Advanced Issues  235 leases. Discount each future rental commitment by an interest rate on low- risk debt to determine the present value of operating leases. Since companies report only five years of payments and aggregate the remaining payments into a single number, use an annuity to value remaining payments beyond the first year. Exhibit 11.15 presents the adjustment for operating leases for Costco’s his- torical statements.13 The present value of lease payments for Costco in 2018 equals $2.5 billion. To determine interest embedded in 2019 EBITA, multi- ply 2018 capitalized operating leases by the rate of secured debt. (Given the ease of repossessing capital for operating leases, use an AA interest rate for 13 Because Costco’s fiscal year ends prior to December 15, the company will not adopt the new leasing standard until 2020.Therefore, the value of operating leases must be estimated for historical years prior to 2020. For companies whose fiscal years end after December 15, no adjustment is required for 2019. EXHIBIT 11.15  Costco: Impact of Capitalizing Operating Leases on ROIC $ million 2015 2016 2017 2018 2019 EBITA EBITA, using rental expense 3,624 3,672 4,111 4,480 4,737 Implied interest expense1 73 75 57 74 91 EBITA, adjusted for operating leases 3,967 3,747 4,168 4,554 4,828 Yield-to-maturity on 10-year AA-rated debt 3.19% 3.36% 2.44% 2.91% 3.63% Operating cash taxes Operating cash taxes, using rental expense 1,156 1,121 1,471 1,434 987 Tax shield on implied interest expense2 27 28 21 21 22 Operating cash taxes, adjusted for operating leases 1,184 1,149 1,493 1,455 1,009 NOPAT NOPAT, using rental expense 2,468 2,551 2,640 3,046 3,750 After-tax implied interest expense 46 47 35 52 68 NOPAT, adjusted for operating leases 2,513 2,598 2,675 3,098 3,818 Invested capital Invested capital, without operating leases 13,023 15,607 14,978 15,651 16,583 Capitalized operating leases3 2,230 2,320 2,528 2,500 2,414 Invested capital, including capitalized operating leases 15,253 17,928 17,506 18,151 18,997 ROIC, using beginning-of-year capital ROIC, using rental expenses 19.5% 19.6% 16.9% 20.3% 24.0% ROIC, adjusted for operating leases 16.8% 17.0% 14.9% 17.7% 21.0% 1 Implied interest is calculated by multiplying the yield-to-maturity of 10-year AA-rated debt by the beginning-of-year capitalized operating leases. 2 The tax shield on implied interest expense is calculated by multiplying implied interest expense by the statutory tax rate. The statutory tax rate is reported in Exhibit 11.10. 3 Capitalized operating leases are estimated for 2019 in Exhibit 22.10. 236  Reorganizing the Financial Statements discounting and estimating embedded interest.) Next, adjust operating taxes to eliminate the tax shield related to implied interest. Subtract adjusted op- erating taxes from adjusted EBITA to determine NOPAT, adjusted for leases. Note how capitalizing operating leases increases both NOPAT and invested capital. The increase is not symmetric, causing ROIC to fall for Costco. This is because operating leases are a form of debt. For companies earning a return greater than their cost of debt, leverage artificially increases returns. While capitalizing operating leases improves the quality of benchmarking, whether or not you capitalize will not affect intrinsic value as long as it is incorpo- rated correctly in free cash flow, the cost of capital, and debt equivalents. Chapter 22 demonstrates how to incorporate operating leases throughout the valuation. The chapter also discusses alternative models to value operating leases. Retirement Obligations Such as Pensions Following the passage of FASB Statement 158 under U.S. GAAP in 2006, com- panies now report the present value of pension shortfalls (and excess pension assets) on their balance sheets.14 Since excess pension assets do not generate operating profits, nor do pension shortfalls fund operations, pension accounts should not be included in invested capital. Instead, pension assets should be treated as nonoperating assets, and pension shortfalls as a debt equivalent (and both should be valued separately from operations). If pension accounts are not explicitly detailed on the company’s balance sheet, search the pension footnote to determine where they are embedded. Often excess pension assets are embedded in other assets, and unfunded pension liabilities are in other liabilities. Reporting rules under IFRS (IAS 19) differ slightly in that companies can postpone recognition of their unfunded pension obligations resulting from changes in actuarial assumptions, but only as long as the cumulative unrecog- nized gain or loss does not exceed 10 percent of the obligations. For companies reporting under IFRS, search the notes for the current value of obligations. On the income statement, new GAAP accounting for pensions in 2018 dictates that only service cost—the new benefits promised to employees for service rendered in a given year—be included in operating expenses like cost of goods sold.15 The remaining items, such as expected return on assets and interest cost on the liabilities, are now included as nonoperating income or expense. For years prior to 2018, an adjustment is still required. 14 From December 2006, FASB Statement 158 eliminated pension smoothing on the balance sheet. Com- panies are now required to report excess pension assets and unfunded pension obligations on the bal- ance sheet at their current values, not as smoothed values as in the past. 15 The FASB published ASU 2017-07, “Compensation—Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost,” on March 10, 2017. IFRS already separates service cost from financial performance in pensions.