Introduction
Microsoft's income statement for its fiscal year to June 2026 shows revenue of $331.8 billion. Its unearned revenue note shows something the income statement cannot: $684 billion of revenue already contracted but not yet recognized, of which $678 billion came from commercial customers, up 84% in a year, with a weighted average duration of about 2.3 years. Microsoft expects to recognize about 30% of it over the next twelve months, according to its 2026 annual report. For anyone forecasting its revenue, that disclosure, a single paragraph in the twelfth note, is among the most important numbers in the filing.
The notes to the financial statements are where reported figures are explained, broken down and qualified. They are audited, like the statements themselves, and they contain most of the information bankers need to adjust, forecast and value a company. The overview in how to read a 10-K and 10-Q lists the notes read on almost every deal; this article sets out what to extract from each and how to read them efficiently.
Start With the Policies and the Auditor
The first note describes the company's significant accounting policies, and it is the place to learn the choices behind every later number: when revenue is recognized, which costs are capitalized, how inventory is costed, how long assets are depreciated over and what is treated as cash. It also lists new accounting standards adopted and those still to come, with an estimate of their effect where the company can make one. Policy changes from one year to the next deserve particular attention, because they can move results without any change in the business.
Two other sections outside the notes point to where judgment is concentrated. The critical accounting estimates in management's discussion describe the assumptions that most affect the results and, often, how sensitive the figures are to them. And the auditor's report now lists critical audit matters.
- Critical audit matter
A matter communicated by the auditor to the audit committee that relates to accounts or disclosures material to the financial statements and involved especially challenging, subjective or complex auditor judgment. Under Public Company Accounting Oversight Board (PCAOB) standard AS 3101, the auditor's report must describe each one and how the audit addressed it.
The most common critical audit matters concern the valuation of goodwill and intangible assets, revenue recognition and income taxes. A matter flagged by the auditor is not a sign of error, but it tells the reader which numbers the auditor found hardest to verify, and therefore which assumptions to test first.
Notes That Change the Numbers in a Model
Revenue
The revenue note breaks revenue down by product, geography, customer type or timing, often in more detail than the segment note. It shows contract assets and contract liabilities, which reveal whether customers are paying ahead of or behind the work, the balances covered in contract liabilities and contract assets. And it discloses remaining performance obligations, the contracted revenue still to be recognized, which for subscription and long-term contract businesses is the best available measure of backlog. A backlog growing much faster than revenue, as Microsoft's has, signals future growth but also concentration: a few very large contracts can account for much of it, and the timing of their recognition matters.
Debt and Leases
The debt note lists each borrowing with its interest rate, maturity and key terms, and a schedule of maturities for the next five years and beyond. Read with the market risk disclosures in Item 7A of the 10-K, it shows the share of debt at fixed and floating rates, which drives sensitivity to interest rates: Charter Communications, for example, disclosed in its 2025 annual report that 87% of its debt principal carried fixed rates at the end of 2025, with a blended average rate of 5.1%. The lease note gives the equivalent schedule for lease payments, the discount rates used and the split between operating and finance leases. Together they show the company's fixed obligations by year, the starting point for any liquidity or refinancing analysis, and they connect to the mechanics in debt accounting basics.
Income Taxes
The tax note became more informative from 2025. Under Accounting Standards Update (ASU) 2023-09, public companies must present their effective tax rate reconciliation in standard categories, separating out items above a threshold, and disclose income taxes paid split between federal, state and foreign jurisdictions, with any single jurisdiction at 5% or more of the total shown separately. Chevron's 2025 reconciliation, for instance, now shows the tax effects of operations in individual countries such as Nigeria and Saudi Arabia, and its taxes paid of $7.3 billion by jurisdiction, as its 2025 annual report shows. Comparing taxes paid with the tax expense in the income statement shows how far book and cash taxes diverge, the gap explained in effective, statutory and cash tax rates.
Stock Compensation, Earnings per Share and Acquisitions
Three further notes feed the share count and the earnings forecast. The stock compensation note gives the awards outstanding and, importantly, the unrecognized compensation cost and the period over which it will be expensed, which is effectively a forecast of the stock-based compensation still to come from awards already granted. The earnings per share note lists the securities excluded from diluted shares because they were antidilutive, which can become dilutive if the share price rises or losses turn to profits. And the business combination note gives each material acquisition's purchase price allocation, the useful lives of the intangibles, whether goodwill is tax-deductible and pro forma revenue, the inputs needed to project amortization and to measure organic growth.
Notes That Hold the Risks
The notes on commitments and contingencies describe litigation, regulatory investigations, environmental liabilities, guarantees and purchase obligations. Contingent losses are recorded only when probable and estimable, so the note often describes exposures that are not on the balance sheet at all, the distinction explained in contingencies and litigation reserves. Commitments elsewhere in the notes can be large relative to a company's debt: Microsoft's lease note discloses $329.1 billion of leases, mostly for data centers, that had not yet commenced, against $46.1 billion of debt principal.
The fair value note classifies assets and liabilities measured at fair value into three levels, according to how observable the inputs are. Level 3 items, valued with significant unobservable inputs, deserve the closest reading, because small changes in assumptions move them a lot. AbbVie's contingent consideration liabilities, for example, are Level 3 measurements, and the weighted average discount rate it used fell from 4.8% to 4.0% in 2025, one of the reasons the liability rose by billions. The pension note gives the funded status, the discount rate and the expected return on assets that drive pension cost and the size of any deficit.
Off-balance sheet arrangements and guarantees, described in off-balance sheet arrangements and guarantees, and the subsequent events note, which covers significant events between the balance sheet date and the filing date, such as an acquisition, a refinancing or a large legal judgment, complete the set. A subsequent event can make the balance sheet out of date the day it is published.
Reading the Notes Efficiently
Annual reports for large companies run to well over a hundred pages, and the notes take up much of that. Three habits make them manageable. First, compare each year's notes with the previous year's, ideally with a document comparison tool: new paragraphs, deleted sentences and changed numbers point to what management or the auditor thought had changed. Second, read the notes in the order that matters for the task, debt and liquidity first for a financing, revenue and segments first for a valuation, tax and business combinations first for an acquisition. Third, follow each figure that matters from the statement to its note and back, so that every number in a model rests on its disclosure.
The notes in quarterly reports are condensed and update only what has changed materially since the annual report, so the annual notes remain the reference for the rest of the year. For a company with a history of acquisitions, the business combination notes of earlier years are worth keeping too, because they explain the goodwill, intangibles and amortization that later results still carry, as described in purchase price allocation. In every case, the statements show what the numbers are; the notes show what they mean.
