220  Reorganizing the Financial Statements deferred-tax account—in this case related to accelerated depreciation—is no longer necessary. This is why the deferred-tax account is referred to as an eq- uity equivalent. It represents the adjustment to retained earnings that would be made if the company reported cash taxes to investors instead of accrual taxes. Not every deferred-tax account is operating. Although both operating and nonoperating deferred-tax accounts are equity equivalents, incorporate only deferred-tax accounts associated with ongoing operations into operating cash taxes.6 In contrast, value nonoperating deferred taxes as part of the correspond- ing account.7 For instance, when valuing an underfunded pension, do not use the book value of deferred taxes to value potential tax savings. Instead, reduce the underfunding by the projected taxes likely to be saved when the plan is funded. Exhibit 11.7 converts deferred-tax assets and liabilities for Costco into operating, nonoperating, and tax loss carryforwards, using the tax foot- note in the company’s annual report. Although individual operating-related accounts, such as accrued liabilities and reserves, are large, the net amount is close to zero. For this reason, operating cash taxes for Costco will not differ significantly from accrual-based taxes. EXHIBIT 11.7  Costco: Reorganized Deferred Taxes $ million As reported Reorganized 2017 2018 2019 2017 2018 2019 Deferred-tax assets Operating deferred-tax assets, net of liabilities Equity compensation 109 72 74 Equity compensation 109 72 74 Deferred income/membership fees 167 136 180 Deferred income/membership fees 167 136 180 Foreign tax credit carryforward — — 65 Accrued liabilities and reserves 647 484 566 Accrued liabilities and reserves 647 484 566 Property and equipment (747) (478) (677) Other 18 — — Merchancise inventories (252) (175) (187) Total deferred-tax assets 941 692 885 Valuation allowance — — (76) Operating deferred-tax assets, net of liabilities (76) 39 (120) Valuation allowance — — (76) Total net deferred-tax assets 941 692 809 Nonoperating deferred-tax assets, net of liabilities Other assets 18 — — Deferred-tax liabilities Foreign branch deferreds — — (69) Propery and equipment (747) (478) (677) Other liabilities — (40) (21) Merchandise inventories (252) (175) (187) Nonoperating deferred-tax assets, net of liabilities 18 (40) (90) Foreign branch deferreds — — (69) Other — (40) (21) Tax loss carryforwards Total deferred-tax liabilities (999) (693) (954) Foreign tax credit carryforward — — 65 Deferred-tax assets, net of liabilities (58) (1) (145) Deferred-tax assets, net of liabilities (58) (1) (145) 6 Separating deferred taxes into operating and nonoperating items can be challenging and often re- quires advanced knowledge of accounting conventions. For an in-depth discussion of deferred taxes, see Chapter 20. 7 As discussed earlier, deferred-tax assets related to past losses should be classified as a nonoperat- ing asset and valued separately. Deferred-tax liabilities related to amortization of acquired intangibles should be netted against acquired intangibles. These accounts are not equity equivalents. Reorganizing the Accounting Statements: In Practice  221 Hybrid Securities and Noncontrolling Interests  Some sources of financing resist easy classification as debt or equity. These include hybrid securities and noncontrolling interests. Unlike debt, these accounts do not have fixed inter- est payments. Unlike equity, they are not the residual claim on cash flows. Therefore, these accounts should be valued separately and deducted from en- terprise value to determine equity value. • Hybrid securities. The three most common hybrid securities are convert- ible debt, preferred stock, and employee options. Since hybrid securi- ties contain embedded options, they cannot be treated as common stock. Instead, use the market price or, if necessary, option-pricing models to value these claims separately. Failing to do so can undervalue the hybrid security and overstate the value of common stock. This is especially im- portant for venture-capital-backed preferred stock and long-dated em- ployee options. • Noncontrolling interests. A noncontrolling interest occurs when a third party owns a minority holding in one of the company’s consolidated subsidiaries. If a noncontrolling interest exists, treat the balance sheet amount as a source of financing. Treat the earnings attributable to any noncontrolling interest as a financing cash flow similar to dividends. If data are available, value the subsidiary separately, and deduct the non- controlling interest from the company’s enterprise value to determine equity value. If data for the subsidiary are available, discount earnings related to the noncontrolling interest at an appropriate cost of equity. Chapter 16 presents various valuation methodologies for noncontrol- ling interests. Correctly classifying balance sheet items can be a daunting task. But fret not: perfect classification is not required. You need only to assure that each account is included as part of free cash flow or valued separately. Calculating NOPAT To determine NOPAT for Costco, we turn to the income statement (see Exhibit 11.8) and convert it into NOPAT, as shown in Exhibit 11.9. Net Operating Profit (EBITA)  NOPAT starts with earnings before interest, taxes, and amortization (EBITA) of acquired intangibles, which equals rev- enue minus operating expenses, such as cost of goods sold, selling costs, gen- eral and administrative costs, and depreciation. Why use EBITA and not EBITDA? When a company purchases a physi- cal asset such as equipment, it capitalizes the asset on the balance sheet and depreciates the asset over its lifetime. Since the asset wears out over time,