This method is known by different names such as Redemption Fund Method, Amortization Fund Method, Sinking Fund Method of Assets Depreciation.
It requires the depreciation on the asset to be provided through a depreciation or Sinking Fund brought into being by accumulating thereon the amount of depreciation at a flat rate charged to the profit and loss account every year investing the amount of depreciation annually allocated to the fund in outside securities bearing interest at a stipulated rate which is also credited to the fund and invested in securities and the process continuing year after year till the time for the replacement of the asset, when the securities are sold and amount realised for purchasing the new asset so that fund is sometimes called ‘Cumulative Depreciation or Sinking Fund’.
Merits and demerits of sinking fund method of assets depreciation
It makes provision for the replacement of the asset at the end of its working life while such a feature is conspicuous by its absence in other methods. The main disadvantage of the Sinking Fund Method is that as depreciation on amount remains fixed throughout the life of the asset, it has a tendency to place the equal burden on Profit and Loss Account and repairs put together with the result that profit and loss account is let off lightly in earlier years and is heavily burdened in latter years.
Application of Sinking Fund Method
The method is eminently suited for plant and machinery and many wasting assets which require replacement.
A company purchased a lease for $30,000 on 1st Jan. 2017. It is to be renewed at the end of three years. For this purpose, a sinking fund is established. The sinking fund investments will realise 5 %. Sinking Fund Table shows that $0.317208 must be invested each year to obtain $1 at the end of 3 years, the rate of interest being 5%.
On 1st December, 2019 the investments were realisd for $19,400. A new lease was purchased on the same date for $35,000. The balance at bank before realisation of investments was $20,000. Give entries in the books of the company.
The annual instalment required will be : 30,000 x 0.317208 or $9,516.24.
Lease and Sinking Fund Method