Reorganizing the Financial Statements with Pensions  461
­operating profit to rise in 2017. As a result, the unadjusted operating margin rose 
from 10.7 percent to 15.1 percent in 2017, even though adjusted margins—that is, 
those that only include service expense—fell from 11.3 percent to 10.8 percent.
To eliminate plan performance from past operating expenses, remove the pen-
sion expense—in Kellogg’s case, a $431 million gain in 2017—and replace it with 
the service cost of $114 million. These adjustments are shown in the middle sec-
tion of Exhibit 23.3. If benchmarking across companies, one can also include the 
amortization of prior service costs as an operating expense. While these prior 
service costs represent real benefits given to employees, they are noncash and 
represent past changes. Therefore, they should not be incorporated into free cash 
flow. These service costs are also often small and unlikely to change our percep-
tion of historical performance; for simplicity’s sake we usually treat them as non-
operating. 
Under new accounting standards, the pension expense is no longer treated 
as operating. Instead, service cost is allocated to the appropriate operating 
expense account (cost of goods sold or SG&A), and the nonoperating portion 
of pension expense is treated as “other income or expenses,” as is the case for 
Kellogg in 2018. Since other income or expenses usually accumulates nonop-
erating items, this makes reorganizing simple.
Given that accounting guidelines across countries may differ, always check 
the notes for the location of various elements and adjust accordingly.
Expected Return and Earnings Manipulation
To avoid volatility in the income statement, accounting standards allow com-
panies to include an “expected return” on pension plan assets as part of pen-
sion expense, rather than actual returns. For example, Exhibit 23.2 shows that 
Kellogg recorded $455 million in expected return on plan assets in 2018, even 
EXHIBIT 23.3  Kellogg: EBITA Adjusted for Pensions
$ million
2016
2017
2018
Operating profits, unadjusted
Revenues
13,014
12,923
13,547
Operating costs
(11,619)
(10,977)
(11,841)
EBITA, unadjusted
1,395
1,946
1,706
Operating profits, adjusted
Revenues
13,014
12,923
13,547
Operating costs
(11,619)
(10,977)
(11,841)
Add: Net periodic (benefit) cost
199
(431)
–
Less: Service cost
(119)
(114)
–
EBITA, adjusted
1,475
1,401
1,706
Operating margin, %
Operating margin, unadjusted
10.7
15.1
12.6
Operating margin, adjusted
11.3
10.8
12.6
Source: Kellog 2016–2018 annual reports.

462  Retirement Obligations
though the plan assets lost $350 million that same year. This enables companies 
to smooth pension returns from year to year, avoiding volatility in net income.
Since expected return must be estimated, company management has dis-
cretion over the rate used—a license that management may sometimes use to 
manipulate accounting profitability. Bergstresser, Desai, and Rauh found that 
management increases expected rates of return to increase profitability im-
mediately before acquiring other firms and before exercising stock options.5 
They also found that companies with the weakest shareholder protections 
tend to use the highest estimates for expected return. With nonoperating items 
now incorporated into other income and expenses, cost of sales and operating 
profit are no longer affected by expected-return choices. Even so, net income 
remains susceptible, which is just one of many reasons why NOPAT, and not 
earnings per share (EPS), remains a critical measure of accurate benchmarking 
and financial forecasting.
Pensions and the Cost of Capital
A key component of valuation is the cost of equity, which is typically esti-
mated using the capital asset pricing model (CAPM) and beta. As discussed in 
Chapter 15, it is difficult to accurately measure the beta of a single company. 
Therefore, we recommend using an industry beta derived from multiple com-
panies in similar lines of business.
To isolate the economic risk each company faces, it is important to remove 
the effect of leverage and, if meaningful, the effect of pensions from beta. In 
Exhibit 23.4, we present the pension details, debt, and equity of three consumer 
EXHIBIT 23.4  Capital Structures of Three ConsumerProducts Companies, 2018
$ million
Kellogg
General Mills
Mondele–z
Projected benefit obligations1
6,186
7,415
11,089
Value of plan assets1
(5,817)
(6,904)
(9,975)
Unfunded pension liabilities
369
511
1,114
Debt, net of cash
9,221
16,225
19,826
Debt and debt equivalents
9,590
16,736
20,940
Market value of equity
19,784
25,073
58,197
Enterprise value
29,374
41,809
79,137
1 Includes domestic pensions, foreign pensions, and other retirement obligations.
Source: Kellogg, General Mills, and Mondele–z 2018 annual reports.
5 D. B. Bergstresser, M. A. Desai, and J. Rauh, “Earnings Manipulation, Pension Assumptions, and 
Managerial Investment Decisions,” Quarterly Journal of Economics 121, no. 1 (February 2006): 157–195. 
For more on shareholder protection indexes, see P. Gompers, J. Ishii, and A. Metrick, “Corporate Gov-
ernance and Equity Prices,” Quarterly Journal of Economics 118, no. 1 (2003): 107–155.