Sinking fund method of depreciation
/What is the Sinking Fund Method of Depreciation?
The sinking fund method of depreciation is used when an organization wants to set aside a sufficient amount of cash to pay for a replacement asset when the current asset reaches the end of its useful life. As depreciation is incurred, a matching amount of cash is invested, with the interest proceeds being deposited into an asset replacement fund. The interest deposited into this fund is also invested. By the time a replacement asset is needed, the funds needed to make the acquisition have accumulated in the associated fund.
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When to Use the Sinking Fund Method
This approach is most applicable in industries that have a large fixed asset base, so that they are constantly providing for future asset replacements in a highly organized manner. It is also most applicable to long-term, established industries where it is most likely that the same assets will need to be replaced, over and over again.
Disadvantages of the Sinking Fund Method
There are several disadvantages associated with the sinking fund method, which are as follows:
Multiple funds needed. The sinking fund method requires the use of a separate asset replacement fund for each asset, so it can result in an unusually complex amount of accounting. For this reason, it is usually only applied to a few of the most expensive assets.
Varying investment rates. Investment rates will vary over the life of the asset, so the amount accumulated in the fund will probably not match the asset's original cost. If it turns out to be lower than the replacement cost, then the business will need to find funding for the disparity.
Varying replacement cost. The replacement cost of the asset may have changed (up or down) over its life, so the funded amount may exceed or be short of the actual purchase requirement.