Chapter III · 5 — How to Read a 10-K
10-K Red Flags Checklist
Every major accounting scandal had at least three of these in the 10-K before the stock collapsed. The information was always there.
Every major accounting scandal had at least three of these in the 10-K before the stock collapsed. The information was always there. The investors who lost money chose not to read it.
How to Use This Checklist
This checklist covers ten warning signals that have appeared in 10-K filings ahead of major accounting problems, financial distress, or significant stock price declines. None of them is a definitive sell signal in isolation — each requires investigation before drawing conclusions. But each is worth pausing on.
The working method: pull the most recent 10-K for a company you are researching. Go through the checklist and mark each item as present, absent, or unclear. One item present: research trigger, investigate and explain it before deciding. Two or three items: meaningful concern, the burden of proof shifts — you need to explain why the flags are benign rather than assume they are. Four or more: this is a short candidate or a company requiring exceptional scrutiny before committing capital.
The Earnings Quality Score runs a quantitative version of several items on this list automatically — cash conversion, accrual ratio, and non-GAAP divergence. Use it alongside a manual 10-K review for the items that require reading rather than calculation.
Red Flags 1–5
1. Auditor Change
Where to find it: the company files an 8-K within four business days of any auditor change, disclosing whether there was a “reportable event” or disagreement. Also disclosed in the 10-K in Item 9.
Why it matters: auditor changes happen for legitimate reasons — mandatory rotation, fee negotiations, or the company outgrowing a smaller firm. They also happen when an auditor resigns over disagreements about accounting treatment or when a company fee-shops for a more permissive audit opinion. The 8-K language distinguishes between these: a resignation “to pursue other opportunities” is less concerning than one that includes any mention of “disagreements on matters of accounting principles or practices.” The Luckin Coffee fraud surfaced within months of the company cycling through audit questions with its external reviewers.
What to investigate: read the 8-K carefully. Does the former auditor characterize the departure? Does the company disclose any disagreements, even as resolved? Does the new auditor have a history of more permissive opinions in the same industry? Cross-reference the auditor change timing with any changes to non-GAAP metrics or revenue recognition policy.
2. Going Concern Note
Where to find it: audit opinion (first pages of Item 8) and sometimes in the Liquidity section of MD&A. The language is specific: “substantial doubt about the Company's ability to continue as a going concern.”
Why it matters: this is the auditor formally stating that they have reviewed the evidence and have significant doubt about whether the company can meet its obligations for the next twelve months without additional financing or operational changes. It is the most severe routine disclosure in auditing outside of an outright adverse opinion.
What to investigate: cash runway (months of operating expenses covered by current cash), debt maturities in the next 18 months, and whether management has disclosed a financing plan or remediation plan. Going concern disclosures sometimes resolve — the company raises capital and the following year's filing omits the language. They sometimes don't. Bed Bath & Beyond had going concern language in its 10-K several quarters before its 2023 bankruptcy filing.
3. Material Weakness in Internal Controls
Where to find it: Item 9A (Controls and Procedures) of the 10-K, and any interim 10-Q filings where the weakness was identified.
Why it matters: a material weakness means that one or more controls over financial reporting are deficient to the point where a material misstatement could occur and not be detected in a timely manner. The financial statements themselves may be technically correct — but the internal processes that produce them have gaps that the auditor has concluded are significant enough to require disclosure.
What to investigate: what specific control failed? Is it in revenue recognition, inventory valuation, goodwill impairment, or IT systems? Companies that disclose material weaknesses restate financial statements at roughly eight times the rate of companies that don't. The restatement is not guaranteed, but the odds are materially higher. Also check whether management discloses a remediation plan and timeline, and verify in subsequent filings whether the weakness was resolved or persists.
4. Aggressive Revenue Recognition Signals
Where to find it: the revenue recognition footnote (Note 1 or Note 2 in most filings), the working capital section of the cash flow statement (receivables and deferred revenue changes), and any changes in the revenue recognition policy language year over year.
Why it matters: revenue recognition choices determine whether reported revenue reflects current economic activity or is pulled forward from future periods. The most common forms: bill-and-hold (recognizing revenue when goods ship to a warehouse rather than when the customer takes delivery), channel stuffing (pushing inventory to distributors at quarter-end to recognize revenue before end-customer demand), and recognizing subscription revenue faster than the ratable period requires.
What to investigate: compare revenue growth to cash collected from customers (the “cash received from customers” line on the indirect method cash flow statement, or back into it from receivables changes). If revenue is growing 25% and cash collected is growing 10%, revenue is being recognized before cash is arriving. Also compare deferred revenue growth to revenue growth — declining deferred revenue in a subscription business means backlog is shrinking relative to recognized revenue.
5. Related-Party Transactions at Non-Arm's-Length Terms
Where to find it: the Related Party Transactions footnote (typically one of the later footnotes in Item 8), and sometimes in the Proxy Statement (Schedule 14A) for executive and director transactions.
Why it matters: related-party transactions are not automatically problematic — founders maintaining consulting agreements after stepping back, or biotech founders licensing IP to their company, are common and sometimes legitimate. The red flag is transactions where pricing appears favorable to the related party at the expense of the company: real estate leased from a CEO's family trust at above-market rates, contracts with suppliers owned by board members, loans to executives on below-market terms.
What to investigate: every related-party transaction must be disclosed if it is material in the aggregate. The word “material” is doing a lot of work — companies disclose as little as legally required. Look for any transaction that lacks a stated price or describes itself as “on terms substantially similar to arm's-length” without specifying the terms. The qualifier “substantially similar” is hedge language for “not actually arm's-length.”
Red Flags 6–10
6. Non-GAAP Exclusions of Recurring Items
Where to find it: the non-GAAP reconciliation table in MD&A. Build the same table from the prior two or three years' 10-Ks.
Why it matters: the entire purpose of non-GAAP metrics is to exclude genuinely non-recurring items that obscure the underlying economics of the business. When the same item appears in the reconciliation for three consecutive years, it is not non-recurring — it is a cost of operating the business that management has chosen to exclude from their preferred metric.
The most common repeat offenders: restructuring charges (real if the company restructures every year), “integration costs” for companies that make acquisitions regularly, “strategic review costs” for companies that always seem to be reviewing their strategy, and amortization of acquired intangibles for serial acquirers. Stock-based compensation exclusion is near-universal and consistently misleading — SBC is a real cost, it uses equity rather than cash as currency. The test: what percentage of revenue do the recurring exclusions represent? At 10%+ of revenue, the adjusted metric and the GAAP metric are describing materially different businesses.
7. Goodwill Exceeding 50% of Total Assets
Where to find it: the balance sheet (goodwill line item divided by total assets), and the goodwill impairment footnote for the assumptions used.
Why it matters: goodwill is not a hard asset — it is an estimate of the value of brand, relationships, and synergies at the time of acquisition. When goodwill exceeds half of every balance-sheet dollar, more than half the company's reported asset base is a management estimate that can be revised downward with no cash leaving the company but with a direct hit to shareholders' equity.
What to investigate: the goodwill impairment footnote. Find the discount rate used in the impairment test for the largest reporting unit. Compare it to what the company's cost of capital should be given its business risk profile. Find the headroom language — “exceeded carrying value by approximately X%” — and assess how comfortable that margin is. Kraft Heinz had goodwill exceeding 60% of total assets in 2018. The 2019 impairment charge of $15.4 billion was not a surprise to anyone who read the impairment footnote carefully.
8. Deferred Revenue Declining Faster Than Revenue
Where to find it: the balance sheet (deferred revenue or contract liabilities, typically in current liabilities), and the revenue recognition footnote which often discloses Remaining Performance Obligations (RPO), the total backlog including multi-year contracts.
Why it matters: for subscription and recurring-revenue businesses, deferred revenue represents future revenue the company has already billed but not yet recognized. It is the most direct indicator of whether new bookings are keeping pace with recognized revenue. Declining deferred revenue while management discusses “strong bookings” creates a tension worth investigating — one of those statements is inconsistent with the other.
What to investigate: calculate the deferred revenue growth rate and the revenue growth rate for the same period. If deferred revenue is declining (or growing slower than revenue) for two or more consecutive periods, new bookings are lagging. Cross-reference with the RPO disclosure for multi-year contract backlog trends. Then check what management says about bookings in MD&A — if the language is optimistic, ask whether the balance sheet corroborates it.
9. Executive Stock Sales Coinciding with Positive Guidance
Where to find it: SEC Form 4 filings, submitted within two business days of any insider transaction. Available on EDGAR and most financial data services.
Why it matters: insiders sell for many reasons — diversification, estate planning, tax purposes, and pre-arranged 10b5-1 plans that allow scheduled selling without timing allegations. The pattern worth examining is large, non-plan sales by multiple executives coinciding with periods of management optimism, raised guidance, or unusual stock-price strength, followed by material negative surprises within 12 months.
What to investigate: the timing and structure of the sale. Was it under a 10b5-1 plan, and if so, when was that plan adopted? Plans adopted in the weeks or months before a significant sale carry less insulation against timing concerns than plans adopted 18 months prior. Were multiple executives selling simultaneously? Are the amounts unusual relative to their historical selling pattern? One executive selling 5% of their holdings for diversification is ordinary. A CEO, CFO, and COO all selling 30%+ of holdings in the same 90-day window is a different situation.
10. Pension Liabilities Exceeding 30% of Market Cap
Where to find it: the Retirement Benefits or Pension footnote in Item 8. Look for “projected benefit obligation” (the total pension liability), “plan assets” (invested assets to cover it), and “funded status” (plan assets minus PBO).
Why it matters: pension obligations represent claims on future company cash that don't appear in the headline earnings story. When total pension underfunding (plan assets minus projected benefit obligation) exceeds 30% of market capitalization, the equity value story has a hidden claim underneath it. Additionally, pension expense reported on the income statement is based partly on the “expected return on plan assets” assumption — if that assumption is optimistic relative to actual portfolio returns, future pension expense will be higher than projected and earnings will disappoint even if the core business performs.
What to investigate: the funded status (negative = underfunded), the expected return on plan assets assumption, and the discount rate used to calculate the PBO. A higher discount rate produces a lower PBO — when rates were near zero, companies used rates of 2–3% and PBOs ballooned. Compare pension underfunding to total equity market cap for context. Legacy industrial, manufacturing, airline, and certain retail companies carry the most significant pension liabilities relative to their current size.
What To Do When You Find a Red Flag
One red flag is a research trigger, not an investment decision. The right response to a single flag is to investigate: is there a benign explanation? Has management addressed it directly on an earnings call? Is there a disclosed remediation plan? Does the flag appear in competitors' filings too, suggesting it's industry-wide rather than company-specific?
Two or three flags from the same filing shift the burden of proof. At that point, you need an affirmative explanation for each flag that holds up under scrutiny — rather than assuming each one is benign, you need to verify that each one is. If you can't explain them, the default should be more investigation or no position.
Four or more flags from a single filing is a short thesis until proven otherwise for most investors. The historical pattern is that companies with multiple simultaneous flags are either in active distress or have accounting that will eventually need to be restated. The most important question at that point: what is the downside scenario if the flags reflect reality, and at what price does that scenario become adequately compensated?
One final note: the list above is not exhaustive. Every industry has sector-specific flags — banks have loan loss provision analysis, real estate companies have cap rate assumptions, insurance companies have reserve adequacy. The ten items here are cross-sector flags that have appeared in the 10-Ks of companies across industries before significant problems became public. Add your sector-specific checks on top of them, not instead of them.
Questions worth asking
What is a going concern?
A 'going concern' is an accounting assumption that a business will continue operating for at least the next 12 months. When auditors add a 'going concern' qualification to their audit opinion, they are formally disclosing that they have reviewed the evidence and have substantial doubt about whether the company can continue operating without additional financing, asset sales, or operational changes. It doesn't mean the company will definitely fail — some companies receive going concern qualifications and survive by raising capital. But it means the auditor, who has reviewed the books and internal projections, is worried enough to put their doubt in writing.
How common are material weaknesses?
Roughly 3–5% of public companies disclose material weaknesses in internal controls in any given year. Small-cap companies disclose them at materially higher rates than large-caps — the smaller the company, the fewer financial controls and segregation of duties it typically has. Companies that recently completed significant acquisitions are at higher risk, as integrating financial reporting systems is operationally difficult. A material weakness disclosure doesn't guarantee a restatement, but companies with material weaknesses restate financial statements at roughly eight times the rate of companies without them.
Should I sell immediately if I find a red flag?
No — a single red flag is a research trigger, not a sell signal. The correct first response is to investigate: is there a disclosed explanation? Has management addressed it on a call? Is there an industry-wide context that makes it more benign? Only after you've investigated and can't find a satisfying explanation should the flag influence your investment decision. Two or more flags that you cannot explain change the calculus — at that point, the burden of proof shifts and you need affirmative evidence that the situation is benign, rather than just absence of proof that it isn't.
Where do I find Form 4 insider transaction filings?
SEC EDGAR (sec.gov) is the primary source — search by company name or CIK number, then filter for Form 4 filings. Most major financial data services (Yahoo Finance, Finviz, OpenInsider) aggregate and display Form 4 data in a more readable format. OpenInsider.com is particularly useful for filtering by trade size, whether a 10b5-1 plan was used, and transaction type (open market purchases versus option exercises versus automatic plan sales). Purchases on the open market are generally more informative than sales, since executives sell for many reasons but buy primarily when they think the stock is undervalued.