436  Nonoperating Items, Provisions, and Reserves
EXHIBIT 21.5  Treatment of Provisions and Reserves
Classification
Examples
Treatment in NOPAT1
Treatment in 
invested capital
Treatment in 
valuation
Ongoing operating 
provisions
Product returns and 
warranties
Deduct provisions from 
revenue to determine 
NOPAT.
Deduct reserve from 
operating assets to 
determine invested 
capital. 
Provision is part of free 
cash flow.
Long-term operating 
provisions
Plant decommissioning 
costs and unfunded 
retirement plans
Deduct operating portion 
from revenue to 
determine NOPAT, and 
treat interest portion as 
nonoperating. 
Treat reserve as a debt 
equivalent.
Deduct reserve’s present 
value from the value of 
operations.
Nonoperating provisions
Restructuring charges, 
such as expected 
severance due to layoffs
Convert accrual provision 
into cash provision, and 
treat as nonoperating. 
Treat reserve as a debt 
equivalent.
Deduct reserve’s present 
value from the value of 
operations.
Income-smoothing 
provisions
Provisions for the sole 
purpose of income 
smoothing 
Eliminate provision by 
converting accrual 
provision into cash 
provision.
Treat reserve as an equity 
equivalent.
Since income-smoothing 
provisions are noncash, 
there is no effect.
1 Net operating profit after taxes.
EXHIBIT 21.6  Provisions and Reserves in the Financial Statements
$ million
Today
Year 1
Year 2
Year 3
Year 4
Income statement
Revenue
1,000.0
1,200.0
1,400.0
1,600.0
Operating costs
(750.0)
(900.0)
(1,190.0)
(1,200.0)
Decommissioning asset, depreciation1
(7.7)
(7.7)
(7.7)
–
Decommissioning reserve, accretion2
(15.0)
(16.5)
(18.2)
–
Provision for product defects2
(100.0)
(120.0)
(140.0)
(160.0)
Income-smoothing provision2
(40.0)
(40.0)
80.0
–
Operating profit, as reported
87.3
115.8
124.1
240.0
Provision for restructuring
–
(30.0)
–
–
Net income
87.3
85.8
124.1
240.0
Balance sheet
Decommissioning asset, gross
77.1
77.1
77.1
77.1
–
Accumulated depreciation
(54.0)
(61.7)
(69.4)
(77.1)
–
Decommissioning asset, net
23.1
15.4
7.7
–
–
Other operating assets
700.0
840.0
980.0
1,120.0
–
Total assets
723.1
855.4
987.7
1,120.0
–
Reserve for decommissioning
150.3
165.3
181.8
–
–
Reserve for product defects
100.0
120.0
140.0
160.0
–
Reserve for restructuring
–
–
30.0
–
–
Reserve for income smoothing
–
40.0
80.0
–
–
Equity
472.9
530.1
555.9
960.0
–
Total liabilities and equity
723.1
855.4
987.7
1,120.0
–
1 Typically embedded in depreciation and amortization.
2 Typically embedded in operating costs, such as cost of sales.

Provisions and Their Corresponding Reserves  437
for decommissioning the company’s plant, an operating provision for future 
product defects, a provision for smoothing income, and a restructuring provi-
sion for future severance payments. In this example, we reorganize forecast 
statements, rather than historical statements, to demonstrate how each type 
of provision would be treated from a valuation perspective. (Historical state-
ments should be adjusted in the same way as forecast statements.) For sim-
plicity, we assume the company pays no taxes and has no debt.
The process for adjusting the financial statements depends on the type of 
provision. Exhibit 21.7 shows how to reorganize the income statement and 
balance sheet for each provision for our hypothetical company. In the follow-
ing discussion of this example, all numbers in parentheses refer to the year 1 
reorganized financial statements.
Provisions Related to Ongoing Operations  When a company warranties a 
product, expects that some products will be returned, or self-insures a service, 
it must create a corresponding liability when that product or service is sold. If 
EXHIBIT 21.7  ROIC with Provisions and Reserves
$ million
Today
Year 1
Year 2
Year 3
Year 4
NOPAT
Operating profit, as reported
87.3
115.8
124.1
240.0
Decommissioning reserve, accretion
15.0
16.5
18.2
–
Increase (decrease) in income-smoothing reserve
40.0
40.0
(80.0)
–
NOPAT
142.3
172.3
62.3
240.0
Reconciliation to net income
Net income
87.3
85.8
124.1
240.0
Decommissioning reserve, accretion
15.0
16.5
18.2
–
Increase (decrease) in income-smoothing reserve
40.0
40.0
(80.0)
–
Provision for restructuring
–
30.0
–
–
NOPAT
142.3
172.3
62.3
240.0
Invested capital
Plant decommissioning, net
23.1
15.4
7.7
–
–
Other operating assets
700.0
840.0
980.0
1,120.0
–
Reserve for product defects
(100.0)
(120.0)
(140.0)
(160.0)
–
Invested capital
623.1
735.4
847.7
960.0
–
Reconciliation of invested capital
Reserve for plant decommissioning
150.3
165.3
181.8
–
–
Reserve for restructuring
–
–
30.0
–
–
Reserve for income smoothing
–
40.0
80.0
–
–
Equity
472.9
530.1
555.9
960.0
–
Invested capital
623.1
735.4
847.7
960.0
–
ROIC on beginning-of-year capital, %
22.8
23.4
7.3
25.0