The multi-step income statement

In depth

Lantern’s multi-step income statement

The statement below is prepared from Lantern’s adjusted trial balance at 31 December 2026, after the nine year-end adjustments. Its heading names the business, the statement and the period, which for a first year is “the ten months ended 31 December 2026”. Each section is explained in turn after it.

Net revenue

The statement opens with gross revenue by stream, less the contra-revenue account for refunds, giving net revenue of $193,320, as the revenue recognition lesson derived. Showing the streams separately costs a few lines and tells the reader at once that the shop provides more than half of Lantern’s revenue. A company with sales discounts would deduct them here too.

Cost of sales and gross profit

Cost of sales is the cost of providing what was sold. For the shop it is cost of goods sold, $52,800. For catering and workshops it is cost of services: the event baristas’ wages ($25,200) and the catering supplies and workshop materials used ($10,900), $36,100 in all. In F01’s March books every wage went to Wages Expense and every consumable to Supplies Expense. For the annual statements the accountant records the direct costs of events and workshops in Cost of Services instead, because without them the services would show a gross profit equal to their revenue and the comparison with the shop would be meaningless.

Lantern’s gross margin is $104{,}420 \div 193{,}320 \approx 54.0\%$. The services earn a slightly higher margin than the shop, but the shop also bears costs that sit below gross profit, notably $12,630 of shipping and $4,010 of card and platform fees. Which costs belong in cost of sales is a judgement each business makes and should apply consistently: Lantern treats shipping to customers as a selling cost, while some online retailers include it in cost of sales. When comparing gross margins across companies, check what each puts above the line.

Operating expenses: by function or by nature

Operating expenses are the costs of running the business that are not part of cost of sales. Lantern’s statement lists them account by account, which is common for a small company. Larger companies group them, in one of two ways. The function of expense method groups costs by the activity they serve, such as cost of sales, selling, and general and administrative. The nature of expense method groups them by what they are, such as goods purchased, employee wages, depreciation and rent, without assigning them to activities.

The grouping is approximate: a full function analysis would allocate the kitchen rent and the espresso equipment’s depreciation between cost of services and administration, the van’s fuel and depreciation to delivery, and part of the shop staff’s wages to fulfilment. Lantern’s summary accounts don’t hold the information to split them, one reason small companies list expenses account by account.

The same year by nature looks quite different. There is no cost of sales, so there is no gross profit; instead the reader sees, for example, that wages for all staff come to $43,600, a figure the function method splits between cost of services and operating expenses.

IFRS requires an analysis of expenses by nature or by function, whichever gives information that is reliable and more relevant (IAS 1 paragraph 99). A company using the function method must show cost of sales separately and disclose additional information on the nature of its expenses, including depreciation and amortisation and employee benefits (paragraphs 103 and 104). US GAAP lets a private company such as Lantern choose a single-step or a multi-step format. IFRS 18, which replaces IAS 1 from 2027, changes these requirements; the course’s last lesson, US GAAP and IFRS, explains how.

Operating income

Gross profit less operating expenses, plus any gains on selling long-lived assets, is operating income (also called income from operations or operating profit): $37,716 for Lantern, which sold nothing in 2026. It measures what the business earns from its ordinary activities before the cost of its borrowing and before tax, so it can be compared across businesses financed in different ways. Lantern earns about 19.5 cents of operating income per dollar of revenue; turning such figures into ratios and comparing them is the work of F03.

Other income and expenses

Items that don’t arise from the business’s main operations are shown after operating income, as other income and expenses. Lantern has one: interest expense of $1,200, made up of the $450 paid on the Coastline note on 1 June, 1 September and 1 December, plus $750 accrued at the year end ($50 on the Coastline note for December and $700 on the van note for June to December). Interest revenue on savings would also appear here. Gains and losses on selling equipment would not: US GAAP requires them to be included in income from operations whenever that subtotal is presented (ASC 360-10-45-5), so Lantern’s chart adds a gain after operating expenses and includes a loss among them. IAS 1 doesn’t define operating income, so IFRS practice has varied; IFRS 18 changes this from 2027, as the course’s last lesson explains.

Income tax

A corporation pays income tax on its taxable profit. The US federal corporate rate is 21% of taxable income (26 U.S.C. §11(b)), a flat rate that applies to taxable years beginning after 31 December 2017; many states also tax corporate income. The Lantern case assumes a combined rate of 25% and, to keep the course introductory, that taxable income equals income before income tax. When the two differ, as they often do, deferred tax arises; later courses cover it.

Income tax expense for the year is therefore $0.25 \times 36{,}516 = 9{,}129$ dollars. Lantern paid $6,000 of estimated tax during the year, so the year-end adjustment records the rest as a liability:

Two rates are worth telling apart. The statutory tax rate is the rate set by law (21% federal). The effective tax rate is income tax expense divided by income before income tax: for Lantern $9{,}129 \div 36{,}516 = 25\%$, equal to the assumed rate only because the case has no tax differences. In real companies the two often differ, and the notes explain why.

EBIT and EBITDA

F00 defined EBIT (earnings before interest and taxes) and EBITDA (EBIT plus depreciation and amortisation). With a multi-step statement both can be calculated in two directions. Working up from the bottom, as the SEC staff describe, EBIT is net income with interest and income tax added back: $27{,}387 + 1{,}200 + 9{,}129 = 37{,}716$. Working down, it is operating income plus or minus any non-operating items other than interest: Lantern has none, so EBIT equals operating income, $37,716. Adding back depreciation of $4,800 (Lantern has no amortisation) gives EBITDA of $42,516.

EBITDA is often described as a proxy for operating cash flow, but it is not cash. Lantern’s net cash from operating activities was $39,940, not $42,516: it paid $6,450 of interest and tax, which EBITDA ignores, while unpaid bills and customers’ advance payments ($17,410) more than covered the cash tied up in receivables, inventory, supplies and prepaid insurance ($13,536). Module 3 reconciles the two. And depreciation, though not a cash payment this year, stands for equipment and a van that will have to be replaced.

Earnings per share

Companies whose common shares, or securities that can become common shares, trade in a public market, or that are preparing to sell them in one, must report basic earnings per share, and diluted earnings per share as well when they have potential common shares such as options or convertible securities (ASC 260-10-15-2; IAS 33 sets a similar requirement under IFRS). Basic EPS divides net income available to common shareholders (net income less preferred dividends) by the weighted average number of common shares outstanding during the period; diluted EPS also counts shares that options and convertible securities could add. For example, a fictional listed company, Quarrybank Foods, with net income of $12.6 million, preferred dividends of $0.6 million, and 7.5 million common shares for the first half of the year and 8.5 million for the second, reports basic EPS of $(12.6 - 0.6) \div 8.0 = 1.50$ dollars. Lantern’s shares are privately held, so it reports no EPS.