What Is the Sinking Fund Method?
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.
- 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, though different 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 of compounding 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.
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.
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.