Sinking Fund Method of Depreciation – Example

Sinking Fund Method:

The sinking Fund Method will provide us with an amount of depreciation as well as provide funds for the replacement of this asset when an asset needs replacement like the end of life of an asset. Under this method, we charged depreciation on the value of the asset but will not be credited to the asset account instead we will credit it to the sinking fund account. This account will be shown on the liabilities side of the Balance Sheet(Because it is a funds account) and an asset will be shown on the original value on the assets side of the Balance Sheet. At the end of each accounting year, the total amount of sinking fund credited in a year will be invested in the outside marketable security to provide cash for the replacement of an asset when needed.

It is also called the Depreciation fund account.

*Interest received on marketable security will be invested likewise. So we calculate the amount of depreciation in such a way the amount of compound interest will be a sum equal to the cost of the asset less scrap value by the time it becomes useless.

*So, this amount will be calculated with the help of the sinking fund table.

The formula of Calculation of Sinking Fund table value :

The following table shows the Sinking Fund value period wise. 

Journal Entries for Sinking Fund Method:

1st Year: 

1) Asset A/c                                 Dr     ________

To Bank A/c                                                 ________

(Being asset purchased )

2) Depreciation A/c                        Dr     ________

To Sinking Fund A/c                                 ________

(Being dep. charged for the year)

3) Profit/loss A/c                            Dr.    ________

To Depreciation A/c                              ________

(Being dep. of the year transferred to P/L A/c)

4) Sinking Fund Investment A/c    Dr.   ________

To Bank A/c                                         ________

(Being amount of Dep. Invested in SFI A/c)

Subsequent Years: –

1) Bank A/c                                    Dr.    ________

To Sinking fund A/c                 ________

(Being Interest on Sinking fund investment account received for the year)

2) Depreciation A/c                        Dr.  ________

To Sinking Fund A/c                             ________

(Being dep. charged for the year)

3) Profit/loss A/c                            Dr.  ________

To Depreciation A/c                             ________

(Being dep. of the year transferred to P/L A/c)

4) Sinking Fund Investment A/c    Dr.  ________

To Bank A/c                                          ________

(Being amount of Dep. plus interest on Sinking fund investment Invested in SFI A/c)

In the Last Year: –

1) Bank A/c                                    Dr.    ________

To Sinking fund A/c                 ________

(Being Interest on Sinking fund investment account received for the year)

2) Depreciation A/c                        Dr.  ________

To Sinking Fund A/c                             ________

(Being dep. charged for the year)

3) Profit/loss A/c                            Dr.  ________

To Depreciation A/c                             ________

(Being dep. of the year transferred to P/L A/c)

4) Sinking Fund Investment A/c    Dr.  ________

To Bank A/c

5) Bank A/c                                         Dr.  ________

To Sinking fund Investment a/c                ________

(Being invest sold at par means no profit no loss)

or 

5) Bank A/c                                         Dr.   ________

Sinking Fund A/c                                Dr.   ________

To Sinking fund Investment a/c                 ________

(Being invest sold at on loss)

or 

5) Bank A/c                                         Dr.  ________

To Sinking fund Investment a/c                ________

To Sinking Fund A/c                                  ________

(Being invest sold at on profit)

6) Sinking Fund A/c                              Dr.   ________

To Asset a/c                                            ________

(Being balance of asset account transferred to Sinking fund account)

7) Sinking Fund A/c                              Dr.   ________

To Profit/Loss a/c                                            ________

(Being balance of Sinking fund account transferred to Profit and loss account –  if profit)

Or

7) Profit/Loss A/c                              Dr.   ________

To Sinking Fund a/c                                            ________

(Being balance of Sinking fund account transferred to Profit and loss account –  if Loss)

Example of the sinking fund method of depreciation:

A and B Pvt. Ltd. purchase a machine on 01/04/2012 on lease for 4 years for Rs 10,00,000/-. It decided to provide cash for the replacement of the lease at the end of the 4th year by setting up a sinking fund. It is expected that investment will fetch interest @ 5%. The Sinking fund table shows that an annual payment of Re. 1 at 5% compound interest in 4 years is equal to 0.232012. Investment is made to the nearest rupee. At the end of the 4th year investment sold for Rs.7,50,000/-.

Solution :

Working Note: –

*(it will be shown at the end of the sum in the exam. We have written it here because this is the first step in solving sinking fund method-related questions.)

Calculate the amount of Depreciation or Investment.  

The total cost of an asset     X    value of rupee after four years @ 5% (we got this value from sinking fund table)

10,00,000 X 0.232012 = Rs 2,32,012  (this amount will be amount of depreciation and annual investment amount.)

Calculation of the amount of interest and the total amount of investment for each year-end.

Calculate Profit or Loss on Sinking Fund Investment:

Profit or Loss on SFI = Sale Price of SFI – Book value of SFI

The Journal entries under the Sinking Fund Method of Depreciation: –

Now, we will post all the journal entries year by year is shown as following according to the Sinking Fund Method of Depreciation:

First Year 2012-13

Second Year – 2013-14

 
Third Year – 2014-15

Fourth Year – 2015-16

The Asset account under the Sinking Fund Method of Depreciation: 

Now, we will post all these transactions in the ledger according to the Sinking Fund Method of Depreciation: –

 

 

 

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