ACCOUNTING
6-7 On July 1, a city issued, at par, $100 million in percent, twenty year general obligation bonds. It established a debt service fund to account for resources set aside to pay interest rates. In the year that it issued the debt, the city engaged in the following transactions involving the debt service fund.
1. It estimated that it would make interest payments of $3 million and have interest earnings of $30,000 from investments. It would transfer from the general fund to the debt service fund$2.97 million to pay interest and $500,000 to provide for the payment of principal when the bonds mature. Further, as required by the bond indentures, it would transfer $1 million of the bond proceeds from the capital projects fund to the debt service fund to be held in reserve until the debt matures.
2. Upon issuing the bonds, the city transferred $1 million of the bond proceeds from the capital projects fund. It invested $977,254 of the funds in twenty – year, 6 percent Treasury bonds that had a face value of $1 million. The bond discount of $22,746 reflected an effective yield rate of 6.2 percent.
3. On December 31, the city received $30,000 interest on the Treasury bonds. This payment represented interest for six months. Correspondingly, the market value of the bonds increased by $294, reflecting the amortization of the discount.
4. On the same day the city transferred $2.97 million from the general fund to pay interest on the bonds that it had issued. It also transferred $500,000 for the eventual repayment of principal.
5. Also on December 31, it made its first interest payment of $3 million to bondholders.
a. Prepare appropriate journal entries in the debt service fund, including budgetary and closing entries.
b. The bonds issued by the city pay interest at the rate of 6 percent. The bonds in which the city invested its reserve have an effective yield of 6.2 percent. What might the differences in rates create a potential liability for the city?
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