Accounting practices for interest expenditures may neither reflect actual economic costs nor mirror those for interest revenues.
A town plans to borrow about $10 million and is considering three alternatives. A town official requests your guidance on the economic cost of each of the arrangements and advice as to how each would affect the town's reported expenditures. The alternatives are:
1. The town would issue $10 million of twenty-year, 6 percent coupon bonds on September 1, 2004. The bonds would be issued at par. The town would be required to make its first interest payment of $200,000 on January 1, 2005.
2. The town would issue $10 million of twenty-year, 6 percent bonds on July 1, 2004. Thebonds would be sold for $9,552,293, a price that reflects an annual yield (effective interest rate) of 6.4 percent. The town would be required to make its first interest payment of $300,000 on December 31, 2004.
3. The town would issue $32,071,355 of twenty-year, zero coupon bonds on July 1, 2004. The bonds would be sold for $10 million, an amount that reflects an annual yield of 6 percent. The bonds require no payment of principal or interest until June 30, 2024.
Question 1. For each of the town's three alternatives, what would be the town's economic cost of using the funds in the year ending December 31, 2004? What would be the amount of interest expenditure that the town would be required to report for the year ending December 31, 2004 in its governmental funds?
Question 2. Suppose that the town elects the first option and issues $10 million of twenty-year, 6 percent coupon bonds at par on September 1, 2004. The town establishes a debt service fund to account for resources that it sets aside to pay principal and interest on the bonds. On December 31, 2004, the town transfers $200,000 from the general fund to the debt service fund to cover the first interest payment that is due on January 1, 2005.
a. How would the transfer be reported in the general fund?
b. How would the transfer be reported in the debt service fund? What options are available to the town to record 2004 interest in the debt service fund?
Question 3. Suppose that the town borrowed $10 million on September 1, 2004, and temporarily invested the proceeds in two-year, 6 percent Treasury notes. The first payment of debt interest, $200,000, is payable on January 1, 2005.
a. What would be the town's economic gain from investing the funds in the year ending December 31, 2004? Ignore borrowing costs.
b. How much investment revenue should the town report for the year ending December 31, 2004? Assume there was no change in prevailing interest rates.