What Is the Sinking Fund Method?
The sinking fund method is a technique for depreciating an asset while generating enough money to replace it at the end of its useful life.
As depreciation charges are incurred to reflect the asset's falling value, a matching amount of cash is invested. These funds sit in a sinking fund account and generate interest.
Key Takeaways
- The sinking fund method is a depreciation technique used to finance the replacement of an asset at the end of its useful life.
- As depreciation is incurred, a matching amount of cash is invested, usually in government-backed securities.
- Companies rarely use the sinking fund method of depreciation because of its complexity.
- Companies may use the sinking fund method of depreciation for real estate assets, thoughdifferent scenarios may apply to real estate.
Understanding the Sinking Fund Method
Companies use depreciation to expense an asset over time, not just in the period that it was purchased. In other words, depreciation involves stretching out the cost of assets over many different accounting periods, enabling companies to benefit from them without deducting the full cost from net income (NI).
One of the biggest challenges of depreciation is determining how much to expense. 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.
Under this method, the amount of money added to the asset-replacement fund each year is calculated by determining the cost to replace the asset, how many years the asset is expected to last, and the expected rate of return on the investment, as well as potential earnings from the effects ofcompounding 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.The asset's depreciation schedule determines the investment amounts.
The sinking fund method is mainly used by large-scale industries, such as utility companies, that require expensive, long-term assets to function.
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.In this situation, a depreciation schedule is based on the lease term and expected interest.
Special Considerations
Most companies rarely use the sinking fund method, preferring instead to employ the simplerstraight-lineordeclining balance depreciation techniques.
The sinking fund method is seen as complex, particularly as it requires the use of a separate replacement fund for each asset. Moreover, companies recognize that the cost of replacing an old asset can change over time and are also mindful that it is difficult to put enough cash aside when interest rates are unpredictable and consistently fluctuate.
Important
When interest rates cannot reasonably be predicted, the sinking fund method is generally undesirable.
In addition to the added complexities of the sinking fund method, there are other reasons why this method is not suitable.For example, some companies prefer to invest capital resources in other areas with more promising returns.
While the sinking fund provides for the purchase of a new asset at the end of the former's useful life, some firms prefer to instead use their working capital for this purchase.Also, companies wanting to keep their depreciation expenses low find this method unfavorable.
FAQs
The sinking fund method is a technique for depreciating an asset while generating enough money to replace it at the end of its useful life. As depreciation charges are incurred to reflect the asset's falling value, a matching amount of cash is invested. These funds sit in a sinking fund account and generate interest.
What is a sinking fund and how does it work? ›
A sinking fund is an account containing money set aside to pay off a debt or bond. Sinking funds may help pay off the debt at maturity or assist in buying back bonds on the open market. Callable bonds with sinking funds may be called back early removing future interest payments from the investor.
What is the sinking fund method? ›
Sinking fund method is a method of calculating depreciation for an asset in which apart from calculating depreciation, it also keeps aside a fund for replacing the asset at the end of its useful life. This method is used when the assets that need to be replaced are of high cost.
What are the advantages of sinking fund method of depreciation? ›
Advantages Of Sinking Funds
A significant advantage of a sinking fund is that it ensures funds availability for specific purposes, offering financial discipline and management. Here are some more advantages: Predictability: Provides a structured method for managing debt or saving for future expenses.
What is the biggest benefit to a sinking fund? ›
Reduce Temptation: Since sinking funds help you save for a specific goal, you may be less tempted to use the money on other items or purchases. It may also make you less likely to dip into other funds (like your rainy day fund) to cover a large purchase.
How to make sinking funds work? ›
Here's how sinking funds work: Every month, you'll save a certain amount of money for a specific purpose to use at a later date. That way, you're saving up small amounts over time, instead of having to come up with a big chunk of money all at once.
What are the disadvantages of a sinking fund? ›
The various disadvantages of a sinking fund are:
- Companies may Incur Losses. Sinking funds may also lose value over time. ...
- Zero Benefits from a Repurchase Scenario. Most of the time, sinking fund stocks and bonds contain specific provisions important for investors to know.
A sinking fund is a fund that includes funds set aside or borrowed to pay off a loan or debt. A business that issues debt will have to pay off the debt in the future, and the sinking fund helps ease the burden of a significant revenue outlay.
What are the rules for sinking funds? ›
Sinking funds are in 'trust' for the scheme and should not be returned to lessees upon assignment, or at any time. Interest earned on funds should be added to the funds unless the lease states otherwise. If funds are held in 'trust' then a tax will be charged on the interest earned.
Why do people use sinking funds? ›
A sinking fund can be used as a budgeting tool to help you save for specific future expenses that you know are coming. Using a sinking fund, you can save for the expense gradually over time rather than needing to use a credit card or use money from your emergency fund once you need to pay for that expense.
Having sinking funds can help prevent you from withdrawing money from your emergency fund or going into debt to pay for things. You can use a budgeting app, like You Need a Budget (YNAB) or PocketGuard, to monitor your sinking funds.
What does the sinking fund approach allow you to avoid? ›
If you're fully committed to making the purchase, a sinking fund is always a good idea because it helps you avoid borrowing money or dipping into savings earmarked for other financial goals.
How does sinking fund work? ›
The sinking fund method is a technique for depreciating an asset while generating enough money to replace it at the end of its useful life. As depreciation charges are incurred to reflect the asset's falling value, a matching amount of cash is invested. These funds sit in a sinking fund account and generate interest.
What is the main reason why the sinking fund method? ›
Regarding the sinking fund method, it is a good way to manage the payment of debts that have accumulated over many years and need to be paid at the same time or replacement assets. Initially, a sinking fund is created and a fixed amount of money is allocated to it every set period.
How long does a sinking fund last? ›
The body corporate must prepare a sinking fund budget (and an administrative fund budget) each financial year. The sinking fund budget must: provide for necessary and reasonable spending for the financial year. reserve an amount to meet likely spending for at least 9 years after the current financial year.
Can you withdraw from a sinking fund? ›
If one sinking fund has a shortfall for an expense, you can always withdraw from another sinking fund to avoid going into debt.
Is sinking fund a good investment? ›
Is a sinking fund risky? A sinking fund is a very low-risk way of saving money. Because you use a regular checking or savings account to store money in a sinking fund, there's no risk you will lose money like there is if you invest the money.
