What is the Sinking Fund Method
The sinking fund method is a depreciation method that provides funds for the replacement of an asset at the end of its useful life. A depreciation account is created whereby the asset's annual depreciation amount is credited. An amount equal to the depreciation amount is then invested to earn interest, which is subsequently deposited into the fund and then reinvested.
BREAKING DOWN Sinking Fund Method
Advantages of the Sinking Fund Method
The sinking fund method of depreciation provides the funds needed to purchase a replacement asset upon the full depreciation of the old asset. As a result, the sinking fund method requires higher depreciation expenses. The higher depreciation expenses account for amounts paid into the sinking fund for the future purchase of a replacement asset.
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 of compounding interest. When interest rates cannot reasonably be predicted, the sinking fund method is generally undesirable.
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.
Reasons for Not Choosing the Sinking Fund Method
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.
Industries That Regularly Use This Method
While the sinking fund method is uncommon, some industries regularly use it. Large-scale industries (e.g. utility) with expensive long-term assets 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 lease term and expected interest.