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Home Depreciation, Provisions and Reserves Sinking Fund Method of Depreciation
 
 

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:

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
Depreciation or sinking fund method

Period 3% 4% 5% 6%
1 1.000000 1.000000 1.000000 1.000000
2 .492611 .490196 .487805 .485437
3 .323530 .320348 .317209 .314110
4 .239027 .235490 .232012 .228591
5 .188355 .184627 .180975 .117396
         
6 .154597 .150762 .147017 .143363
7 .130506 .126610 .122820 .119135
8 .112456 .108528 .104772 .101036
9 .098434 .094493 .090690 .087022
10 .087231 .083291 .079505 .075868
         
15 .053767 .049941 .046342 .042963
20 .037216 .033582 .030243 .027185
25 .027428 .024012 .020952 .018277
30 .021019 .017830 .015051 .012649
35 .016539 .013577 .011072 .008974
40 .013262 .010523 .008278 .006442
45 .010785 .008262 .006262 .004701
50 .008866 .006550 .004777 .003444

Example:

C acquires a 5 years' lease for $40,000. It is decided to provide for the renewal of lease immediately after 5 years by setting up a depreciation fund. It is expected that investment will fetch interest at 5% p.a. Sinking fund table shows that $0.180975 invested each year will produce $1 at the end of 5 years at 5% p.a.

At the expiry of the lease, the depreciation fund investments are sold for $31,205 and immediately thereafter the lease is renewed for a further period of 5 years by a payment of $44,000.

Required: Make journal entries.

Solution:

Annual depreciation = 40,000 .180975

Journal Entries

1st Year        
Jan. 1 Lease Account Dr. 40,000  
       Bank Account     40,000
  (Being lease purchased for 5 years)      
 
     
Dec. 31 Profit and loss Account Dr. 7,239  
       Depreciation fund Account     7,239
  (Being annual depreciation charged)      
 
     
Dec. 31 Depreciation fund investment Account Dr. 7,239  
       Bank Account     7,239
  (Being amount of depreciation fund invested)      
 
     
2nd Year        
Dec. 31 Bank Account Dr. 362  
       Depreciation fund Account     362
  (Being interest received on depreciation fund investments)      
 
     
Dec. 31 Profit and loss Account Dr. 7,239  
       Depreciation fund Account     7,239
  (Being annual depreciation charged)      
 
     
Dec. 31 Depreciation fund investment Account Dr. 7,601  
       Bank Account     7,601
  (Being investment purchased)      
 
     
3rd Year        
Dec. 31 Bank Account Dr. 742  
       Depreciation fund Account     742
  (Being interest received on depreciation fund investments)      
 
     
Dec. 31 Profit and loss Account Dr. 7,239  
       Depreciation fund Account     7,239
  (Being annual depreciation charged)      
 
     
Dec. 31 Depreciation fund investment Account Dr. 7,981  
       Bank Account     7,981
  (Being investment purchased)      
 
     
4th Year        
Dec. 31 Bank Account Dr. 1,141  
       Depreciation fund Account     1,141
  (Being interest received on depreciation fund investments)      
 
     
Dec. 31 Profit and loss Account Dr. 7,239  
       Depreciation fund Account     7,239
  (Being annual depreciation charged)      
 
     
Dec. 31 Depreciation fund investment Account Dr. 8,380  
       Bank Account     8,380
  (Being investment purchased)      
 
     
5th Year        
Dec. 31 Bank Account Dr. 1,560  
       Depreciation fund Account     1,560
  (Being interest received on depreciation fund investments)      
 
     
Dec. 31 Profit and loss Account Dr. 7,239  
       Depreciation fund Account     7,239
  (Being annual depreciation charged)      
 
     
Dec. 31 Bank Account Dr. 31,205  
       Depreciation fund investment Account     31,205
  (Being depreciation fund investments sold)      
 
     
Dec. 31 Depreciation fund investment Account Dr. 4  
       Depreciation fund Account     4
  (Being the profit on the sale of investment transferred to depreciation fund account)      
 
     
Dec. 31 Depreciation fund Account Dr. 40,004  
       Lease Account     40,004
       Profit and loss Account      
  (Depreciation fund account transferred to lease account)      
 
     
Dec. 31 Lease Account Dr. 44,000  
       Bank Account     44,000
  (Being new lease purchased for 5 years)      
         

Relationship Between Annuity Method and Depreciation Fund Method:

There is very close relationship between annuity method and depreciation fund method. Under both the method:

  1. Compound interest is taken into account.

  2. Provision is made for the replacement of asset.

  3. There are equal annual charges to revenue.

Shortcomings of Depreciation Fund Method:

Depreciation fund method assumes a constant rate of return on investments in identical securities. This is hardly true, because rates of interest do vary every now and then. Variation of rate upsets the earlier periodic allocation of depreciation and entails recitation. Further the amount realized on sale of security rarely agrees with its acquisition cost due to market fluctuations. This method cannot be used where any additions are made to an asset during the year.

 

More study material from this topic:

Definition, explanation and causes of depreciation
Depreciation is not a matter of valuation but a means of cost allocation
Activity method of depreciation
Straight line method of depreciation
Sum of the years' digits method of depreciation
Reducing balance method
Annuity method
Depreciation fund method or sinking fund method
Insurance policy method
Revaluation method
Depletion method
Machine hour rate, mileage, and global method
Methods of recording depreciation
Reserves
Difference between general reserve and specific reserve
Difference between capital reserve and general reserve
Difference between reserve and reserve fund
Difference between provision and reserve

 

 
 

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Financial Accounting Topics


  Introduction to Accounting
 ----------------------------------------------------------------------------
  Transactions and Accounting Equation
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  Analysis of Business Transactions
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  Journal, Ledger and Trial Balance
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  Accounting for Bills of Exchange
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  Special Journals
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  Cash Book
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Bank Reconciliation Statement
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  Final Accounts
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  Work Sheet
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  Capital and Revenue Items
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  Valuation of Inventories
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  Accounts of Non-profit Making Organizations
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  Statement of Cash Flows
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  Accounting Ratios Analysis
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  Depreciation, Provisions and Reserves
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  Accounting Dictionary
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  Financial Calculators
 
 
 
Managerial Accounting Topics

  Financial Statements
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  Cost Volume Profit Relationship
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  Variable Costing System
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  Materials and Inventory Cost Control
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  Activity Based Costing System
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  Standard Costing and Variance Analysis
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  Balanced Scorecard
----------------------------------------------------------------------------
  Capital Investment Analysis/Capital Budgeting
 
 

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