Sinking Fund Method

Sinking Fund or Debenture Redemption Fund of an equal amount is created out of profits every year. The amount to be credited to sinking fund is calculated with the help of Sinking Fund Table. This fund is invested out-side the business in securities every year.

The amount invested in securities is debited to ‘Sinking Fund Investment, or Debenture Redemption Fund Investment Account. The amount invested in securities is allowed to accumulate with compound interest. The face value and market price of securities may differ. But the interest is always calculated on the face value of securities.

The ideal method is to set aside every year a certain sum of money by creating a Sinking Fund or Debenture Redemption Fund. The provision is made out of Profit and Loss Appropriation Account and the fund so appropriation are invested outside the business in earmarked securities.

The Sinking Fund may also be of two types:

(1) Cumulative Sinking Fund where the amount received as interest on securities of Sinking Fund is also reinvested;

(2) Non-Cumulative Sinking Fund where the amount received as interest on securities is not reinvested but treated as revenue profit of the business.

Generally, the Sinking Fund is allowed to accumulate together with interest year by year. In this way, a portion of profits is utilised towards the Debenture Redemption Fund. At the end of a stipulated period, when the time for redemption of debentures comes, securities are realised and the sale proceeds are used to redeem debentures.

Until the debentures are paid off, the sinking fund appears in the liabilities side and the sinking fund investment on the assets side of the balance sheet. It should be remembered that while making investment in sinking fund the amount of interest received and the yearly sinking fund installment are invested together. In the last year no amount is invested rather the investments are sold and debentures amount is refunded.

Profit or loss on sale of investments is transferred to sinking fund. After the redemption of all debentures, balance left in sinking fund is transferred to general reserve but the portion of the profit on sale of sinking fund investment is preferably transferred to capital reserve. In case only a part of the debentures are redeemed, an amount equivalent to the face value of debentures redeemed will only be transferred to general reserve.

Accounting Entries:

The requisite entries in the books of company, relating to sinking fund will be as follows:

At the end of the first year

1. For creating sinking fund:

Profit and loss appropriation a/c Dr.

To Sinking fund a/c

(For the annual installment to be invested).

2. The amount appropriated is invested:

Sinking fund investment a/c Dr.

To Bank A/c

(For the actual amount invested).

At the end of all subsequent years:

1. When interest on debenture redemption fund is received:

Bank Dr.

To Interest on sinking fund investment a/c

(For the amount of interest received)

Note:

The important point to note here is that if securities are purchased from open market, the nominal value of investments purchased will normally be different from the amount paid. The investments are recorded in the books at the actual amount paid but the rate of interest on investments will be calculated with reference to the face value of investments.

2. For the transfer of interest on debenture redemption fund investments:

Interest on sinking fund investment Dr.

To Sinking fund a/c

(For the transfer of interest to sinking fund a/c)

3. When the annual installment is appropriated out of profits:

Profit and loss appropriation a/c Dr.

To Sinking fund a/c

(For the annual installments to be invested).

4. When the annual amount appropriated plus the interest received is invested in securities:

Sinking fund investment a/c Dr.

To Bank A/c

(For investment of annual installment and the interest received)

At the end of last year:

1. When interest is received:

Bank a/c Dr.

To Interest on sinking fund investment a/c

(Being interest received on investments)

2. When interest is transferred:

Interest on sinking fund investments a/c Dr.

To Sinking fund a/c

(Being interest transferred to sinking fund)

3. When annual installment is appropriated out of profits:

Profit and loss appropriation a/c Dr.

To Sinking fund a/c

(Being annual installment is charged)

Note:

The important point to note is that in the last year the entry for purchase of sinking fund investments is not to be recorded, because the debentures are due for redemption and company needs money for the same.

Thus, investments representing sinking fund should be disposed off for which following entry is recorded:

4. When Sinking fund investments are sold—at profit:

Bank a/c Dr. (with amount realised)

To Sinking fund investments a/c (with book value of investments sold)

To Sinking fund a/c (with amount of profit)

(Being investments sold at profit)

Or

If Sinking fund investments are sold at loss:

Bank a/c Dr. (with amount realised)

Sinking fund a/c Dr. (with amount of loss)

To Sinking fund investment a/c (with book value of investments sold)

(Being sinking fund investments sold at loss)

5. For transfer of loss on issue of debenture not yet written off:

Sinking Fund a/c Dr.

To Loss on Issue of Debenture A/c

6. When debentures are redeemed:

Debentures account Dr.

To Debenture-holders a/c

(Being debentures due for redemption)

Debenture-holders a/c Dr.

To Bank a/c

(Being debentures redeemed)

Note:

Sinking fund represents accumulated profits, set aside for the purpose of redemption of debentures. So after the debentures are redeemed the sinking fund account should be closed by transferring it to general reserve account:

7. When sinking fund account is transferred to general reserve:

Sinking fund a/c Dr.

To General Reserve A/c