1. The Core Principle of Dilution
Diluted EPS reflects the maximum potential dilution that could occur if all outstanding contracts to issue common shares were exercised or converted. The calculation incorporates all dilutive potential common shares that were outstanding during the period.
 
2. The Mechanics of the If-Converted Method
The If-Converted Method is used to calculate the dilutive impact of convertible bonds and convertible preferred stock. The method assumes that the conversion of these instruments into common shares took place at the beginning of the period (or at the date of issuance of the potential common shares, if later).
 
3. Adjusting both the Numerator and Denominator
Because conversion is assumed to occur on Day 1, the company would not have paid interest or dividends on those convertible instruments. Therefore, the EPS components are adjusted as follows:
┌─────────────────┬───────────────────────────────────────────┬───────────────────────────────────────────┐
│ Instrument Type │ Numerator Adjustment (Earnings)           │ Denominator Adjustment (Shares)           │
├─────────────────┼───────────────────────────────────────────┼───────────────────────────────────────────┤
│ Convertible     │ ADD back the saved interest expense, net  │ ADD the maximum number of new common      │
│ Bonds           │ of tax: + [Interest Expense x (1 - Tax R)]│ shares generated upon bond conversion.    │
├─────────────────┼───────────────────────────────────────────┼───────────────────────────────────────────┤
│ Convertible     │ ADD back the saved preferred dividend amount│ ADD the maximum number of new common      │
│ Preferred Stock │ originally deducted: + Preferred Dividend │ shares generated upon stock conversion.   │
└─────────────────┴───────────────────────────────────────────┴─────────────────
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