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Sinking Fund Method

Accounting for Fixed Assets
And Depreciation

A sinking fund formed by the usual investment of a fixed amount to gather the amount of money required to replace an asset to set date in the future. This technique is based on idea of present values. The sinking fund method not only considers depreciation into account however also makes provision for replacement of the asset. Under this method, a fund is formed by giving debit to depreciation account and giving credit to Sinking Fund Account.

Depreciation account is finally shifted to Profit and Loss Account. An amount counterpart to depreciation charged is invested outside the business in giltedged or other securities and are allowed to gather at compound interest so as to create the requisite amount to reinstate the asset after a specified phase of time. The main benefit of this method is that it keeps away from strain on working capital, if considerable money is withdrawn from the business to reinstate the asset at the end of its life. However, during inflation, the depreciable cost of an asset is likely to be less than the replacement cost of the asset.

The asset is placed in the balance sheet each year at its actual value. Sinking fund is placed on the liabilities side and sinking fund investment is placed in the assets side of the balance sheet.. At the end of the useful life of the asset all investments are sold away. The profits are utilized for purchasing the new asset. The asset account is closed by setting it off against the sinking fund account. It must be noted that profit and loss on sale of investment is also shifted to the sinking fund account. The equal amount of cash to be invested every year is determined from the sinking fund table.

On 1st July 2009, A Ltd purchased a machine for $55,500 and spent $3,000 on its installation. The expected life of the machine is 4 years at the end of which the estimated scrap value will be $8,000. Aspiring to replace the machine on the expiry of its life, the company establishes a sinking fund. Investments are expected to realize 5% interest. On 30th June 2013, the machine was sold off as scrap for $9,000 and the investments were realized at 5% less than the book value. On 1st July 2013, a new machine is installed at a cost of $62,500. Sinking fund tables show that $0.2320 invested every year will make $1 at the end of 4 years at 5%. Show the required ledger accounts in the books of A Ltd for all the years.

Amount Required = $55,500 + 3,000 – 8,000 = $50,000; Therefore, Annual Contribution = $50,000 x 0.232 = $11,600.

An adjustment has been made in the depreciation charged in 2012-2013.

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