If converted method

A convertible becomes shares without the holder paying anything, which is what separates it from an option and why the treasury stock method does not apply to it. An option holder pays a strike price, so that method gets to assume the cash repurchases shares and count only the net addition. A convertible holder hands back a bond. There are no proceeds and nothing is repurchased, so every share issued on conversion is a new share, and for the same face amount a convertible is the more dilutive instrument.

The method assumes conversion at the start of the period, or at the date of issue if that came later. The full as converted share count goes into the denominator. Because the assumed world is one in which the instrument was equity all along, the payments it would never have made go back into the numerator: interest net of tax relief for convertible debt, and the preference dividend with no tax adjustment for convertible preference shares, since a preference dividend is an appropriation of profit rather than a deductible expense.

Both sides move together, and that is the step people miss. Adding the shares without adding back the interest overstates the dilution and understates diluted earnings per share. Adding the interest back gross rather than net of tax makes the opposite error, by exactly the tax relief spread over the diluted count.

Under IAS 33 the instrument is included only if it is dilutive, which is an arithmetic test rather than a look at the share price. Divide the after tax interest saved by the shares conversion would issue and compare that with basic earnings per share: below basic it goes in, above basic it is anti dilutive and comes out. A valuation bridge asks a different question and applies a different test, namely whether the instrument is in the money at your own implied price, which is why the same convertible can sit outside reported diluted earnings per share and inside the diluted count you divide equity value by.