On June 1, 2018, a city issues $2 million in 7 percent 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 May 31, 2019. The bonds pay interest semiannually.
1. Prepare journal entries to reflect how the bonds would be recorded in the city's general fund or other governmental fund for fiscal year December 31, 2018, financial statements assuming:
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, 2020, prevailing interest rates for bonds of similar credit risk had fallen to 4 percent. A bondholder needed immediate cash for personal reasons. Assuming that the bonds were publicly traded, do you think the bondholder would redeem his bonds? Do you think that any other bondholders would redeem their bonds? Explain.
3. Suppose, instead, that prevailing interest rates had increased to 9 percent. Do you think that the bondholder needing cash would redeem his bonds? Do you think that the other bondholders would 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 percent, at approximately what rate is it likely that the financing institution would 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)?