A fixed asset is generally acquired for use over a number of accounting periods. During its useful life, the asset is used in business operations and depreciation is charged to allocate its cost over the periods benefiting from its use. At the end of its useful life, the asset may have to be replaced by a new asset so that business operations can continue.
The charging of depreciation reduces accounting profit and allocates the cost of the existing asset over its useful life. However, depreciation itself does not involve a current cash outflow and does not automatically create a separate cash fund for purchasing a replacement asset. For this reason, a business may create a Sinking Fund for the replacement of a fixed asset.
Replacement of a Fixed Asset
Replacement of a fixed asset means substituting an old asset with a new asset when the existing asset reaches the end of its useful life or is no longer suitable for continued use.
A depreciable asset provides economic benefits to the business over its estimated useful life. As the asset is used, its cost is systematically allocated through depreciation. At the end of its useful life, the book value of the asset may be reduced to its estimated residual or salvage value.
The business may then dispose of the old asset and acquire a new asset for continued business operations. The purchase of the new asset requires cash. Therefore, the business may need to make financial arrangements during the useful life of the existing asset to ensure that funds are available when replacement becomes necessary.
Depreciation and Replacement of an Asset
Depreciation is a method of allocating the cost of an asset and not a direct source of cash. Depreciation expense is charged to the Profit and Loss Account and reduces accounting profit, but no cash is paid when depreciation is recorded.
For example, when depreciation is recorded, the entry may be:
Depreciation Expense A/c Dr.
To Accumulated Depreciation A/c
This entry records the depreciation expense and accumulated depreciation. However, it does not separately set aside cash for purchasing a new asset.
Therefore, the mere charging of depreciation does not guarantee that sufficient cash will be available for the replacement of the fixed asset. A business may create a separate fund for this purpose.
Meaning of Sinking Fund
A Sinking Fund is a fund created by setting aside amounts periodically for a specific future purpose, such as the replacement of a fixed asset.
Under the Sinking Fund approach, a business systematically sets aside an amount during the useful life of the asset. The purpose is to accumulate funds that can be used when the existing fixed asset requires replacement.
The fund is created over a period of time instead of arranging the entire replacement amount at the end of the asset’s useful life.
Thus, the creation of a Sinking Fund provides a systematic method of accumulating resources for the future replacement of a fixed asset.
Creation of Sinking Fund for Replacement
When a fixed asset is expected to require replacement after a specified period, the business may determine the amount that will be required for replacement.
An amount is then periodically set aside for the Sinking Fund. The process continues during the useful life of the asset so that funds accumulate over time.
The accumulated amount can ultimately be used for purchasing a new fixed asset when the existing asset reaches the end of its useful life.
Therefore, the Sinking Fund links the periodic setting aside of amounts with a specific future financial requirement.
Sinking Fund Method and Depreciation
Under the Sinking Fund approach, depreciation is associated with a systematic arrangement for accumulating funds for asset replacement.
An amount is periodically provided and amounts may be invested so that the fund grows over the useful life of the asset. The accumulated amount is intended to provide funds for replacing the asset at the end of its useful life.
The amount accumulated includes the periodic amounts set aside together with the return earned on the investments, where such investments are made.
The method therefore helps the business gradually build the financial resources required for replacement.
Investment of Sinking Fund Amount
Amounts set aside for the Sinking Fund may be invested periodically. The purpose of investment is to allow the fund to earn income and increase over time.
The income earned on the investment becomes part of the fund and contributes towards the amount required for replacing the fixed asset.
Thus, the required replacement amount is accumulated through the periodic amounts set aside and the income earned on their investment.
The investments are generally maintained for the specific purpose for which the Sinking Fund has been created.
Accounting Entries for Creation of Sinking Fund
When an amount is provided for depreciation or transferred for the creation of the Sinking Fund, the relevant expense or Profit and Loss Account is charged and the Sinking Fund or Depreciation Fund Account is credited.
The general entry may be shown as:
Profit and Loss A/c Dr.
To Sinking Fund A/c
This entry represents the amount set aside for the Sinking Fund.
When the amount is invested, the entry is:
Sinking Fund Investment A/c Dr.
To Bank/Cash A/c
This entry records the investment of the amount set aside for the replacement of the asset.
Interest or Income on Sinking Fund Investment
When income or interest is received on the Sinking Fund investments, the amount contributes to the growth of the fund.
The receipt of interest may be recorded as:
Bank/Cash A/c Dr.
To Interest on Sinking Fund Investment A/c
The interest or investment income is then transferred to the Sinking Fund:
Interest on Sinking Fund Investment A/c Dr.
To Sinking Fund A/c
The income earned on the investment therefore increases the balance of the Sinking Fund.
Investment of Annual Amount
The amount periodically set aside, together with the investment income where applicable, may be invested for the purpose of building the replacement fund.
The entry for investment is:
Sinking Fund Investment A/c Dr.
To Bank/Cash A/c
The investment process continues during the useful life of the fixed asset.
As a result, the Sinking Fund balance and the related investments gradually increase.
Sale of Sinking Fund Investments
When the fixed asset is due for replacement, the Sinking Fund investments may be sold to obtain cash.
The general entry for the sale of investments is:
Bank/Cash A/c Dr.
To Sinking Fund Investment A/c
If the amount received from the sale of investments differs from their recorded value, the resulting difference is adjusted in accordance with the Sinking Fund accounting treatment.
The cash realised from the investments becomes available for purchasing the replacement asset.
Purchase of New Fixed Asset
After the Sinking Fund investments are realised, the accumulated cash may be used to purchase a new fixed asset.
The accounting entry for the purchase of the new asset is:
New Fixed Asset A/c Dr.
To Bank/Cash A/c
The new asset is recorded at its cost and will subsequently be depreciated over its estimated useful life according to the appropriate depreciation method.
Importance of Sinking Fund for Asset Replacement
The creation of a Sinking Fund helps a business systematically accumulate funds for the replacement of a fixed asset.
Instead of arranging a large amount of cash at the time of replacement, the business sets aside amounts over the useful life of the existing asset.
The Sinking Fund also separates the funds intended for asset replacement from the general funds of the business. Where the amounts are invested, the income earned on investments contributes towards the required replacement amount.
Therefore, the Sinking Fund provides a planned financial arrangement for meeting the future cost of replacing a fixed asset.
Difference between Depreciation and Sinking Fund
Depreciation is the systematic allocation of the cost of a tangible asset over its useful life. It is an accounting expense and reduces the profit reported in the Income Statement.
A Sinking Fund is created to accumulate funds for a specified future purpose, such as the replacement of a fixed asset.
Depreciation is a non-cash expense and does not itself create a separate cash balance. In contrast, the Sinking Fund approach involves setting aside amounts and may involve investing those amounts to accumulate resources for future replacement.
Thus, depreciation deals mainly with the allocation of asset cost, while a Sinking Fund deals with the accumulation of funds for a future requirement.
Exam Focus
Replacement of a fixed asset means replacing an old asset with a new asset when the existing asset reaches the end of its useful life or is no longer suitable for continued use.
Depreciation is a non-cash expense and does not automatically create cash for replacement of the asset. Therefore, a business may create a Sinking Fund to systematically accumulate funds for the future replacement of a fixed asset.
Amounts set aside for the Sinking Fund may be invested, and the income earned on such investments contributes to the accumulation of the replacement fund.
The basic distinction is that depreciation allocates the cost of an asset over its useful life, whereas a Sinking Fund accumulates resources for a specific future purpose such as asset replacement.
At the time of replacement, Sinking Fund investments may be realised and the available cash may be used for purchasing the new fixed asset.