Depreciation Fund Method or Sinking Fund Method of Depreciation:

Learning Objectives:

1. What is depreciation fund method or sinking fund method of depreciation?

2. What are its advantages and disadvantages?

Definition and Explanation:

Depreciation fund method is also know as sinking fund method or amortization fund method. Under this method, a fund know as depreciation fund or sinking fund is created. Each year the profit and loss account is debited and the fund account credited with a sum, which is so calculated that the annual sum credited to the fund account and accumulating throughout the life of the asset may be equal to the amount which would be required to replace the old asset. In order that ready funds may be available at the time of replacement of the asset an amount equal to that credited to the fund account is invested outside the business, generally in gilt-edged securities. The asset appears in the balance sheet year after year at its original cost while depreciation fund account appears on the liability side.

Journal Entries:

The following entries are necessary to record the depreciation and replacement of an asset by this method.

The amount of annual depreciation to be provided for by the depreciation fund method will be ascertained from sinking fund table.

Sinking Fund Table

Annual sinking fund installment to provide $1.

Example:

On 1st January, 1990 a four years lease was purchased for $20,000 and it is decided to make provision for the replacement of the lease by means of a depreciation fund, the investment yielding 4 percent per annum interest. Show the necessary ledger account.

Solution:

To get $1 at the end of 4 years at 4 percent an annual investment of $2,35,490 is necessary. Therefore, for $20,000 an annual investment of $4,709.80 i.e., 2,35,490 × 20,000 will be necessary.

Lease Account

Depreciation Fund Account

Depreciation Fund Account

Note: The cash installment at the end of the last year will not be invested because there is no point in buying the investment and selling them on the same date.

Advantages of Depreciation Fund Method Or Sinking Fund Method:

The most important advantages of this method is that it makes available a sum of money for the replacement of the asset, which has become useless. If separate provision was not made, the sum required to purchase the new asset will have to be drawn from the business which might effect the financial position of the concern adversely.

Disadvantages of the Depreciation Fund Method Or Sinking Fund Method:

1. The burden on profit and loss account goes on increasing as years pass by since the amount of depreciation every year remains same but the amount spent on repairs goes on increasing as the asset becomes old.

2. It can also be said that the work of investing money is complicated.

3. Prices of securities may fall at the time when they are to be realized as a result of which loss may have to be suffered.

Scope of Application:

This method is found suitable wherever it is desired not only to charge depreciation but also to replace the asset as happens in the case of plant and machinery and other wasting assets.

You may also be interested in other articles from “accounting for depreciation” chapter:

1. Definition and Explanation of Depreciation
2. Causes of Depreciation
3. Need for Depreciation
4. Depreciation, Depletion and Amortization
5. Difference Between Depreciation and Fluctuation
6. Basic Factors of Determination of Depreciation
7. Depreciation Methods / Methods for Providing Depreciation
8. Fixed Installment Method / Straight Line Method / Original Cost Method
9. Diminishing balance/written Down Value/Reducing Installment Method of Depreciation
10. Annuity Method of Depreciation
11. Depreciation Fund Method or Sinking Fund Method
12. Insurance Policy Method of Depreciation
13. Revaluation Method of Depreciation
14. Sum of the Years’ Digits Method of Depreciation
15. Double Declining Balance Method of Depreciation
16. Depletion Method of Depreciation
17. Basis of Use System of Depreciation
18. Depreciation Of Various Assets
19. Depreciation Accounting – General Questions and Answers