What is a 'Sinking Fund Method'
A sinking fund method is a technique for depreciating an asset in bookkeeping records while generating money to purchase a replacement for the asset when it reaches the end of its useful life. Under the sinking fund method, the business sets aside an amount of money to invest annually so that the principal plus the interest earned in the fund will be enough to replace the asset.
BREAKING DOWN 'Sinking Fund Method'The sinking fund method for asset depreciation is not commonly used in the majority of asset depreciation write-downs, since it is slightly more complicated than other methods. The most common method used in asset depreciation is straight-line and declining balance.
Advantages of the Sinking Fund Method
The sinking fund method of depreciation provides for funds to purchase a new asset when the old asset has been fully depreciated. To do this, the sinking fund method requires higher depreciation expenses. The higher depreciation expenses include amounts paid into the sinking fund for a future purchase of a new asset.
The amount of money that needs to be added to the asset-replacement fund each year is calculated by determining how much it will cost to replace the asset, how many years the asset is expected to last and what rate of interest can be earned as well as how much can be earned through the effects of compound interest. The sinking fund method is sometimes not desirable when interest rates cannot reasonably be predicted.
In most cases, sinking funds invest in government-backed securities such as Treasury notes, bills or bonds. Investments matching the duration of the asset's life are usually used, but shorter-term investments can be reinvested. Investment amounts are determined by the asset's depreciation schedule.
Reasons for Not Choosing the Sinking Fund Method
In addition to the added complexities of sinking fund method depreciation, companies may choose to forego this investment for capital invested at higher rates of return within other areas. While the sinking fund provides for purchasing availability at the end of the asset's life, companies may prefer to use working capital for this repurchase expense instead. Companies may also seek to keep their depreciation expenses at a minimum with a preference for not paying an additional amount to the sinking fund.
Industries That Regularly Use This Method
While the sinking fund method is not common in the broad market, it is used regularly by some specific industries. Large-scale industries with long-term assets that are expensive, such as utilities and industrials, often use this depreciation method. 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 time frame of the lease and the expected interest.