The Pricing of Mismeasured EPS
48 Pages Posted: 23 Aug 2019 Last revised: 7 Nov 2019
Date Written: November 5, 2019
This study examines accounting mismeasurement of dilution related to convertible instruments in calculating diluted EPS. The accounting mismeasurement is caused by GAAP procedures that assume that either 0 or 100% of a convertible instrument will convert in determining diluted EPS. I construct an alternative measure of diluted EPS based on economic theory to derive economic likelihoods of conversion that range from 0 to 100%. I then examine whether and under what conditions common equity prices are associated more with the economic measure of diluted EPS than the GAAP measure. I report a significant association, on average, between prices and the difference between the economic measure of dilution and GAAP diluted EPS. I then examine whether this association varies with differential information processing costs and benefits. I use analyst coverage as a proxy for differences in information processing costs. In addition, I use the magnitude of the convertible instrument and time to expected settlement as proxies for benefits of information processing. Each factor moderates the association between prices and accounting mismeasurement. Overall, results are consistent with prices (not) reflecting accounting mismeasurement where expected net benefits of information processing are highest (lowest).
Keywords: diluted EPS, convertible debt, convertible preferred stock, information costs, if-converted method
JEL Classification: G10, G14, M41
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