457 23 Retirement Obligations To attract and retain talent, companies often offer retirement benefits to em- ployees. These benefits include fixed pension payments, tax-advantaged sav- ings plans, and promises to provide medical benefits when the employee retires. In some countries, companies are required to set up separate funds to pay these benefits, but inconsistencies are common because of differences in regulations and tax policy. For example, in the United States, companies must set up separate funds for pension promises (known as defined-benefit plans) but not for promises of retiree medical benefits. If the value of invest- ments does not fully fund future promises, the company will have unfunded retirement obligations. Since the company is responsible for any shortfalls and these obligations take precedence over equity, any accurate valuation must account for them. This chapter explores how to analyze and value a company with pension and other retirement obligations. Recent accounting changes have made the analysis easier, but careful thinking and reorganizing of financial statements are still required. The challenges include deciding which part of the pension expense is operating versus nonoperating, treating the balance sheet for un- funded or overfunded obligations, estimating the cost of capital for companies with pensions, and adjusting equity value to reflect unfunded (or overfunded) retirement obligations. Reorganizing the Financial Statements with Pensions In the past, accounting for pensions and other retirement obligations severely distorted operating profit, requiring adjustments to correctly measure the im- pact of retirement obligations on the company’s value. In response, accounting policy has changed, gradually bringing the accounting for retirement obliga- tions in line with the underlying doctrines of this text. 458  Retirement Obligations For companies that report under U.S. Generally Accepted Accounting Principles (GAAP), the changes occurred over many decades. Under original accounting principles, companies did not recognize unfunded pension liabili- ties on their balance sheets. The first changes involved recording unfunded retirement liabilities, albeit at a smoothed value intended to address the ef- fects of short-term irregularities. In the 1980s, the rules were updated, and companies were required to record not only unfunded pension liabilities, but also other postretirement obligations, particularly promised medical benefits. Starting in 2006, companies were required to recognize the actual value of the unfunded (or overfunded) pension liability on the balance sheet.1 Although the balance sheet reflected the value of unfunded pension liabilities after 2006, the pension expense continued to include both operating and nonoper- ating items. It included not only new benefits granted to employees, but also inter- est on the liability, returns on plan assets, and adjustments for actuarial changes. In 2018, nonoperating items were removed from pension expense. (This change mirrored adjustments we’d recommended in earlier editions of this book.) Any new benefits granted to employees are now included in the appropriate operating expense, such as cost of sales or selling expenses. All other items, such as interest expense, actuarial changes, and earnings, are classified as “other” expense. Because of these changes, you no longer need to make as many ­adjustments to the GAAP financial statements for pensions and retirement benefits for 2018 and forward. You must still adjust financial statements released before 2018. International Financial Reporting Standards (IFRS) have been updated as well, but under multiple revisions to existing standards, rather than by adopting an entirely new standard. Throughout the chapter, we examine pension accounting using the American food manufacturer Kellogg. Kellogg is an interesting case because, even though its pension obligations are almost fully funded (about 95%, which is within the margin of year-to-year fluctuations), it’s still necessary to dive into the details to make the right adjustments to estimate net operating profit after taxes (NOPAT) and invested capital. The information required to analyze pensions for Kellogg is in the footnotes to their financial statements, note 10, “Pension Benefits,” and note 11, “Nonpension Postretirement and Postemployment Benefits.”2 In these two notes, the company provides information on projected benefit obligations, the fair value of plan assets, and a breakout of the annual pension expense. Reorganizing the Balance Sheet To start, find all the retirement-related assets and liabilities on the balance sheet. If these items are relatively small, companies may include prepaid pension 1 Statement of Financial Accounting Standards (SFAS) 158 was passed by the Financial Accounting Standards Board (FASB) in September 2006. Accounting Standards Update (ASU) Number 2017-07 was passed by the FASB in March 2017. 2 All the data related to Kellogg in this chapter appear in Kellogg’s 2018 10-K filing.