What is the Sinking Fund Method?
The sinking fund method is a technique, where an asset is depreciated while generating enough money to replace it at the end of its own useful life. As depreciation charges are incurred to reflect the asset's value, the same matching amount of cash is also to be reinvested. These funds sit in a sinking fund account and generate the interest. We will chalk the details further to know about the sinking fund method in detail. In the sections, the prevailing concept of sinking funds is to be enunciated.
Understanding the Sinking Fund Method
Many companies use depreciation to expense an asset over time, not only just in the period that it was purchased. The depreciation here has stretched out the cost of the assets over many different accounting periods. This enables the companies to benefit from them without deducting the full cost from the net income.
One disadvantage of depreciation is to determine how much to expense. For companies who want to put the money aside to purchase a replacement asset upon the full depreciation of the old one, here the sinking fund method may be a good option to be used.
Under the sinking fund method, the amount of the money is to be added to the asset-replacement fund each year. After this, the calculation is done to determine the cost which is to be replaced by the asset. The calculation is also required for the number of years the asset is expected to last, for the expected rate of return on the investment, as well as for the potential earnings from the effects of the compounding interest.
Solved Example on Sinking Fund Method
An example is illustrated to further explain the method:
ABC Ltd. issues Rs. 100,000 of the bond to start a new store. Since the issuance, ABC Ltd. created a fund by regularly depositing Rs. 1,000 in it to pay off the principal.
Now, ABC Ltd. plans to repurchase 50 percent of its Rs. 100,000 outstanding bonds in the open market in the current year to lower the principal balance which it will owe at the maturity period. Since the interest rates increase and decrease over time, the price of the bonds might as well increase or decrease. Obviously, ABC Ltd. doesn’t want to purchase the bonds for more than their face value, so the company included a sinking fund provision in the original issuance.
This meant that the company can either purchase the bonds back at random for the market price or the face value, whichever is lower. Thus, ABC Ltd. chooses any bonds to repurchase based on their serial numbers. While purchasing the bonds, it will lower the outstanding principal. There can be limitations on the amount or percent of bond issues which can be repurchased per the fund provisions.
After ABC Ltd. recalls the bonds, it will have effectively lowered the outstanding principal to Rs. 50,000. Thus, it spread the principal payments over a period of time to nullify the effect of a large principal payment on the date of maturity.
Sinking Fund Method Formula
The formula for sinking fund:
Sinking Fund, A= [(1+(r/m) n*m-1] / (r/m) * P
P is the Periodic contribution to the sinking fund,
R is the annualized rate of interest.
n is the No. of years.
m is the No. of payments per year.
FAQs on Depreciation: Sinking Fund Method Explained
1. What is the sinking fund method of depreciation in simple terms?
The Sinking Fund Method is a way of accounting for depreciation where a company sets aside a fixed amount of money each year into a separate fund, called a Sinking Fund. This money is then invested to earn interest. The goal is to accumulate enough money, from both the annual contributions and the interest earned, to replace the asset at the end of its useful life.
2. What is the main objective of using the Sinking Fund Method?
The primary objective is not just to write off the asset's value but to ensure that actual cash is available for its replacement. Unlike other methods that are just accounting entries, this method builds a real fund of money, making it easier for a business to afford a new asset without disrupting its finances.
3. How is the annual depreciation amount calculated in the sinking fund method?
The annual amount to be set aside is not simply the cost divided by years. Instead, you use a special sinking fund table or an annuity formula. This calculation determines the fixed annual payment that, when invested at a specific rate of interest, will grow to the total cost of the asset by the end of its life. The amount charged to the Profit and Loss Account remains constant each year.
4. How is the Sinking Fund Method different from the Straight-Line Method of depreciation?
There are three key differences:
- Purpose: The Straight-Line Method simply allocates the cost of an asset over its life. The Sinking Fund Method's main goal is to accumulate funds for replacement.
- Cash Flow: The Straight-Line Method is a non-cash expense. The Sinking Fund Method involves setting aside real cash and investing it.
- Interest: The Straight-Line Method ignores the time value of money (interest). The Sinking Fund Method is built around the principle of compound interest to grow the fund.
5. What happens to the Sinking Fund and Sinking Fund Investment at the end of the asset's life?
At the end of the asset's useful life, the following steps occur:
- The Sinking Fund Investments are sold to generate cash.
- The cash is used to purchase the new asset.
- Any profit or loss on the sale of investments is transferred to the Sinking Fund Account.
- Finally, the balance in the Sinking Fund Account is used to write off the old asset by transferring it to the Asset Account.
6. What are the main journal entries passed under the Sinking Fund Method?
The key journal entries passed each year are:
- For setting aside depreciation: Profit & Loss A/c Dr. To Sinking Fund A/c.
- For investing the amount: Sinking Fund Investment A/c Dr. To Bank A/c.
- For receiving interest on investment: Bank A/c Dr. To Sinking Fund A/c. (Or by reinvesting it directly: Sinking Fund Investment A/c Dr. To Sinking Fund A/c).
7. What is another name for the Sinking Fund Method?
The Sinking Fund Method is also commonly known as the Depreciation Fund Method. Both terms refer to the same process of accumulating funds for asset replacement through periodic investments.
