The if-converted method calculates the change in the number of shares outstanding if convertible securities were to be converted into shares. This calculation is only performed if the market price of the shares is higher than the exercise price stated in the securities; otherwise, it would not be economical for an investor to convert the securities into shares. This method employs the following rules:
- The conversion is assumed to occur on the later of the issuance date of the securities or the beginning of the reporting period.
- The conversion ratio stated in the security agreement is used to determine the number of shares that would be outstanding in the event of a conversion.
A conversion into shares has two effects. One is that the number of shares outstanding increases, which reduces the amount of earnings per share reported on the income statement of the issuing entity. Second, the interest expense that would have been paid on the securities is now avoided, which increases the amount of earnings in the earnings per share calculation.
The if-converted method is only used by publicly-held companies, since they are the only ones required to report earnings per share information in their financial statements.