Final answer:
Modified accrual accounting is applied to debt service funds by recognizing interest expenditures when they are due, not necessarily when they are paid, reflecting accurate financial position.
Step-by-step explanation:
Modified accrual accounting in the context of debt service funds is unique in its application. The correct way it is used for such funds is option third: It is used to account for interest, with the exception that interest is paid when legally due. This means that revenue is recognized in the accounting period in which it becomes available and measurable, but not necessarily when it is received. However, expenditures for interest are recognized when the interest is due, irrespective of when it is paid. This approach aligns the recognition of interest expenditures with the fiscal period to which they relate, ensuring that the expenses are accounted for in the same period as the associated debt service is incurred, thus providing an accurate reflection of the fund's financial position.