Expenses 8312 Income Tax Expense and Its Liability 8913 Net Income and Retained Earnings;

Earnings per Share (EPS) 95

Part Three—Cash Flow

14 Cash Flow from Operating (Profi t-Making) Activities 103

15 Cash Flows from Investing and Financing Activities 111

16 Growth and Decline Impacts on Cash Flow 119

Part Four—Analysis

17 Footnotes to Financial Statements 13318 Financial Statement Ratios 14319 Profi t Analysis for Business Managers 157

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Contents vii

Part Five—Truthfulness

20 Choosing Accounting Methods and Massaging the Numbers 171

21 Audits of Financial Reports 18122 Basic Questions, Basic Answers 19323 Small Business Financial Reporting 209

About the Authors 215

Index 217

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LIST OF EXHIBITS

Exhibit 1.1 Summary of Cash Flows during Year 5Exhibit 2.1 Year-End Balance Sheets 13Exhibit 2.2 Income Statement for Year 14Exhibit 2.3 Statement of Cash Flows for Year 14Exhibit 2.4 Single Step Income Statement 15Exhibit 3.1 Income Statement and Balance

Sheet Changes during Year from Profi t-Making Activities 26

Exhibit 4.1 Connections between the Three Financial Statements 37

Exhibit 5.1 Sales Revenue and Accounts Receivable 44Exhibit 6.1 Cost of Goods Sold Expense and Inventory 50Exhibit 7.1 Inventory and Accounts Payable 56Exhibit 8.1 Selling, General, and Administrative

Expenses and Accounts Payable 62Exhibit 9.1 Selling, General, and Administrative

Expenses and Prepaid Expenses 68

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x List of Exhibits

Exhibit 10.1 Property, Plant, and Equipment, Depreciation Expense and Accumulated Depreciation 74

Exhibit 11.1 Accruing Unpaid Expenses 84Exhibit 12.1 Income Tax Expense and Income

Tax Payable 90Exhibit 13.1 Net Income and Retained Earnings,

Earnings per Share 96Exhibit 14.1 Cash Flow from Operating

(Profi t-Making) Activities 104Exhibit 14.2 Direct Method Format for Reporting

Cash Flow from Operating Activities in the Statement of Cash Flows 108

Exhibit 15.1 Cash Flows from Investing and Financing Activities 112

Exhibit 16.1 Cash Flow from Operating (Profi t-Making) Activities in Steady-State Scenario 121

Exhibit 16.2 Cash Flow from Operating (Profi t-Making) Activities in Growth Scenario 124

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List of Exhibits xi

Exhibit 16.3 Cash Flow from Operating (Profi t-Making) Activities in Decline Scenario 127

Exhibit 17.1 Three Financial Statements and Footnotes 134

Exhibit 18.1 External Financial Statements of Business (without Footnotes) 146

Exhibit 19.1 External Income Statement for Year 160Exhibit 19.2 Management Profi t Report for Year 163Exhibit 19.3 5% Sales Prices versus 5% Sales

Volume Increase 165Exhibit 19.4 EBIT Breakeven Point for Lower

Sales Prices and Lower Sales Volume 167

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PREFACE TO THE EIGHTH EDITION

When I started this book my new co-author on this edition, my son Tage, was entering his senior year of high school. Today he is a successful business and fi nancial consultant in San Diego. Truth be known, he writes better than his old man. So, it is with great personal pleasure and pride that I welcome my son Tage as co-author on this edition. He’s a chip off the old block. In case you’re wondering about his name, it is Swedish and Danish in origin.

At the time the fi rst edition was released in 1980, the Dow Jones Industrial Average hovered around 850 (really!). This most-watched stock market index reached 11,700 in early 2000, and then it abruptly plunged, causing a big dent in my retirement savings. The Dow recovered over the following years, but then dropped again. As I write this sentence the Dow is about 15,000. As J. P. Morgan once said, “The market will fl uctuate.” Millions of individuals keep their money in the stock market, and stock investments are a large part of most retirement plans. Knowing how to read a fi nancial report is as important as ever.

This edition catches up with the major changes in fi nancial reporting since the previous edition. At the top of this list is the movement toward different fi nan-cial reporting standards for private and small businesses. At the same time, the basic architecture of the book remains unchanged. The framework of the book has proved very successful for more than 33 years. I’d be a fool to mess with this suc-cess formula. My mother did not raise a fool. Cash fl ows are underscored through-out the book. This cash fl ow emphasis is the hallmark of the book.

I prepared all the exhibits in the book as Excel worksheets. To request a copy of the workbook file of all the exhibits, please contact me at my e-mail

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