What is a Sinking Fund Method?
The sinking fund strategy is a depreciation technique for an asset, thus producing enough money to replace it at the end of its useful life. When depreciation costs are paid to reflect the decreasing value of the asset, an equal amount of cash is invested. Such funds remain in an account with a sinking fund and generate interest.
Sinking Fund Method Explained
Enterprises use depreciation over time to invest an asset, not just during the period it was purchased. In other words, depreciation means spreading the expense of assets over many different periods of accounting, allowing businesses to profit from them without deducting the full cost from net income (NI).
Determining how much to pay is one of the major challenges of depreciation. The sinking fund strategy may be a viable option for businesses that want to put money aside to purchase a new asset after complete depreciation of the old one.
Under this process, the amount of money applied each year to the asset-replacement fund is determined by calculating the cost of replacing the asset, how many years the asset is expected to last, and the estimated rate of return on the investment, as well as potential earnings from the compounding interest effect.
In most situations, sinking funds invest in assets backed by the government, such as Treasury notes, bills, and bonds. Investments which suit the length of the life of the asset are typically used, but it is possible to recycle short-term investments. The investment amounts are determined by the depreciation schedule of the asset.
The sinking fund method is mainly used by large-scale industries, such as utility companies, that require expensive, long-term assets to function.
