If a convertible bond is out-of-the-money, how is it treated in calculating diluted shares?

• A. Ignored entirely.
• B. Counted as debt.
• C. Converted to shares.
• D. Counted as equity.

Answer: (B)

When assessing potential dilution, only securities that would be advantageous to convert are treated as adding shares. If a convertible bond is out-of-the-money, the stock price is below the bond’s conversion price, so converting the bond into shares would not be attractive for the holder. In that case, you do not increase the share count for diluted shares calculations; the bond remains a liability. So, it is accounted for as debt rather than as new equity in the diluted shares picture. This reflects that no dilution occurs from that security under current conditions.