Read the notes before the numbers

The financial statements in a 10-K take up a few pages. The notes that follow them usually take up several times that. Most readers look at the statements and skip the notes, which is roughly like reading the headline of an article and skipping the article.

The statements tell you what the numbers are. The notes tell you what the numbers mean, how they were produced, and what they leave out.

Why the notes exist

A number on a balance sheet is the output of a long series of choices. When revenue gets recognized. How long equipment is assumed to last. What a receivable is expected to collect. Which obligations count as debt and which do not.

Accounting rules constrain those choices without eliminating them. The notes are where the company has to state which choices it made, and in many cases what the numbers would look like under different ones. Two companies with identical-looking statements can be making very different choices underneath, and the only place that difference is visible is in the notes.

The notes worth reading first

The order and numbering varies by company, but the same notes appear in almost every filing.

Significant accounting policies. Usually first or close to it. How the company recognizes revenue, values inventory, depreciates assets, and handles estimates. Mostly stable year to year, which is exactly why a change in it is worth noticing.

Revenue. How the company actually earns money, broken down in ways the income statement does not show. By product, by geography, by timing. This note often contains the most honest description of the business anywhere in the filing, because it has to be precise.

Segments. How the company divides itself for internal management, and how each piece performs. This is where you find out which part of a business is carrying the rest. Companies choose their segments, so a change in how they are drawn is a change in how management wants the business seen.

Debt. The terms behind the single borrowing figure on the balance sheet. Interest rates, maturity dates, covenants the company has to meet. A company can look comfortable on the balance sheet and have a large repayment falling due in eighteen months. This note is where that shows up.

Leases. Long-term commitments to pay for property and equipment. For retailers, restaurants, and airlines, this can be among the largest obligations the company has.

Commitments and contingencies. Obligations that have not yet become liabilities, and liabilities that may or may not materialize. Purchase commitments, guarantees, litigation the company considers possible but not yet probable. The phrase not yet is doing a lot of work in this note.

Subsequent events. Anything significant that happened after the period ended but before the filing was published. Short, often empty, and occasionally the most important paragraph in the document.

What to look for

Three things reward attention.

Estimates. Wherever the notes describe a judgment, such as expected returns, credit losses, useful lives of assets, or the value of goodwill, a small change in the assumption can move reported profit substantially without anything changing in the business. When a company revises an estimate, the note is required to say so.

Timing. Maturity tables, lease schedules, and commitment schedules tell you when obligations come due. The balance sheet gives you a total. The notes give you a calendar.

Anything the statements net together. A single line on the income statement can combine gains and losses that move in opposite directions. The notes separate them.

How to use them without reading everything

For a company you do not know, read the revenue note and the segment note before the income statement. You will understand the income statement better for it.

For a company you already follow, compare this year's notes to last year's. Accounting policies and segment definitions change rarely and deliberately. When they do, the change is usually more informative than the numbers that result from it.

And when a figure in the statements looks odd, do not guess. The explanation is almost always in a note, written by people who were required to put it there.