Depreciation Fund Method or Sinking Fund Method of Depreciation:
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.
The following entries are necessary to record the depreciation and replacement of an asset by this method.
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.
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.
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.
Depreciation Fund Account
Depreciation Fund Account
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:
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.
You may also be interested in other articles from “accounting for depreciation” chapter:
Other Related Accounting Articles:
- Fixed Installment Method or Straight Line Method or Original Cost Method of Depreciation
- Diminishing Balance Method of Depreciation
- Sum of the Years’ Digits Method of Depreciation
- Accounting For Depreciation
- Basic Factors of Determination of Depreciation
- Need for Depreciation
- Depreciation Accounting – General Questions and Answers
- Difference Between Depreciation and Fluctuation
- Depletion Method of Depreciation
- Depreciation Methods
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