A sinking fund is fund which is created for a specific purpose. The sinking fund is created for following purposes:-
- To redeem or repay long term liabilities. For example:- debentures, long term loans etc.
- To replace a wasting assets. For example:- mines etc.
- To replace an assets of depreciable nature. For example fixed assets.
REDEMPTION OF DEBENTURES OR OTHER LONG TERM LIABILITIES
For redemption of debentures or other long term liabilities, a fixed amount is kept aside yearly as sinking fund for the specific purpose and the same amount is invested in securities etc. for a specific period so that the sufficient amount is available at the time of redemption of long term liabilities. The amount kept aside should not be debited to Profit and loss account but to Profit and loss appropriation account because the same is a allocation of profit not an expenditure.
SINKING FUND CREATED FOR WASTING ASSETS
In respect of the sinking fund created for wasting assets, the amount kept aside for sinking fund, should be debited to profit and loss account not to profit and loss appropriation account because it is the charge against profit not an allocation of profit. The amount kept aside for sinking funds for wasting assets, should be invested in liquid assets so that the money is available whenever it is needed.
SINKING FUND FOR DEPRECIABLE ASSETS
In case of depreciable assets, the amount kept aside for sinking fund should be debited to profit and loss account not to profit and loss appropriation account because it is the expenditure which should be debited every year. Sinking fund in this case is also known as Depreciation fund.
When the investment is made of money for sinking fund purpose, the investment is called as Sinking Fund Investment Account.
The difference between a Sinking fund and a Reserve Fund
- 1. Sinking fund is created for a specific purpose the reserve fund is usually created for general purpose.
- 2. General fund is created to strengthen the financial position of company but the sinking fund is created to repay a known liability.
- 3. General funds can be utilized for any purpose but the sinking fund can be utilized only for the purposes for which it is created.
When liabilities are redeemed out of the sinking fund and if there is any balance lying in sinking fund account, that will be transferred in general reserve account.
Sinking fund account is shown in liabilities side of balance sheet.