It is not unusual to issue long-term debt in conjunction with an arrangement under which lenders receive an option to buy common stock during all or a portion of the time the debt is outstanding. Sometimes the vehicle is convertible bonds; sometimes warrants to buy stock accompany the bonds and are separable. Interstate Chemical is considering these options in conjunction with a planned debt issue.

“You mean we have to report $7 million more in liabilities if we go with convertible bonds? Makes no sense to me,” your CFO said. “Both ways seem pretty much the same transaction. Explain it to me, will you?”

Required:

Write a memo. Include in your explanation each of the following:

1. The differences in accounting for proceeds from the issuance of convertible bonds and of debt instruments with separate warrants to purchase common stock.

2. The underlying rationale for the differences.

3. Arguments that could be presented for the alternative accounting treatment.