Lesson 10 of 10
Where the 10-K footnotes are
The notes sit inside Item 8 of a 10-K, straight after the statements. Seven of them decide what the figures above them actually mean.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- The footnotes sit inside Item 8, straight after the statements, and, unless a note says otherwise, they are audited: part of the financial statements, not commentary on them.
- Two companies can report the same revenue, margin and profit under different accounting policies, and nothing on the face of the statements shows it.
- A changed estimate can move a margin for years with no change in the business and no cash moving.
The footnotes sit inside Item 8, under the heading Notes to Consolidated Financial Statements, immediately after the statements they explain. They are usually the longest section of the filing, and Note 1, the summary of significant accounting policies, is the shortest route to understanding why one company's margins are not comparable to a competitor's.
One estimate, two operating margins
- 10-year useful life15.0%
- 15-year useful life20.0%
A total is not a fact
A line on a statement is a total. The note beside it says what was added up and under which policy. Two companies can report the same revenue, gross margin and net income while recording different costs as assets, recognising revenue at different points and depreciating over different lives. Nothing on the face of the statements tells them apart. Fridson and Alvarez's premise in Financial Statement Analysis: A Practitioner's Guide is that statements are prepared by a party with an interest in the impression they create. Scepticism about the presentation belongs at the start of the reading, not after the arithmetic.
A changed estimate moves the margin, not the cash
Seven notes worth the extra minute
| Note | Why it changes a reading |
|---|---|
| Accounting policies | Why two companies' margins are not directly comparable |
| Revenue | How much is billed against merely recognised |
| Segments | Restated whenever management redraws the segments |
| Income taxes | Separates a one-off settlement from a rate that will repeat |
| Debt | The maturity schedule that forces a refinancing |
| Leases | Since ASC 842, can exceed a retailer's own borrowings |
| Commitments and contingencies | A loss judged probable and estimable is already recorded; one judged only possible sits outside the balance sheet, sometimes larger than what was recorded |
Two more notes are worth the extra minute. Subsequent events records what happened between the balance sheet date and the filing date. Share-based compensation gives the expense and the awards outstanding, which explains how a company buying back stock every year can show a share count that never falls.
Two lists of the same judgements
Critical accounting estimates are disclosed twice, to two different requirements, and the two lists do not always match.
Note 1, Item 8
- Audited.
- Management's own list of significant accounting policies and estimates.
Critical accounting estimates, Item 7
- Not audited.
- Management naming the accounts most sensitive to judgement, often with a sensitivity range.
Both name the same estimates. Only one of them is audited.
An estimate that appears in one list and not the other is a discrepancy worth a minute.
Diff Note 1 in two minutes
- Put two consecutive years of Note 1 side by side.
- Mark every useful life, allowance or assumption that moved.
- A changed estimate applies going forward, so prior years stay as filed.
A changed accounting policy is different: it is applied to the prior years too, which breaks any series built from your own saved figures. A new standard follows its own transition rules, so read which method it used.
Check yourself
Two companies report the same revenue, margin and profit. Does that mean their accounting choices are the same?
- Yes, matching totals mean matching policies
- Only if both are audited by the same firm
- No, not necessarily
Show the answer
Answer: C.
Different depreciation lives, revenue timing and capitalisation choices can produce identical totals. The notes are where the difference shows.A company extends an asset's useful life from 10 to 15 years. What happens to total depreciation over the asset's whole life?
- It falls
- It rises
- It stays the same; only the timing across years changes
Show the answer
Answer: C.
The cash cost of the asset is fixed. Extending the life only spreads the same total charge over more years, raising near-term margin.Where would you find the reconciliation from a company's statutory tax rate to the rate it actually paid?
- Item 1A, Risk Factors
- The proxy statement
- The income tax note, inside Item 8
Show the answer
Answer: C.
The tax note holds the rate reconciliation. A rate moved by a one-off settlement will not repeat; one moved by where profits are booked probably will.Sources
- Fridson and Alvarez, Financial Statement Analysis: A Practitioner's Guide: statements are prepared by an interested party, so scepticism precedes arithmetic.
- ASC 280, Segment Reporting: segments restated whenever the chief operating decision maker's view of the business changes.
- ASC 450, Contingencies: a loss is accrued once it is probable and can be reasonably estimated; a merely possible loss is disclosed without being recorded.
- ASC 842, Leases: right-of-use assets and liabilities on the balance sheet since fiscal years beginning after 15 December 2018.
What this leaves out
- A 10-Q carries a selected subset of these notes, chosen on the assumption that the reader already has the last annual filing, so an absence there is not necessarily a change.
- The order and the exact headings are conventional rather than required, so a company may present the same content differently.
- The worked example uses round invented numbers so the arithmetic can be checked by hand. Nothing here is advice about any security.