- Unresolved staff comments - make sure the section is blank.
- Changes in and disagreements with accountants - make sure the section is blank
- Auditor's opinion - read a report of an accounting firm
- Legal Proceedings - check what lawsuits the company is currently involved in and think if it can have a serious impact
If an investor researches a US stock, the best place to start is reading 10-K filling. A form 10-K is an annual report required by Securities and Exchange Commission (SEC), that gives a comprehensive summary of a company and its financial performance. It's the best public document the investor can find to get familiar with the company's business. However, the document is large (often over 100 pages), and it takes time to figure it out.
The investor can save time by quickly verifying the most important things first and filtering companies with big red flags out. For this purpose I've prepared the checklist I use personally and I hope it will be useful for you. I put the checklist at the top, so you can bookmark the page and refer to the list whenever you research a new company.
Each list item is explained below in detail. But before we go further...
Where do I find 10-K reports?
There is a public database called Edgar available for everyone for free. Just put a ticker symbol of a company you're interested in in "Fast Search" input field, and you'll get all reports of the company. Among them, you'll also find 10-K.
Now let's go through the items you need to check. I recommend combining the reading with practice. Find the latest 10-K of your favorite company and verify each item along the way (if you haven't done that yet).
Unresolved Staff Comments
Search for "Unresolved Staff Comments" section in 10-K report. Ensure it is empty or does not exist.
Item 1B - “Unresolved Staff Comments” requires the company to explain certain comments it has received from the SEC staff on previously filed reports that have not been resolved after an extended period. Check here to see whether the SEC has raised any questions about the company’s statements that have not been resolved.
If SEC has disagreements that were not resolved, there is no reason why you should trust and rely on the report. It's better to stop research immediately and switch to another stock.
Here is an example of what you want "Unresolved Staff Comments" section to look like:
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Search for "Changes in and Disagreements with Accountants on Accounting and Financial Disclosure" section and make sure it's empty.
When a company and its auditors disagree to large degree it's disclosed in that section.
And if it's the case, it makes little sense to research the company further, because you can not rely on numbers provided in a report.
This is what SEC says about it:
Item 9 - “Changes in and Disagreements with Accountants on Accounting and Financial Disclosure” requires a company, if there has been a change in its accountants, to discuss any disagreements it had with those accountants. Many investors view this disclosure as a red flag.
This is what you would like to see in 10-K report of your company:
Search for "Report of Independent Registered Public Accounting Firm" section and read it completely.
Pay special attention if you see words like "concern".
Here is a good-looking example from 10-K of Netsol Technologies Inc.
Search for "Legal Proceedings" section and carefully read what is inside.
Ideally, you don't want your company to be sued, but for many businesses that is practically impossible. For example, there is always a number of small and ongoing proceedings (and even big ones) against Facebook, and that is OK for a company that has 2.4 billion active users.
However, you need to be aware if there are proceedings that may have a significant financial impact on a company if they materialize.
For an exercise you may read Legal Proceedings section from Facebook's 10-K 2019 right now.
To be continued..
I hope you've performed the exercise haven't found any critical red flags in your favorite stock. In the next article I'll cover a few other checks that are more time consuming but still very worth performing.
P.S. I get knowledge from books. And information that inspired me to write the article and create a checklist came mostly from Fundamental Analysis For Dummies.