Demand bonds may provide the issuer with the disadvantages but not the advantages of long-term debt.

On January 1, 2013 a city issues $2 million in 7% demand bonds. Although the bonds have a term of 10 years, they contain a ‘‘put’’ option, permitting the holder to present the bonds for redemption, at par, any time after December 31, 2014. The bonds pay interest semiannually.

1. Prepare journal entries in the city’s general fund or other governmental fund to record the bonds, assuming that:

a. The city has entered into a qualifying take-out agreement.

b. The city has not entered into a qualifying take-out agreement.

2. Suppose that on January 1, 2015, prevailing interest rates for bonds of similar credit risk had fallen to 4%. A bondholder needed immediate cash for personal reasons. Assuming that the bonds were publicly traded, would the bondholder redeem his or her bonds? Would any other bondholders redeem their bonds? Explain.

3. Suppose, instead, that prevailing interest rates had increased to 9%. Would the bondholder needing cash redeem his or her bonds? Would the other bond holders redeem their bonds?

4. Suppose that, because it is not mandated by the applicable GASB pronouncement, the take- out agreement does not specify the interest rate at which the financing institution would provide the funds necessary for the city to redeem its bonds. If prevailing rates had increased to 9%, at approximately what rate would the financing institution likely loan the city the required funds?

5. Comment on the extent to which the demand bonds provide the city with one of the primary benefits of issuing long-term debt—the guarantee of a fixed interest rate over the life of the bond. To what extent does it burden the city with the corresponding disadvantage—being required to pay no less than the stated rate over the life of the bond (or otherwise retire the bonds at market prices)?