Depreciation Fund Method or Sinking Fund Method of Depreciation

12/08/2008 21:05

 

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.

(a). First year (at the end)
  (1). Debit profit and loss account and credit depreciation fund account with the amount of the annual depreciation charge.
  (2). Also debit depreciation fund investment account and credit cash account with an equal amount.
(b).

In subsequent years.

  (1). Debit depreciation fund investment account and credit depreciation fund account with the amount of interest earned and reinvested.
  (2). Debit profit and loss account and credit depreciation fund account with the annual depreciation installment.
  (3). Debit depreciation fund investment account and credit cash account with an equal amount.
(c).

On replacement of asset.

  (1). Debit cash account and credit depreciation fund investment account with the amount realized by the sale of investment.
  (2). Transfer any profit or loss on sale of investment to profit and loss account.
  (3). Debit the new asset purchased and credit cash account.
  (4). Debit depreciation fund account and credit the account of the old asset which has become useless.

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.

Years 3% 3.5% 4% 4.5% 5%
3 0.323540 0.321934 0.320349 0.318773 0.317208
4 0.239027 0.237251 0.235490 0.233741 0.232012
5 0.188350 0.186481 0.184627 0.182792 0.180975
6 0.154598 0.152668 0.150762 0.148878 0.147017
7 0.130506 0.128544 0.126610 0.124701 0.122820
8 0.112446 0.110477 0.108528 0.106610 0.104722

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

1990     1990    
Jan.1 To Cash 20,000 Dec. 31 By Depreciation fund 20,000
           

Depreciation Fund Account

1990     1990    
Dec. 31 To Balance c/d 4,709.80 Dec. 31 By P & L account 4,709.80
   
   
1991     1991    
Dec. 31 To Balance c/d 9607.99 Jan. 1 By Balance c/d 4709.80
      Dec. 31 By Depreciation fund investment 188.39
      " By P&L account 4709.80
   
   
    9607.99     9607.99
   
   
1992     1992    
Dec. 31 To Balance c/d 14702.11 Jan. 1 By Balance b/d 9607.99
      Dec. 31 By Depreciation fund investment 384.32
      " By P & L account 4709.80
   
   
    14702.11     14702.11
   
   
1993     1993    
Dec. 31 To Lease account 20,000 Jan. 1 By Balance b/d 14702.11
      Dec. 31 By Depreciation fund investment 588.9
        By P & L 4,709.80
   
   
    20,000     20,000
   
   

Depreciation Fund Account

1990     1990    
Dec. 31 To Cash 4709.80 Dec. 31 By Balance c/d 4709.80
   
   
1991     1991    
Jan. 1 To Balance b/d 4709.80 Dec. 31 By Balance c/d 9,607.99
Dec. 31 To Depreciation fund 188.39      
Dec. 31 To Cash 4,709.80      
   
   
    9,607.99     9,607.99
   
   
1992     1992    
Jan. 1 To Balance b/d 9,607.99 Dec. 31 By Balance c/d 14,702.11
Dec. 31 To Depreciation fund 384.32      
Dec. 31 To Cash 4709.80      
   
   
1993     1993    
Jan. 1   14,702.11 Dec. 31 By Cash 20,000.00
Dec. 31   588.9      
Dec. 31   4709.80      
   
   
    20,000     20,000
   
   
           

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.