Reorganizing the Financial Statements with Pensions  459 assets in other long-term assets and unfunded pension liabilities as part of other long-term liabilities, but the details will be in the pension footnote. Exhibit 23.1 reports the funded status of Kellogg’s defined-benefit plans and the location of the company’s underfunding on the balance sheet, as re- ported in the notes. In 2018, Kellogg had $369 million in unfunded pension and other postretirement liabilities. This amount does not appear as a single value on the balance sheet. Instead, the net underfunding is disaggregated across four accounts, including $335 million embedded in other assets, $19 million embedded in other current liabilities, a pension liability of $651 mil- lion, and $34 million embedded in other liabilities. A company can have both excess pension assets and unfunded pension liabilities, because companies may have multiple pension plans, and pension assets from one plan are not netted against underfunding from another. Note that most companies don’t fund their “other” retirement obligations, like promised medical benefits, so this will typically appear as showing zero assets and only the liability. When reorganizing the balance sheet, separate operating assets from pen- sion assets, and treat excess pension assets as nonoperating. Unfunded pen- sion liabilities (on a gross basis) should be treated as a debt equivalent and, as such, should not be deducted from operating assets to determine invested capital. Instead, they will be valued separately during the transition from en- terprise value to equity value. Reorganizing the Income Statement Pension accounting combines several items into a single expense, known as the pension expense. Some components are operating, while others are re- lated to the performance of the plan assets. As such, pension expense must be EXHIBIT 23.1  Kellogg: Pension Note in Annual Report, Funded Status $ million Pension benefits1 Other benefits2 Total benefits Fair value of plan assets at end of year 4,677 1,140 5,817 Projected benefit obligation at end of year (5,117) (1,069) (6,186) Funded status (440) 71 (369) Amounts included in the consolidated balance sheet Other assets 228 107 335 Other current liabilities (17) (2) (19) Pension liability (651) – (651) Other liabilities – (34) (34) Net amount recognized (440) 71 (369) 1 Kellogg 2018 annual report, Note 10, “Pension Benefits.” 2 Kellogg 2018 annual report, Note 11, “Nonpension Postretirement and Postemployment Benefits.” 460  Retirement Obligations analyzed line by line. Exhibit 23.2 presents the pension expense for Kellogg. For ease of exposition, the exhibit combines pension expense with other post- retirement benefits, which Kellogg reports in two separate notes. In Exhibit 23.2, you will find six accounts. Service cost and the amortiza- tion of prior service cost represent benefits granted to the employee in return for service to the company.3 Interest cost on plan liabilities, expected return on plan assets, and recognized gains and losses represent the evolution of plan assets and liabilities over time.4 If the change in plan assets matched the change in plan liabilities each year, these accounts would cancel. Since mar- kets are volatile, this is not the case. As a result, the investment performance of plan assets contaminates pension expense. Curtailments represent changes to the pension plan that restrict benefits. Prior to 2018, companies using GAAP reported the entire pension expense as part of operating expenses. Although not visible on the income statement, the expense was subtly embedded in cost of sales and in selling, general, and administrative (SG&A) expenses. This meant operating expenses and conse- quently operating profit were a function of the investment performance of plan assets, leading to distortions in competitive benchmarking. To better understand potential distortions, examine the portion of pension ex- pense titled “recognized net (gain) loss” in Exhibit 23.2. In 2016, Kellogg recognized $304 million in losses on plan assets. This increased pension expense relative to other years. In 2017, Kellogg reported recognized gains of $126 million. This caused pension expense to convert from a $199 million expense in 2016 to a $431 million benefit in 2017. Since pension expense is embedded within cost of sales, this caused EXHIBIT 23.2  Kellogg: Pension and Other Postretirement Expenses $ million 2016 2017 2018 Service cost 119 114 105 Operating expense Amortization of prior service cost 4 – (1) Operating for historical benchmarking only Interest cost 213 201 201 Expected return on plan assets (442) (469) (455) Nonoperating, related to plan performance Recognized net (gain) loss 304 (126) 350 Settlements (curtailments) 1 (151) (30) Net periodic (benefit) cost 199 (431) 170 Information recorded on income statement Source: Kellogg 2016–2018 annual reports. 4 Interest cost represents the present value of service cost growing into the actual retiree payout. Ex- pected return on plan assets equals the expected return based on asset mix. Recognized gains and losses represent the gradual recognition of past gains and losses of the pension fund. 3 Service cost represents the present value of retirement promises given to the company’s employees in a particular year. Prior service costs are additional retroactive benefits given to employees from an amendment to the pension plan. Prior service costs are not expensed immediately. Instead, they are amortized over the expected lifetimes of employees. For more on pension accounting, see D. Kieso, J. Weygandt, and T. Warfield, Intermediate Accounting, 17th ed. (Hoboken, NJ: John Wiley & Sons, 2019), chap. 20.