428  Nonoperating Items, Provisions, and Reserves nonoperating expenses from ongoing operating expenses. The idea sounds simple, but implementing it can be tricky. Nonoperating expenses are often spread across the income statement, and some are hidden within other ac- counts and can be discovered only by searching the company’s notes. Even after you’ve properly identified nonoperating expenses, the job is not done. Each nonoperating expense must be carefully analyzed to determine its im- pact on future cash flow, and if necessary, forecasts must be adjusted to reflect any information embedded in the expense. To assess the impact of nonoperating expenses and incorporate their infor- mation in cash flow forecasts, we recommend a three-step process: 1. Separate operating from nonoperating items. This process requires judg- ment. As a general rule, treat items that grow in line with revenues and are related to running the core business as operating. For line items that are lumpy but only tangentially related to core operations, test the im- pact of each line item on long-term ROIC. 2. Search the notes for embedded one-time items. Not every one-time charge will be separately disclosed on the income statement. Sometimes the management discussion and analysis section of the annual report will disclose additional information on one-time items. 3. Analyze each nonoperating item for its impact on future operations. Line items not included in earnings before interest, taxes, and amortization (EBITA) will not be included in free cash flow (FCF), so they are not part of core operating value. Therefore, it is critical to analyze each nonop- erating line item separately and determine whether the charge is likely to continue in the future, in which case it should be incorporated into FCF projections. Separating Operating from Nonoperating Expenses Many companies include a line item on their income statement that reads “Operating income (loss)” or “Operating profit/loss.” For example, in Exhibit 21.1, the income statement for Boston Scientific shows that in 2018 the company reported an operating profit of $1.5 billion. But is this profit an accurate reflection of the company’s long-run earnings poten- tial? The accounting definition of operating profit differs from our defi- nition of EBITA, in that the accounting standards for classifying items as nonoperating (i.e., to be recorded below operating profit or loss) are extremely strict. To benchmark core operations effectively, EBITA and net operating profit after taxes (NOPAT) should include only items related to the ongoing core business, regardless of their classification by accounting standards. Nonoperating Expenses and One-Time Charges  429 Boston Scientific reports several so-called operating expenses that are in fact nonoperating. Amortization of intangibles ($599 million in 2018) and intangible-asset impairment charges ($35 million) are all noncash reductions in the value of intangible assets; they differ only in their timing and regu- larity. Other nonoperating expenses include contingent consideration benefit ($21 million), restructuring charges ($36 million), and litigation-related charges ($103 million). For valuation purposes, such nonoperating expenses should not be deducted from revenue to determine EBITA. The right side of Exhibit 21.1 presents the calculation of EBITA for ­Boston Scientific. Only operating expenses that grow in line with revenue— such as cost of products sold; selling, general, and administrative (SG&A) expense; research and development (R&D) expense; and royalty expense—are included in the calculation of EBITA. Note how the accounting definition of operating income grows dramatically, while the growth in EBITA is much more measured. As noted earlier, judgment is called for in classifying items as operating or nonoperating. Operating expenses tend to be ongoing and tied to revenue, so a long-term perspective is critical. For instance, treat a plant closure that occurs once in ten years as nonoperating. Conversely, for a retailer with hun- dreds of stores, treat expenses related to closing stores each year as operating. For Boston Scientific, we classify royalty payments as operating because royalties are a fundamental part of the medical-devices industry and grow in line with revenue. In contrast, litigation expenses are sporadic and come in waves. Exhibit 21.2 presents litigation expenses for Boston Scientific between 2004 and 2018. While litigation expenses have been declining over the last three years, this trend does not capture the long-term levels. We could treat the litigation expenses as operating, but this would depress ROIC during EXHIBIT 21.1  Boston Scientific: Income Statement $ million Accounting income statement1 2016 2017 2018 Reorganized income statement 2016 2017 2018 Net sales 8,386 9,048 9,823 Net sales 8,386 9,048 9,823 Cost of products sold (2,424) (2,593) (2,813) Cost of products sold (2,424) (2,593) (2,813) Gross profit 5,962 6,455 7,010 Gross profit 5,962 6,455 7,010 SG&A expense (3,099) (3,294) (3,569) SG&A expense (3,099) (3,294) (3,569) R&D expense (920) (997) (1,113) R&D expense (920) (997) (1,113) Royalty expense (79) (68) (70) Royalty expense (79) (68) (70) Amortization expense (545) (565) (599) EBITA 1,864 2,096 2,258 Intangible-asset impairment charges (11) (4) (35) Contingent consideration benefit (29) 80 21 Restructuring charges (28) (37) (36) Litigation-related charges (804) (285) (103) Operating income (loss) 447 1,285 1,506 1 As reported in the Boston Scientific 2018 annual report.