Sinking Funds Meaning, Formula and Example

The Sinking Fund Method of Depreciation is a depreciation method that considers not only the depreciation of an asset but also the accumulation of funds to replace the asset at the end of its useful life. Under this method, a fixed sum of money is set aside and invested annually, such that the amount accumulated, along with the interest earned, will be sufficient to replace the asset at the end of its useful life. The best option is a dedicated savings account with a competitive interest rate, ensuring your funds remain secure and easily accessible when needed.

Sinking Fund vs. Savings Account

Similarly, for personal finance, imagine you plan to buy a car in five years for Rs. 10 lakh. By creating a sinking fund, you save Rs. 2 lakh annually, enabling you to purchase the car outright without needing a loan. This disciplined saving method helps you avoid borrowing costs like interest or the financial burden of a lump sum payment.

Hence, in the last year entries nos. (1), (2), and (3) will be repeated but entry no. (4) Will not be passed. However, many people fail to create one because they lack the discipline to set aside a specific amount regularly. A sinking fund is not similar to an emergency fund, as the former is purposely established for something definite while the latter is for something unexpected. CFI is the global institution behind the financial modeling and valuation analyst FMVA® Designation. CFI is on a mission to enable anyone to be a great financial analyst and have a great career path.

Types of sinking funds

This fund is particularly relevant for assets like machinery, equipment, or vehicles that depreciate quickly and require renewal shortly after purchase. The process involves allocating resources consistently over an extended period to ensure adequate funds are available when needed. The sinking fund method is seen as complex, particularly as it requires the use of a separate replacement fund for each asset. Additionally, companies may also use the sinking fund method of depreciation for real estate assets. Different scenarios may apply to real estate assets, but one of the most common is depreciation for lease renewals.

1. For companies that want to put money aside to purchase a replacement asset upon the full depreciation of the old one, the sinking fund method may be a viable option.
2. Since these investments are purchased for a specific purpose, the interest earned is also reinvested.
3. The primary objective of a sinking fund is to ensure financial readiness for future expenditures or liabilities, minimising potential disruptions to cash flow.
4. By creating a sinking fund, you save Rs. 2 lakh annually, enabling you to purchase the car outright without needing a loan.
5. Lower debt-servicing costs due to lower interest rates can improve cash flow and profitability over the years.
6. A sinking fund is established to cover unforeseen major expenses, helping to avoid the need for loans or immediate out-of-pocket payments.

At the end of March 2025, the sale proceeds from debenture fund investments were ₹ 90,000. Further, invest this amount of annual depreciation outside business each year except last year. The investments must preferably be made in readily saleable securities like government securities. The amount charged as depreciation is invested in securities at a certain interest rate. However, Sinking Fund Tables or Annuity Tables determine the annual depreciation amount.

1. Also, the sinking fund allows ExxonMobil the option to borrow more money if needed.
2. A sinking fund is established so the company can contribute to the fund in the years leading up to the bond’s maturity.
3. Where S – the amount that needs to be saved every year; P- the entire amount that should be paid off or the cost of the asset today; i – interest rate; n – how many years you will keep this saving.
4. In the books of Lakshmi Mills Ltd. the Machinery account stood at Rs.25, 00,000.
5. Depreciation Fund amounted to Rs.20, 00,000, which was represented by outside investments.

New Lease Account:

Also, companies wanting to keep their depreciation expenses low find this method unfavorable. The salient feature of sinking fund method is that it provides funds for replacement of the asset. It is suitable for plant and machinery and many other wasting assets, which require replacement. Since a sinking fund adds an element of security and lowers default risk, the interest rates on the bonds are usually lower.

It is designed in such a way that, apart from providing depreciation on the asset, it provides the required funds for the replacement of the asset when the asset is to be replaced by new asset. To determine the annual contribution to sinking fund method of depreciation the sinking fund such that, at the end of 5 years, TechCorp has enough money to replace the server (i.e., $18,000, which is the difference between the cost and the salvage value). Setting aside money to pay off debts is a prudent financial decision for companies to manage their obligations when debt comes due. Companies that don’t, may struggle to find the capital to make good on their outstanding debt obligations.

They ensure that funds are readily available for specific goals, preventing last-minute borrowing or budget disruptions. The sinking fund formula will identify how much you need to set aside every year to accumulate a certain amount over time. It is particularly helpful if you have a debt or an asset that needs to be paid or replaced in a few years. When interest rates cannot reasonably be predicted, the sinking fund method is generally undesirable. Straight-line depreciation is a very common, and the simplest, method of calculating depreciation expense. In straight-line depreciation, the expense amount is the same every year over the useful life of the asset.

A sinking fund helps companies that have floated debt in the form of bonds to gradually save money and avoid a large lump-sum payment at maturity. Sinking funds and emergency funds are essential financial tools but serve different purposes. A sinking fund is meant for planned, predictable expenses like buying a car, replacing appliances, or repaying debts. Conversely, an emergency fund is designed for unforeseen expenses, such as medical emergencies or job loss, providing a financial safety net during crises.

Is a Sinking Fund a Current Asset?

Instead of paying the entire amount at the end of the term, the company sets up a sinking fund to gradually accumulate the required sum. It allocates Rs. 5 lakh annually into this fund, ensuring the full Rs. 50 lakh is available at maturity. A sinking fund is a targeted savings pool for a specific purpose, such as debt repayment or asset replacement, with systematic contributions over time. A savings account, however, is a general-purpose account used for various financial needs, offering flexibility but without a predetermined goal. A sinking fund is a financial strategy employed by organisations or individuals to save systematically over time for specific purposes, such as repaying a debt or replacing an asset.