Some financial instruments such as convertible bonds, preferred stocks, warrants, and options can have both debt and equity features. They can be converted into common stock, or into preferred stocks by investors. Explain whether these securities should be reported as:

1. Issuers should account for an instrument with both liability and equity characteristics entirely as a liability or entirely as an equity instrument depending on which characteristic governs; or
2. Issuers should account for an instrument as consisting of a liability component and an equity component that should be accounted for separately.

Which of the two options is favorable and why? Develop and explain your argument. Focus on conceptual issues regarding the practicable and theoretically appropriate treatment, unconstrained by US GAAP and IFRS. Also, focus your deliberations on convertible bonds as the instrument with both liability and equity characteristics.