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The concept behind sinking funds – putting money aside throughout the year to pay for an expense – isn’t rocket science. In fact, it’s something that most of us do every day. But what are sinking funds? Is a sinking fund a current asset? Find out the answer to these questions, and many more, with our comprehensive guide to sinking funds in accounting.
What are sinking funds?
Sinking funds are funds that are set aside to pay off a bond or debt. Essentially, the owner of the account will place a specific amount of money into the sinking fund regularly for the sole purpose of repaying debt. In many cases, sinking funds are used by businesses to repurchase issued bonds (or parts of bonds) before their maturity date arrives. Bottom line: sinking fund provisions ensure that you won’t be at risk of defaulting on your debts, as you’ll always have enough money to make the repayment.
What are the advantages of sinking funds in accounting?
There are many benefits associated with sinking funds. Firstly, they can help make your business a more attractive prospect for investors. Although large debts can be a red flag for companies attempting to attract financing, sinking fund provisions provide a certain security level, which can help soothe the fears of potential investors. Furthermore, sinking funds in accounting can help to stabilise your finances. Put simply, they secure your ability to repay debts and buy back bonds, which increases your credit standing and raises the possibility of lower interest rates.
Is a sinking fund a current asset?
Although sinking funds are listed on your balance sheets as an asset, they aren’t considered to be a current asset (assets that are expected to be converted to cash within a year) because your business cannot use them as a source of working capital.
Sinking funds vs. reserve accounts vs. emergency funds: what’s the difference?
Although sinking funds may sound similar to reserve accounts and emergency funds, there are several fundamental differences that you should pay attention to. Most importantly, sinking funds in accounting are intended for a specific purpose: paying off a bond or debt. In contrast, reserve accounts are profits that have been set aside for a range of different purposes, from purchasing fixed assets to paying unexpected expenses. While emergency funds have a specific purpose – providing your business with capital in the event of a crisis – their stated goal is different from the purpose of sinking funds.
Understanding the sinking fund formula
Now that you know more about sinking funds, it’s important to understand exactly how to calculate how much you’ll need to deposit into the fund on a regular basis. To do this, you can use the following sinking fund formula:
A = Targeted accumulated amount, i.e., the amount that your sinking fund needs to reach to meet its purpose
n = payment frequency, i.e., number of payments per year
t = number of years over which payment will be made
r = annual interest rate
To give you a better sense of how this complicated formula works in practice, let’s take a look at an example of a sinking fund provision. Imagine that Company A has decided to set up a sinking fund with a targeted accumulated amount of $2,000,000 over 12 years. Assuming an interest rate of 5% and quarterly payments, you can use the sinking fund formula to calculate the payment amount:
So, there you have it – 48 quarterly payments of $30,661.50 will accumulate to the $2,000,000 you need for your sinking fund.
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