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TYPES OF DEPRECIATION - SINKING FUND METHOD

March 25, 2019

SINKING FUND METHOD OF DEPRECIATION

 

There are other types of depreciation less commonly used by companies, one of them is sinking fund method of depreciation. These methods are not widely used as much as the four most popular ones which we discussed in our previous post. There are many reasons to it, one being their complexity. However, some companies use them for other obvious reasons. In this post, we shall discuss about the sinking fund method of depreciation and when it is warranted.

 

 

 

 

WHAT IS SINKING FUND METHOD OF DEPRECIATION AND HOW DOES IT WORK?

 

Usually, in other methods of depreciation, although companies set aside a particular amount every year, it is not usually invested elsewhere and is ploughed back into the business. When the need to replace the asset arises, the money is usually taken from the working capital.

 

However, this is not the case with the sinking fund method of depreciation. In the sinking fund method, the depreciated money is set aside in a fund and then the money is again invested in Government Securities. These money then earn interest as they do with any other Government Securities. The interest earned is again taken to the Sinking Fund Account.

Finally, at the end of the life of the asset, the Government Securities are sold off and the money received from the sale proceeds are used in replacing the asset.

 

 

Unlike other methods of depreciation, which are calculated using formulas, the amount to be set off every year to the sinking fund account is determined by using "Sinking Fund Table".

 

 

Note: Often depreciation of the asset in sinking fund method is often called as "Contribution to sinking fund" or "Investment to sinking fund"

 

WHEN IS SINKING FUND METHOD OF DEPRECIATION IS USED?

 

Sinking fund method of depreciation is mostly used by companies having high cost machinery and assets. Large scale industries.

At the end of useful life of the asset, often the companies would require funds to replace the asset. The cost involved in replacement depends on the nature of the asset. If the asset is huge and cost is too high, the companies should make some arrangements to keep a reserve at the end of useful life of the asset to replace it.

If the assets are not replaced well within time, production gets affected resulting in business loss.

 

JOURNAL ENTRIES FOR SINKING FUND METHOD

 

a) At the end of first year 

 

Setting aside the amount of depreciation

 

Depreciation  A/c                                                               Dr.

   To Sinking Fund A/c

 

Charging depreciation to profit and loss account

 

Profit and Loss A/c                                                           Dr.

   To Depreciation A/c

 

When the amount equivalent to depreciation is invested

 

Sinking Fund Investment A/c                                       Dr.

    To Bank A/c

 

JOURNAL ENTRIES FOR OTHER YEARS

 

Interest earned on Sinking Fund Investments

 

Bank A/c                                                                           Dr.

   To Interest on Sinking Fund Investment A/c

 

Interest on Sinking Fund Investment A/c                    Dr.

    To Sinking Fund A/c

 

Transfer of Depreciation for that year to Sinking Fund Account

 

Depreciation A/c                                                             Dr.

    To Sinking Fund A/c

 

Charging Depreciation to Profit and Loss Account

 

Profit and Loss A/c                                                         Dr.

   To Depreciation A/c

 

Investment of amount equivalent to current year depreciation and interest earned

 

Sinking Fund Investment A/c                                      Dr.

   To Bank A/c 

 

End of useful life of the asset

 

On sale of sinking fund investments

 

Bank A/c                                                                          Dr.

  To Sinking Fund Investment a/c

 

Profit on sale of sinking fund investment

 

Sinking Fund Investment Account                               Dr.

   To Sinking Fund Account

 

If there is a loss on sale of sinking fund investment

 

Sinking Fund Account                                                     Dr.

   To Sinking Fund Investment Account

 

Transfer from the asset account, an amount equivalent to book value of the asset

 

Sinking Fund Account                                                     Dr.

  To Asset Account

 

The surplus in sinking fund account is transferred to General Reserve account and the deficit in the sinking fund account is transferred to the profit and loss account.

 

Sinking Fund Account                                                      Dr.

  To General Reserve Account

 

Profit and Loss Account                                                   Dr.

  To Sinking Fund Account

 

 

We will shortly post problems on Sinking Fund Method of Depreciation.

 

If you have any questions on sinking fund, drop us an email to therankholer@gmail.com.

 

 

 

 

 

 

 

 

 

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