Earnings per share is calculated by dividing net after-tax income by the number of shares of common stock the company has outstanding. Companies that operate in foreign countries that experience high rates of inflation often have to recalculate earnings per share to reflect changes in the relative worth of their assets and earnings. This is caused by currency fluctuations and general economic inflation, as measured by indexes such as the consumer price index. When inflation is high, cost basis for accounting purposes is less meaningful.
Even in developed countries, price increases can distort the way a company calculates its cost of goods sold. This is important, because cost of goods sold is a major component of the net earnings computation that is used to calculate earnings per share. During a period of rising prices, a company can use the last-in, first out (LIFO) method of accounting, which uses current prices for inventory sold, even though the components of that inventory may have been purchased earlier at a lower price. This increases cost of goods sold and lowers net income.
Inflationary accounting is used in highly inflationary operating markets, incorporating the general price accounting to reflect a company's losses related to decreases in value of its non-monetary assets. In doing so, assets such as inventory and fixed assets are stated at their current replacement costs, as opposed to their cost basis. Under the current-cost method, increases or decreases in income from continuing operations in the form of holding gains and investment profits are recorded on the income statement below income from ordinary operations.
Mechanics of Current-cost Method
Using current figures, updated values for cost of goods sold, depreciation and minority interest are calculated. The differences are summed, which are referred to as realized holding gains. On the income statement, a line item is inserted under reported net income from continuing operations for realized holding gains. This results in income adjusted for inflation, which is divided by the outstanding number of common shares to arrive at earnings per share. Balance sheet figures are reported in the notes and do not factor in the earnings per share calculation.
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