Sorry to bump an old thread guys, but I'm still experiencing this problem on iTunes 11.1.0.126 with an iPhone 5 64gb running iOS 7.0.2
I am using the 'Convert higher bit rate songs to 128kbps AAC' option, and it's definitely showing the error in free space due to this as I have 8861 songs on my iPhone at time of writing, which iTunes tells me only takes up 31.27gb (note that this is only after a synchronisation). This leaves 4.73gb of free space after all my videos, photos, applications and documents.
However when I plug my iPhone in, it shows that the 8861 songs take up 34.24gb of space, which leaves 2.15gb of free space after all my videos, photos, applications and documents.
It's worth noting that the iPhone itself shows that there is 2.2gb of space available, so the 4.73gb statistic is incorrect.
It is impractical for me to not utilise this conversion feature unless I heavily condense the amount of music on my iPhone (which I'm not willing to do), as when I un-tick the conversion option it puts me over by 20.44gb, a huge difference.
Could it be that some of the songs are not converting properly to 128kbps AAC, and instead of giving an error message, iTunes just ignores this and shows the capacity statistics as if the conversion and synchronisation had gone though flawlessly?
Has anyone been able to get any further with this, or spoken to Apple
regarding this? It seems to be an issue that's been ongoing for several years and through several versions of iTunes, without a fix coming to fruition.
Sorry for the long winded post, just wanted to give as much info as possible.