Incurring long-term debt with an arrangement whereby lenders receive an option to buy common stock during all or a portion of the time the debt is outstanding is a frequently used corporate financing practice. In some situations, the result is achieved through the issuance of convertible bonds; in others, the debt instruments and the warrants to buy stock are separate.

Required

1. a. Explain the differences that exist in current accounting for original proceeds of the issuance of convertible bonds, and of debt instruments with separate warrants to purchase common stock.

b. Explain the underlying rationale for the differences described in Requirement 1a.

c. Summarize the arguments that have been presented for the alternative accounting treatment.

2. At the start of the year, AB Company issued $6 million of 7% notes along with warrants to buy 400,000 shares of its $10 par value common stock at $18 per share. The notes mature over the next 10 years, starting one year from date of issuance, with annual maturities of $600,000. At the time, AB had 3,200,000 shares of common stock outstanding and the market price was $23 per share. The company received $6,680,000 for the notes and the warrants. For AB Company, 7% was a relatively low borrowing rate. If offered alone, at this time, the notes would have been issued at a 20 to 24% discount. Prepare journal entries for the issuance of the notes and warrants for the cash consideration received.