SINKING FUND METHOD OF DEPRECIATION — MEANING, ADVANTAGES AND DISADVANTAGES

The sinking fund method of depreciation is a depreciation method whereby funds are accumulated for replacement purposes.

With this form of depreciation, a business can depreciate an item while also saving up money to replace it later.

In a sinking fund depreciation, a fixed amount of money is debited annually to the depreciation account and credited to the depreciation fund account.

The asset is, however, shown each year at its original cost rather than its net book value in the books of account.

The amounts credited to the depreciation fund account are usually invested in the short-term securities and investments, which can be easily converted to cash should the need arises.

At the end of the asset's useful year, the securities purchased with the sinking fund are then sold so that the asset can be replaced without affecting the financial position of the business.

Sinking fund depreciation is mostly used when we want to depreciate an asset while also providing funds for the replacement of the asset at the end of its useful life.

It should be noted that sinking fund depreciation is also called depreciated fund depreciation

Advantages of sinking fund depreciation

1. Replacement funds are made available:  One benefit of sinking fund depreciation is the availability of asset's replacement money

When using the sinking fund method of depreciation, a specific amount of money is set aside to be used for the asset's replacement after it has fully depreciated.

2. Reduced pressure on working capital: Sinking fund depreciation lessens the strain on working capital because the money is invested outside the company, negating the need to withdraw funds for replacement at the end of an asset's useful life.

READ ALSO: DOUBLE DECLINING METHOD OF DEPRECIATION

Disadvantages of sinking fund depreciation

1. Difficult to calculate: Sinking fund depreciation is very difficult to calculate as it requires serious and rigorous calculation.

2. Price changes are not considered: Sinking fund method of depreciation is based on the principle of historical cost.

It assumes that the number of available funds will not exceed the historical cost of the asset.

This assumption is very doubtful in the sense that price fluctuation may prevent available funds from effort effectively replacing the asset.

3. Risk factor: There is always risk associated with the realization of invested depreciation fund.

If the market price of the investment made with the depreciated funds falls, then the amount realized may be lesser than the asset's cost, which would result in a loss for the company.

4. Difficulty in getting a good investment: The company may find it difficult to find a viable investment which provides the desired rate of return.

As a result of this, the company may settle for an investment that provides less than the desired rate of return, resulting in a loss.

5. Depreciation does not correspond to service-generating: Under sinking fund depreciation, the depreciation is more or less fixed.

Since it is generally believed that assets are more effective in their early years than in the later years, the depreciation charged to the sinking fund does not relate to the assets' ability to provide services

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