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Frequently Asked Questions about Sinking fund depreciation

What is a sinking fund?

A sinking fund is a fund established by an organization by regularly setting aside a certain amount of money to pay off debts or replace wasting assets.

It is a special fund set aside from the revenue of a company to repay a debt or replace a long-term asset.

In a sinking fund, the periodic payments and the interest earned are intended to produce a specific amount at some future time.

Sinking funds are usually used to pay the principal of a loan at some time in the future.

A sinking fund becomes an ordinary annuity if its periodic payments are all the same amount and are made at the end of a regular period

What is an ordinary annuity?

An ordinary annuity is a series of equal payments made at end of a regular period.

A sinking fund becomes an ordinary annuity if it meets two conditions: (i) if its periodic payment is made at equal and (ii) if its periodic payment is made at the end of a regular period.

If a sinking fund is set aside for the replacement of an asset, it becomes sinking fund depreciation.

What is sinking fund depreciation?

Sinking fund depreciation is a method of depreciation where a particular amount of money is periodically set aside for the replacement of long-lived assets.

Sinking fund depreciation works this way: A fixed amount of money is debited to the depreciation account and credited to the depreciation fund account on an annual basis

How do you calculate the sinking fund?

The accumulated sum of a sinking fund can be calculated as follows:

$$A=P\left[\frac{\left(1+\frac{i}{m}\right)^{n m}-1}{\frac{i}{m}}\right]$$

If we are looking to calculate the periodic contribution to a sinking fund, it is as follows: 

$$P=\frac{A}{\left(\frac{\left(1+\frac{i}{m}\right)^{n m}-1}{\frac{i}{m}}\right)}$$

Where A is the money to be accumulated.

P is the periodic contribution.

i is the interest rate.

m is several payments per year.

n is the number of years 

What is A in Sinking Fund formula?

In a sinking fund, A denotes the desired accumulated amount, which is the amount that a sinking fund must accumulate to meet its purposes

For example, if you intend to replace equipment worth €40,000, then A is equal to €40,000

What is P is sinking fund formula?

P in the sinking fund formula is the periodic contribution to the sinking fund.

It refers to the amount of each periodic payment made to the sinking fund

What is i in a sinking fund formula? 

In the sinking fund formula, i is the annual interest rate which is the rate of return which applies to a sinking fund for a year.

Some authors use r instead of I, to denote interest rates. They all mean the same thing

What is m in sinking fund?

In a sinking fund, m is the payment frequency, which is the number of contributions per year

It means how many times a periodic amount will be paid into a sinking fund each year

If the periodic contribution is to be made annually, then m will be 1.

If the periodic contribution is to be made semi-annually, then m is 2.

If the periodic contribution is to be made quarterly, then m is 4

What is n is sinking fund?

n in sinking fund is the number of years over which the entire sinking fund will be distributed.

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