Above the line item

What Is Above the Line (Item)?

In financial reporting, an "above the line" item refers to revenues and expenses that are directly related to a company's core business operations. These items are fundamental to determining a company's operational profitability and are typically found at the top half of an income statement. The distinction between "above the line" and "below the line" items is crucial for financial analysis as it helps stakeholders understand the recurring performance of a business, separate from non-operating or extraordinary events. Understanding what constitutes an above the line item is essential for evaluating a company's underlying financial performance.

History and Origin

The concept of distinguishing operational from non-operational items on an income statement evolved as financial reporting became more standardized to provide clearer insights into a company's core business activities. This differentiation gained prominence with the development of modern accounting principles aimed at ensuring transparency and comparability across financial statements. In the United States, the Financial Accounting Standards Board (FASB) is responsible for establishing and improving accounting and financial reporting standards, which are known as Generally Accepted Accounting Principles (GAAP)²¹. These standards, alongside regulations from the Securities and Exchange Commission (SEC), govern how companies present their financial information, reinforcing the importance of separating operating results from other financial activities²⁰,¹⁹.

Key Takeaways

• "Above the line" items represent revenues and expenses directly linked to a company's primary business operations.
• These items are used to calculate key profitability metrics like gross profit and operating income.
• The classification helps analysts assess a company's core operational efficiency and sustainability.
• "Above the line" expenses are typically recurring and vary with sales levels.
• Regulatory bodies like the SEC and FASB influence the presentation and classification of these items in financial statements.

Formula and Calculation

While "above the line (item)" isn't a single formula, it refers to the components that contribute to the calculation of a company's gross profit and operating income.

The calculation of gross profit is:

Here, both revenue and Cost of Goods Sold are considered "above the line" items.

Subsequently, operating income (or Earnings Before Interest and Taxes - EBIT) is calculated by:

Operating expenses (such as selling, general, and administrative expenses, and research and development) are also "above the line" items for service industries and often for manufacturing as well, contributing to the core operational view,¹⁸.

Interpreting the Above the Line (Item)

Interpreting "above the line" items involves analyzing a company's ability to generate profit from its core business operations. A robust and consistently growing stream of "above the line" revenue, coupled with controlled "above the line" expenses (like Cost of Goods Sold and operating expenses), indicates strong operational health. Analysts often focus on these figures to gauge a company's efficiency in its primary activities, separating this performance from other financial influences such as interest income or non-recurring gains and losses. For instance, a company with high revenue but also high Cost of Goods Sold might have a low gross profit margin, indicating inefficiency in production, which is an "above the line" concern¹⁷.

Hypothetical Example

Consider "Alpha Manufacturing Inc.", a company that produces industrial parts. In a given quarter, Alpha Manufacturing Inc. reports the following:

• Sales Revenue: $10,000,000
• Cost of Goods Sold (COGS): $6,000,000 (includes raw materials, direct labor, and manufacturing overhead)
• Selling, General, & Administrative (SG&A) Expenses: $2,000,000 (includes salaries for administrative staff, marketing costs, and rent for office space)
• Research & Development (R&D) Expenses: $500,000

All of these are "above the line" items because they are directly tied to Alpha Manufacturing's core business of producing and selling industrial parts.

From these figures, we can calculate:

1. Gross Profit:
   $10,000,000 (Sales Revenue) - $6,000,000 (COGS) = $4,000,000

2. Operating Income:
   $4,000,000 (Gross Profit) - $2,000,000 (SG&A) - $500,000 (R&D) = $1,500,000

This $1,500,000 represents the income generated purely from Alpha Manufacturing's ongoing operational activities, before considering non-operating items like interest or taxes, providing a clear picture of its core business profitability.

Practical Applications

"Above the line" items are critical in several areas of finance and analysis:

• Investment Analysis: Investors scrutinize "above the line" figures like revenue and operating expenses to assess the sustainability and quality of a company's earnings. Consistent growth in these core metrics indicates a healthy business that can generate profits from its primary activities. For example, when Thomson Reuters reported its first-quarter 2024 results, an increase in operating profit reflected higher revenues, demonstrating the impact of "above the line" performance on overall financial health¹⁶.
• Credit Analysis: Lenders evaluate a company's ability to cover its operational costs and generate sufficient cash flow from its main business before considering debt obligations. Strong "above the line" performance suggests a lower risk profile.
• Tax Planning: For tax purposes, many "above the line" expenses are considered ordinary and necessary business deductions, which can reduce a company's taxable income¹⁵,¹⁴. These typically include costs related to generating sales and running day-to-day operations. The Internal Revenue Service (IRS) provides guidance on what qualifies as a deductible business expense¹³.
• Management Decision-Making: Company management uses these classifications to identify areas of operational efficiency or inefficiency. Controlling Cost of Goods Sold or optimizing operating expenses directly impacts the "above the line" results and, consequently, the core profitability of the business.

Limitations and Criticisms

While the "above the line" distinction provides valuable insights into core operational performance, it is not without limitations. One criticism is that the exact "line" can sometimes be subjective and vary across industries or even within companies, particularly in service-based businesses where the direct costs of service (akin to Cost of Goods Sold) might include certain administrative expenses,¹². This subjectivity can make direct comparisons challenging unless the underlying components are clearly understood.

Another potential drawback arises when companies engage in "creative accounting" or aggressive financial reporting practices¹¹. By misclassifying certain non-operating costs as operating expenses or vice versa, a company might attempt to present a more favorable picture of its core profitability than warranted. Regulators, such as the SEC, enforce strict rules to ensure transparency and prevent such misrepresentations in publicly filed financial statements¹⁰. However, analysts must always apply critical judgment and look beyond surface-level figures to understand the true nature of a company's "above the line" items.

Above the Line (Item) vs. Below the Line (Item)

The primary difference between an "above the line" item and a below the line (item) lies in its relationship to a company's core operations. "Above the line" items, such as revenue, Cost of Goods Sold, and operating expenses (like selling, general, and administrative costs), are directly associated with the company's primary business activities and contribute to the calculation of its gross profit and operating income⁹. They are typically recurring and fluctuate with the volume of sales or services provided⁸.

Conversely, below the line (item) refers to incomes and expenses that are non-operational, non-recurring, or are recognized after the operating profit on the income statement. Examples include interest income or expense, gains or losses from the sale of assets, extraordinary items, and income taxes⁷,⁶. These items are considered separate from the day-to-day business performance and affect the net income but not the core operational profitability⁵. The distinction allows for a clearer assessment of how well a company's main business is performing, isolated from one-off events or financial structuring.

FAQs

What are common examples of "above the line" items?

Common examples of "above the line" items include sales revenue, Cost of Goods Sold (COGS), and operating expenses such as salaries, rent, utilities, marketing costs, and research and development expenses, as long as they relate to the primary business activities⁴,³.

Why is the "above the line" distinction important for businesses?

The "above the line" distinction is vital because it helps businesses, investors, and analysts understand the core operational health and efficiency of a company. By separating these items, it becomes easier to assess how effectively a business generates profits from its main activities, independent of financing decisions, extraordinary events, or taxes². This clarity supports better strategic decision-making and performance evaluation.

Do "above the line" items affect a company's taxes?

Yes, "above the line" expenses are generally considered tax-deductible as they are typically ordinary and necessary costs incurred in running a business¹,. These deductions reduce a company's taxable income, thereby lowering its overall tax liability.

Can "above the line" items change for a company over time?

While the category of "above the line" items remains consistent (i.e., operational revenues and expenses), the specific items and their magnitudes will change as a company's operations evolve. For instance, new product lines introduce new costs of goods sold, and changes in business strategy can alter operating expenses. These changes reflect the dynamic nature of a company's financial performance.