Depreciation Fund Method or Sinking Fund Method of Depreciation:

Learning Objectives:

1. Define and explain the depreciation fund method or sinking fund method of depreciation.

2. Prepare journal entries to record depreciation under this method.

Contents:

• Definition and Explanation

• Entries

• Example

• Relationship Between Annuity Method and Depreciation Fund Method

• Shortcomings

Definition and Explanation:

Under depreciation fund method or sinking fund method, a fund is created with the amount of annual depreciation. An amount equal to annual depreciation is invested each year in government papers or in some other gilt-edged securities outside the business. The income earned from investment is deposited into the fund and immediately reinvested. This process is carried out throughout the life of the asset and at the end of its life a sum equal to the cost of the asset is accumulated in the fund. Then the whole investment is sold and a new asset is acquired with the sale proceeds.

The special feature of this method is that the sum required to buy the new asset is available from depreciation or sinking fund. As a result, the working capital of business is preserved. Sinking fund method is specially applicable to costly machines in large scale industries.

Entries:

The entries to be made will be as follows:

At the end of the first year:

1. Debit profit and loss account and credit depreciation fund account with amount of annual depreciation.

2. Debit depreciation fund investment account and credit bank account with an equal amount.

At the end of each subsequent year:

1. Debit bank account and credit depreciation fund account with amount of interest earned on investment.

2. Debit profit and loss account and credit depreciation fund account with amount of annual depreciation.

3. Debit depreciation fund investment account and credit bank account with amount of annual depreciation plus interest received.

In the last year:

1. Debit bank account and credit depreciation fund account with amount of interest earned on investment.

2. Debit profit and loss account and credit depreciation fund account with amount of annual installment.

3. Debit bank account and credit depreciation fund investment account with proceeds of sale of investment. Any profit or loss on sale of investment should be transferred to depreciation fund account.

4. Debit the account of new asset and credit the bank account with cost of replacement.

5. Debit depreciation fund account and credit the account of old asset which has now become useless.

Note: In the last year this amount should not be invested in the purchase of investments.

In the balance sheet that is prepared during the period of building up the depreciation fund, depreciation fund account shall be shown on the liabilities side and depreciation and depreciation fund investment account on the asset side, whereas the asset for which this depreciation fund is being created will appear at its original cost.

The amount of annual depreciation to be provided for the depreciation will be ascertained from sinking fund table, an extract from which is given below:

Sinking Fund Table

Periodic deposit which will amount $1

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