Sinking Fund MethodA sinking fund, also known as depreciation fund is established for the purpose of accumulating sufficient funds to replace the asset at the end of its useful life. An amount equal to the annual depreciation of the asset is charged against the profits every year and accumulated in the form of depreciation fund.
An equivalent amount of cash is withdrawn from the business and invested outside the business in securities which are readily convertible into cash. The interest on depreciation fund investments is credited to Depreciation Fund A/c. At the time of replacement of the asset, the investments are realized and the available money is used in replacing the asset.
- This method not only provides depreciation on the asset, but also makes a provision for replacement of the asset
- The financial position of the business is not adversely affected at the time of replacement of the asset as an adequate amount can be realized by sinking fund investments
- Every year, same depreciation is charged, therefore correct profit is not found out
- If the market value of investments goes down, then adequate amount will not be available for the replacement of the asset
Suitability: This method can be used for buildings and leasehold lands.