The financial statements are 5-10 pages. The notes — formally Notes to the Consolidated Financial Statements — are typically 50-150 pages. The notes are not optional reading. They're often where the truth lives.
Why the notes exist
Standardized statements can't capture every nuance. The notes explain accounting policies, break out aggregated lines, disclose contingencies, and describe relationships that wouldn't otherwise be visible. Audited like the statements themselves.
The notes you should always read
- Significant accounting policies — what choices management made within GAAP. Revenue recognition, inventory method (FIFO/LIFO), depreciation method.
- Segment information — revenue and profit by business unit or geography. Often the bigger picture is hidden in here, not the consolidated total.
- Stock-based compensation — for tech companies particularly, SBC can be 10-20% of revenue. Always treat it as a real expense.
- Debt schedule — maturities, covenants, interest rates. Especially critical for leveraged businesses.
- Lease commitments — operating leases and minimum lease payments. Often a hidden form of debt.
- Off-balance-sheet items — guarantees, contingent liabilities, joint ventures.
- Related-party transactions — anything material involving executives, directors, or major shareholders.
- Subsequent events — anything material that happened between period-end and filing date.
Revenue recognition note — read this first
How and when does the company recognize revenue? Software companies: subscription vs perpetual license vs services. Construction: percentage of completion vs completed-contract. Long-term contracts: how are estimates of total cost made? Two companies in the same industry can produce very different revenue numbers from identical underlying activity if their policies differ.
Stock-based compensation — the silent dilution
SBC is real
GAAP requires SBC to be expensed on the income statement. But many tech companies report 'adjusted EBITDA' that excludes it. Don't accept that adjustment. Stock-based comp dilutes shareholders just as surely as cash compensation costs the company — the only difference is the timing of who pays.
Segment information — the hidden picture
Many large companies are really collections of businesses. Amazon: retail + AWS + advertising. Berkshire: insurance + railroads + utilities + manufacturing + investments. The consolidated income statement averages these together. Segment data lets you see which business is driving the result and which might be a drag.
Exercise
You're reviewing a tech company. Adjusted EBITDA: $400M. Stock-based compensation: $300M. What is GAAP operating income approximately, and how should you think about the gap?