The Pricing of Mismeasured EPS Under the If-Converted Method
61 Pages Posted: 23 Aug 2019
Date Written: August 18, 2019
GAAP potentially mismeasures diluted EPS in two ways in the presence of convertible instruments - debt or preferred stock. First, GAAP treats certain convertible instruments that are not likely to convert as if they will convert. Second, GAAP treats certain convertible instruments that are likely to convert as if they will not convert. In both cases, GAAP understates diluted EPS. I examine whether and under what conditions investors incur the information costs necessary to reflect the accounting mismeasurement of diluted EPS in common equity prices. I provide evidence that suggests, on average, that investors do. However, the association between common equity prices and accounting mismeasurement of the economic conversion effects varies with the magnitude of the measurement error, as a proxy for benefit of information, and/or analyst coverage, as a proxy for the information environment. This evidence suggests investors partially process accounting mismeasurement of diluted EPS.
Keywords: diluted EPS, convertible debt, convertible preferred stock, information costs, if-converted method
JEL Classification: G10; G14; M41
Suggested Citation: Suggested Citation