Why sinking fund for depreciation is created

A sinking fund is established so the company can contribute to the fund in the years leading up to the bond 's maturity. A sinking fund helps companies that have floated debt in the form bonds gradually save money and avoid a large lump-sum payment at maturity.

Some bonds are issued with the attachment of a sinking fund feature. The prospectus for a bond of this type will identify the dates that the issuer has the option to redeem the bond early using the sinking fund. While the sinking fund helps companies ensure they have enough funds set aside to pay off their debt, in some cases, they may also use the funds to repurchase preferred shares or outstanding bonds. A sinking fund adds an element of safety to a corporate bond issue for investors.

Since there will be funds set aside to pay off the bonds at maturity, there's less likelihood of default on the money owed at maturity. In other words, the amount owed at maturity is substantially less if a sinking fund is established. As a result, a sinking fund helps investors have some protection in the event of the company's bankruptcy or default.

A sinking fund also helps a company allay concerns of default risk, and as a result, attract more investors for their bond issuance. Since a sinking fund adds an element of security and lowers default risk, the interest rates on the bonds are usually lower. As a result, the company is usually seen as creditworthy, which can lead to positive credit ratings for its debt. Good credit ratings increase the demand for a company's bonds from investors, which is particularly helpful if a company needs to issue additional debt or bonds in the future.

Lower debt-servicing costs due to lower interest rates can improve cash flow and profitability over the years. If the company is performing well, investors are more likely to invest in their bonds leading to increased demand and the likelihood the company could raise additional capital if needed.

If the bonds issued are callable , it means the company can retire or pay off a portion of the bonds early using the sinking fund when it makes financial sense. The bonds are embedded with a call option giving the issuer the right to "call" or buy back the bonds. The prospectus of the bond issue can provide details of the callable feature including the timing in which the bonds can be called, specific price levels, as well as the number of bonds that are callable.

Typically, only a portion of the bonds issued are callable, and the callable bonds are chosen by random using their serial numbers. A callable is typically called at an amount slightly above par value and those called earlier have a higher call value. If interest rates decline after the bond's issue, the company can issue new debt at a lower interest rate than the callable bond. The company uses the proceeds from the second issue to pay off the callable bonds by exercising the call feature.

As a result, the company has refinanced its debt by paying off the higher-yielding callable bonds with the newly-issued debt at a lower interest rate. Also, if interest rates decrease, which would result in higher bond prices, the face value of the bonds would be lower than current market prices.

In this case, the bonds could be called by the company who redeems the bonds from investors at face value. The investors would lose some of their interest payments, resulting in less long-term income. Sinking funds may be used to buy back preferred stock. Preferred stock usually pays a more attractive dividend than common equity shares. In most situations, sinking funds invest in assets backed by the government, such as Treasury notes, bills, and bonds.

Investments which suit the length of the life of the asset are typically used, but it is possible to recycle short-term investments. The investment amounts are determined by the depreciation schedule of the asset. The sinking fund method is mainly used by large-scale industries, such as utility companies, that require expensive, long-term assets to function. Products IT. About us Help Center. Log In Where do you want to login? Sign Up.

Income Tax Filing. Expert Assisted Services. The asset is shown at its cost value in the balance sheet while the depreciation accumulated separately on the depreciation fund is placed on the liabilities side of the balance sheet.

It makes provision for the replacement of the asset at the end of its working life while such a feature is conspicuous by its absence in other methods. The main disadvantage of the sinking fund method is that as depreciation on the amount remains fixed throughout the life of the asset, it has a tendency to place an equal burden on the profit and loss account.

The result is that the profit and loss account is let off lightly in earlier years and is heavily burdened in later years.