Depreciation expense is used in accounting to allocate the cost of a tangible asset over its useful life. In other words, it is the reduction in the value of an asset that occurs over time due to usage, wear and tear, or obsolescence. The four main depreciation methods mentioned above are explained in detail below.
sinking fund method depreciation pdf download
Straight-line depreciation is a very common, and the simplest, method of calculating depreciation expense. In straight-line depreciation, the expense amount is the same every year over the useful life of the asset.
In the sum-of-the-years digits depreciation method, the remaining life of an asset is divided by the sum of the years and then multiplied by the depreciating base to determine the depreciation expense.
Below is a short video tutorial that goes through the four types of depreciation outlined in this guide. While the straight-line method is the most common, there are also many cases where accelerated methods are preferable, or where the method should be tied to usage, such as units of production.
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.
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/-.
A sinking fund, also known as an annual sinking fund, is characterized by its name. It is fundamentally designed to sink. A sinking fund compares closely to a reserve fund, although, the primary difference between the two is found in their purpose. Sinking funds have a specific purpose, whereas reserve funds generally do not have particular purposes. A reserve fund is simply a savings mechanism that a company has where it deposits excess money. Reserve funds can serve a multitude of purposes. They can be used to finance business expansions, capital expenditures, asset purchases, emergency expenditures, and a wide range of other expenses.
A sinking fund, on the other hand, has a very specific focus. It is commonly formed to repay debt. This type of fund is a vehicle where a company would deposit sums of money to pay for liabilities like buying back bonds. Two fundamental aspects of a sinking fund are the borrower and the principal. The borrower is the entity that would create the sinking fund to repay money that is borrowed from a lender. The principal refers to the amount that was borrowed. This, along with the interest amount, must be paid back to the lender. A sinking fund is a way to pay down a principal amount that an entity owes before the principal payment date occurs. It is like prepaying the principal amount. In the final year of the loan agreement, the borrower is responsible for repaying the principal and interest of the bond. Sinking funds have a number of characteristics relating to their duration, liability reduction, and management:
With further regard to the management of sinking funds, it is possible to consider it as being actively managed. Despite the mentioned reasons why it does not invest in other assets, the extremely vast scope of the financial market certainly holds beneficial possibilities. Though investments into assets like long-term debt and real estate are certainly not viable considering how illiquid they are, the money market offers a selection of short-term, risk-averse investment options. Assets like government bonds, Treasury bills, and high-yield savings accounts are widely recognized as high-quality investments that are very liquid.
The sinking fund formula is used to determine how much money must be put into the fund in order to meet the financial obligation that the fund was created for. The elements that factor into the formula are combined to create an equation. These elements simply include the principal amount and the interest rate:
John lends $1 million to Steve at a 10 percent interest rate. Ten percent of $1 million equates to $100,000. Adding $1 million and $100,000 results in a total of $1.1 million. This is the amount of money that the sinking fund needs to have by the time that the loan matures.
Tesla looks to finance a $1 billion expansion plan. To raise this money, it sells a $1 billion corporate bond on the open market. This bond has a 10% interest rate and is set to mature in 20 years, which means Tesla will be repaying $1.1 billion in 20 years to buy back the bond. To finance this loan agreement, the company forms a sinking fund in which it will aim to deposit at least $55 million every year. After 20 years, the fund would amount to $1.1 billion when it would then be dissolved to meet Tesla's financial obligation.
A sinking fund is a way to pay down a principal borrowed amount that an entity owes before the principal payment date occurs. A fund like this is typically formed 3-4 years before the maturity date of the loan agreement. Sinking funds are essentially used for prepaying a principal amount. In the final year of a loan agreement, the borrower is responsible for repaying the principal and interest of the bond. The main benefit of using a sinking fund is that it is easier to make many small payments instead of one large payment. The sinking fund formula is used to determine how much money the fund should raise to meet the set financial obligation. The formula relates to calculating the final owed amount, which includes interest.
First, multiply the percentage interest by the principal amount. This will equate to the interest amount, which is then added to the principal amount. This total is the amount of money that needs to be in the sinking fund to meet the set financial obligation. 2ff7e9595c
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