Sinking Fund Meaning
Sinking funds are funds designed to pay off debts that have been created and set up specifically for that purpose. A certain amount of money is set aside regularly in the account and is used only for that purpose. It is often used by corporations to deposit money for bonds and to buy back issued bonds or parts of bonds before maturity. Moreover, the fund helps convince investors that the issuer won’t default on payments.
An effective sinking fund is meant to make it easier to pay off debt and to prevent defaults by having a sufficient amount of money to pay off the debt. Despite the fact that most bonds take several years to mature, it is always more convenient and easier to be able to reduce the principal amount before the maturity date, therefore lowering credit risk.
Sinking funds are well known to many people since even school children understand how important it is to save money for something that they want to own or purchase. During the school year, a class that wants to go to the zoo at the end can create a sinking fund that will grow toward the end of the year and can be used to pay for the field trip.
Advantages of Sinking Fund
Some of the advantages of sinking fund are:
i. Attracts investors
Investors are very well aware of the potential risks associated with companies or organizations that have a large amount of debt. They will, however, see some level of protection once they are informed that there is a sinking fund in place so that in case of a default or bankruptcy, they can still get their investment back.
ii. Possible reductions in interest rates
Unless a company offers higher interest rates, it will be hard to attract investors with a poor credit rating. The sinking fund offers investors an alternative way to protect themselves while allowing companies to offer lower interest rates.
iii. Stable finances
Certain financial issues can shake a company’s stability, and its economic situation cannot always be expected to remain stable. A sinking fund, however, allows a company to repay its debts and buy back bonds without any difficulty. Investors will feel confident about the company’s credit standing.
iv. Tax and Capital gain benefits
For making interest payments to their creditors, companies can receive deductions from the Internal Revenue Service. The deduction of taxes improves the cash flow of businesses. A portion of annual sinking fund payments can be financed by tax savings. Additionally, sinking funds have the benefit of allowing companies to reap the benefits of capital gains.
Sinking Fund Method
In the sinking fund method, an asset is depreciated while enough money is generated to replace it at the end of its useful life. With the depreciation charges associated with an asset’s falling value, a matching amount is invested. This money is invested in a sinking fund account where it earns interest.
Assets are expensed by companies over time, not just during the period when they are purchased. As a consequence, depreciation involves spreading the cost of an asset across many different accounting periods, allowing companies to benefit from the asset without deducting the full cost from net income (NI). This method involves adding money each year to the asset-replacement fund based on the cost of replacing the asset, how long the asset is expected to last, what the return on investment is expected to be and the potential earnings from compound interest. Sinking funds typically invest in government-backed securities, such as Treasury notes, bills, and bonds. Long-term investments are typically used, but shorter-term investments can also be reinvested. Investment amounts are determined by the asset’s depreciation schedule.
Sinking fund methods are mostly used by large-scale industries such as utilities that require expensive, long-term investments. Furthermore, companies may also use the sinking fund method for depreciation of real estate assets. Depreciation for lease renewals is one of several scenarios that apply to real estate assets. In these situations, a depreciation schedule is developed based on the lease term and expected interest. This method is viewed as complex, since it requires the use of a separate replacement fund for each asset.
Furthermore, companies are aware that the cost of replacing older assets changes over time and that it is difficult to put enough cash aside when interest rates are unpredictable and consistently fluctuate. There are other reasons why sinking fund methods are not appropriate in addition to the extra complexity. For example, some companies prefer to invest capital in more promising areas.
Sinking Fund Formula
Sinking Fund can be calculated by using following formula:
Where
• A – Money accumulated
• P – Periodic contribution,
• r – Interest rate
• t – Number of years
• n – Number of payments per year
To put it another way, we can determine what is the Periodic Payment by:
Consolidated Sinking Fund
Consolidating Sinking Fund is a reserve fund which is mainly used for amortization of debt. Governments can use this as one of their buffers for servicing their liabilities. Through it, some financial discipline is insured. The RBI established the consolidated sinking fund in 1999-2000 to meet the redemption of market loans by the States.
In the beginning, 11 states – Andhra Pradesh, Arunachal Pradesh, Assam, Chhattisgarh, Goa, Maharashtra, Meghalaya, Mizoram, Tripura, Uttaranchal and West Bengal – created sinking funds. Subsequently, the 12th Finance Commission (2005-10) endorsed sinking funds for all states. Despite the state’s consolidated fund and the government’s public accounts, the fund should exist separately. Additionally, it should not be used for any other purpose other than the repayment of loans.
Sinking Fund Factors
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Sinking fund factors, also known as accumulation factors or capital recovery factors, calculate the periodic contributions that must be made to a sinking fund to accumulate a significant amount of money at a later date. The formula for the sinking fund factor is:
where: To determine how much money to contribute to achieving a certain goal, such as saving for a down payment on a house or accumulating a retirement fund, the sinking fund factor is often used in finance and investing. If you’re interested in investing in bonds, you can also use it to determine the periodic payments needed to retire a bond issue by its maturity date. |
Sinking Fund Quiz
Sinking fund factor is the reciprocal of mcqa) Present value interest factor of a single cash flow. Sinking fund account for redemption of debenture is shown underc) The balance of sinking fund account is transferred tod) For redemption of debentures sinking fund is created out ofe) Balance of sinking fund for redemption of debenture isf) Interest on sinking fund investment is credited tog) The calculation of sinking fund depends onh) Sinking fund account always shows which balancei) Interest on investment representing sinking fund should be credited toj) Sinking fund method of providing depreciation isk) A sinking fund is managed by a trustee for which one of the following purposes?l) The auditor can best verify a client’s bond sinking fund transactions and year-end balance bym) Sinking fund investments would be classified on the balance sheet as |
Call Provision – Multiple Choice Questions | Long Term Debt Financing
MBA,BBA.
I am Smirti Bam, an enthusiastic edu blogger with a passion for sharing insights into the dynamic world of business and management through this website.
I hold a MBA degree from Presidential Business School, Kathmandu, and a BBA degree with a specialization in Finance from Apex College,
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