On July $1,$ a city issued, at par, $$100$ million in $6$ percent, $20-$year general obligation bonds. It established a debt service fund to account for resources set aside to pay interest and principal on the obligations.

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 $$2\mathrm{.}97$ million to pay interest and $$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 $20-$year, $6$ percent Treasury bonds that had a face value of $$1$ million. The bond discount of $$22,746$ re$$ected an effective yield rate of $6\mathrm{.}2$ 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,$ re$$ecting the amortization of the discount.

$4.$ On the same day the city transferred $$2\mathrm{.}97$ million from the general fund to pay interest on the bonds that it had issued. It also transferred $$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 $6\mathrm{.}2$ percent. Why might the difference in rates create a potential liability for the city?

There are $4$ steps to solve this one.

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Step $1$

A bond functions as a debt instrument. Entities in need of funds, such as governments, municipalities, or corporations, issue bonds to secure loans from willing investors. When bonds are purchased means lending money to the issuer. In return, the issuer commits to paying you a predetermined interest rate throughout the bond's lifespan and repaying the principal amount, referred to as the face value or par value, when the bond reaches its maturity date, which is a predetermined future point in time.

Explanation:

Bonds offer a reliable source of income, with interest payments usually made semi$-$annually.

Step $2$

Preparing journal entries for all transaction$-$related bonds:

$1$

Date

Account

Dr

Cr

Transfer from general fund

$$2,970,000$

Transfer from capital projects fund

$$1,000,000$

Transfer principal amount to General fund

$$500,000$

Revenue interest

$$30,000$

Appropriation interest

$$3,000,000$

Balance fund

$$1,500,000$

Explanation:

To create the budget, it is necessary to aggregate all the projected transfers from various funds and subtract the allocated interest, resulting in the available fund balance.

$2$

Date

Account

Dr

Cr

Cash

$$1,000,000$

Transfer from capital projects fund: non$-$reciprocal

$$1,000,000$

Date

Account

Dr

Cr

Bonds investment

$$977,254$

Cash

$$977,254$

Step $3$

Journal entries for all transaction$-$related bonds:

$3$

Date

Account

Dr

Cr

Cash

$$30,000$

Bonds investment

$$294$

Revenue interest

$$30,294$

Explanation:

The total interest is received interest for the first six months plus the corresponding increased market value.

$4$

Date

Account

Dr

Cr

Cash

$$3,470,000$

Transfer from general fund interest: non$-$reciprocal

$$2,970,000$

Transfer from general fund principal: non$-$reciprocal

$$500,000$

$5$

Date

Account

Dr

Cr

Interest expenses

$$3,000,000$

Cash

$$3,000,000$

Step $4$

a$.$ Preparing appropriate journal entries in the debt service fund, budgetary, and closing entries:

Date

Account

Dr

Cr

Appropriation interest

$$3,000,000$

Revenue interest

$$30,294$

Transfer from capital projects fund: non$-$reciprocal

$$1,000,000$

Transfer from general fund interest: non$-$reciprocal

$$2,970,000$

Transfer from general fund principal: non$-$reciprocal

$$500,000$

Transfer from general fund

$$2,970,000$

Transfer from capital projects fund

$$1,000,000$

Transfer principal amount to General fund

$$500,000$

Revenue interest

$$30,000$

Interest expenses

$$3,000,000$

Balance fund

$$294$

Prepare the Financial Statements from the journal entries recorded?