Sinking Fund Method of Depreciation

A sinking fund is established to cover unforeseen major expenses, helping to avoid the need for loans or immediate out-of-pocket payments. This essay is going to explain what a sinking fund is, identify types of sinking funds, and explain its source of establishment. A sinking fund is a type of fund that is created and set up purposely for repaying debt. The owner of the account sets aside a certain amount of money regularly and uses it only for a specific purpose.

1. The constant depreciation charge is such that the sum of annual investment and the interest accumulations is equal to the cost of replacement of equipment after its useful life.
2. 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.
3. This essay is going to explain what a sinking fund is, identify types of sinking funds, and explain its source of establishment.
4. The provision will then allow him to buy back the bonds at a lower price if the market price is lower or at face value if the market price goes higher.
5. In other words, it is the reduction in the value of an asset that occurs over time due to usage, wear and tear, or obsolescence.
6. This platform offers a diverse selection of over 1000 mutual fund schemes, catering to different investment needs, from beginner individual investors to large institutions planning endowments.

Most Searched Terms

If the company is performing well, investors are more likely to invest in their bonds leading to increased demand and the likelihood the company could raise additional capital if needed. A company’s economic situation is not always definite, and certain financial issues can shake its stable ground. However, with a sinking fund, the ability of a company to repay its debts and buy back bonds will not be compromised. 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. For instance, if you have a loan of Rs. 500,000, which needs to be paid in 10 years and the interest is 5%, then according to the sinking fund formula, your yearly saving should be Rs. 65,145. It means that you need to save approximately Rs. 65,145 every year for 10 years to be able to pay the loan.

It refers to a fund created from the company’s profit for a certain period to replace an asset or repay the long-term liability. The Sinking Fund Method of Depreciation involves the creation of a contingency fund that assures the availability of funds for asset replacement upon completing its useful life. Under this method, one Depreciation Fund Account is opened and the amount of depreciation is credited to that account. TechCorp should contribute approximately $1,563.35 to the sinking fund each year for 5 years.

Sinking Fund Bonds are the ones that are backed by a sinking fund, especially for the repayments. sinking fund method of depreciation It requires the issuer to create a sinking fund that will ensure the availability of funds during maturity. Usually, companies opt for this method when the cost of the concerned asset is high. The amount accumulated within this fund is invested in the securities and realized when required. The object behind creating this fund is to generate enough funds for repayment or replacement.

Sinking Fund Method of Depreciation (With Accounting Entries)

Often, it is used by corporations for bonds and deposits money to buy back issued bonds or parts of bonds before the maturity date arrives. It is also one way of enticing investors because the fund helps convince them that the issuer will not default on their payments. A sinking fund and a savings account serve distinct purposes in financial planning. A sinking fund is a targeted pool of money set aside for a specific goal, such as repaying debt or replacing assets.

What are sinking funds?

It is a great method for calculating depreciation, but it involves many critical calculations. Consequently, it increases the complexity during Book Keeping and leaves room for errors. A callable is typically called at an amount slightly above par value and those called earlier have a higher call value. For example, a bond callable at a price of 102 pays the investor $1,020 for each $1,000 in face value, yet stipulations might state that the price goes down to 101 after a year. She holds a Bachelor of Science in Finance degree from Bridgewater State University and helps develop content strategies. Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs.

1. Tutorials Point is a leading Ed Tech company striving to provide the best learning material on technical and non-technical subjects.
2. In this case, the bonds could be called by the company that redeems the bonds from investors at face value.
3. It is suitable for plant and machinery and many other wasting assets, which require replacement.
4. A sinking fund is a type of fund that is created and set up purposely for repaying debt.
5. While the sinking fund helps companies ensure they have enough funds set aside to pay off their debt, in some cases, they may also use the funds to repurchase preferred shares or outstanding bonds.
6. A sinking fund is a fund containing money set aside or saved to pay off a debt or bond.
7. Since only $8 billion of the $20 billion in original debt remains, it would likely be able to borrow more capital since the company has had such a solid track record of paying off its debt early.

Oil and gas companies are capital intensive because they require a significant amount of capital or money to fund long-term operations such as oil rigs and drilling equipment. Preferred stock usually pays a more attractive dividend than common equity shares. A company could set aside cash deposits to be used as a sinking fund to retire preferred stock. In some cases, the stock can have a call option attached to it, meaning the company has the right to repurchase the stock at a predetermined price. If interest rates decline after the bond’s issue, the company can issue new debt at a lower interest rate than the callable bond. The company uses the proceeds from the second issue to pay off the callable bonds by exercising the call feature.

As a result, the company is usually seen as creditworthy, which can lead to positive credit ratings for its debt. Good credit ratings increase the demand for a company’s bonds from investors, which is particularly helpful if a company needs to issue additional debt or bonds in the future. A sinking fund adds an element of safety to a corporate bond issue for investors. Since there will be funds set aside to pay off the bonds at maturity, there’s less likelihood of default on the money owed at maturity.

It is also most applicable to long-term, established industries where it is most likely that the same assets will need to be replaced, over and over again. The disadvantage of a sinking fund is that it limits the availability of cash on hand for a business. It is listed as an asset on a balance sheet but it is not used as a source of working capital so cannot be considered a current asset. Also, the sinking fund allows ExxonMobil the option to borrow more money if needed. In our example above, let’s say by year three, the company needed to issue another bond for additional capital. Since only $8 billion of the $20 billion in original debt remains, it would likely be able to borrow more capital since the company has had such a solid track record of paying off its debt early.

Periodic investments equivalent to depreciation amount (charged annually) are made outside the business. Moreover, the interest earned from these investments is also invested (compound interest). Each year, TechCorp will also record a depreciation expense of $1,563.35, representing the annual contribution to the sinking fund. The actual cash will be invested in some form of security to earn the expected return.

In this situation, a depreciation schedule is based on the lease term and expected interest. In most cases, sinking funds invest in government-backed securities, such as Treasury notes, bills, and bonds. Investments matching the duration of the asset’s life are usually used, but shorter-term investments can be reinvested.

In order to help you advance your career, CFI has compiled many resources to assist you along the path. Here is a graph showing the book value of an asset over time with each different method. For example, at the beginning of the year, the asset has a remaining life of 8 years. Consider the following example to more easily understand the concept of the sum-of-the-years-digits depreciation method.

Now let’s see the accounting treatment of the sinking fund method of depreciation. In other words, the amount owed at maturity is substantially less if a sinking fund is established. As a result, a sinking fund helps investors have some protection in the event of the company’s bankruptcy or default. A sinking fund also helps a company allay concerns of default risk, and as a result, attract more investors for their bond issuance. The prospectus for a bond of this type will identify the dates that the issuer has the option to redeem the bond early using the sinking fund.