Sinking Fund

Sinking funds are funds that are periodically accumulated by the company as reserve. Later the reserve fund is used for a specific purpose—repayment of debts or repurchase of bonds on maturity. As a result, companies are not burdened with paying a huge sum at once.

The sinking fund also improves a company’s credibility in front of investors. It is a strategic move—companies prepare for future lump sum payments and minimize investors’ risk.

A sinking fund is money kept aside every month, quarter, or year towards a specific purpose. The purpose could be the repayment of a debt, buying back of bonds, etc. It is also called a stockpile, nest egg, or stash. Most corporations use this provision for bonds. It is an added assurance that investors won’t lose money on these bonds.

Also, it reduces the company’s burden of disbursing a lumpsum amount at the time of maturity. The company is taking responsibility by creating a fund that reduces bond buyers’ credit risk. In such scenarios, companies can negotiate the interest rates as well. In addition, companies can add a call feature option to the bonds. As a result, the company can buy the bonds back at the price they want—even if there’s a factorial change in the market.

Also, money can be set apart for future capital purchases—machinery, real estate, or other fixed assets. Businesses apply the sinking fund method. On the one hand, they depreciate assets—on the other hand, they set aside an equivalent amount as a stockpile. The stockpile is used for replacing depleted assets in the future. Simply put, a stockpile or a stash is a strategy devised to deal with emergencies and huge expenses in the foreseeable future.

The four different types of sinking funds are as follows:

1. Callable Bonds: Such a fund is maintained for calling the bond issued by the company—at a fixed call price.
2. Specific Purpose Fund: Businesses set funds aside for a specific pre-determined purpose.
3. Regular Payment Fund: Many organizations separate a certain amount for settling up regular payments—to creditors, trustees, and other parties.
4. Buying Back Fund: Sinking funds are set aside to buy a bond back upon maturity—from the bondholders—either at the stockpile price or market price.

The formula for computing the amount of periodic contribution made for the sinking fund is as follows:

Here,

• The “money to accumulate” refers to the lump sum amount required on maturity.
• Interest is the annual rate of compound interest that the company receives on the collected money.
• Compound frequency is the number of times interest is paid in a given period.
• The period refers to the number of years the contribution was made.

Let us assume that P&R Ltd. issued 100 bonds, each costing $500. The bonds were issued at a 5% coupon rate—payable every year for the next ten years. At the end of this tenure, the company must repurchase the bonds at par value. Evidently, the company declares it as a sinking fund bond and plans to deposit a sum semi-annually for ten years. Find the stockpile contribution if the annual interest rate is 6% per annum.

Solution:

• Money to Accumulate = $500 × 100 = $50000
• Interest = 6% ÷ 2 = 3% or 0.03
• Compound Frequency = 2 times (semi-annually)
• Period = 10 years

Therefore, PQR Ltd.’s semi-annual contribution towards the stockpile is $1860.79. 

On a company’s balance sheet, stockpiles are represented as a long-term investment. This is because such a fund is not utilized within one accounting period but is maintained long-term. Till maturity, stockpiles are either invested in secured long-term schemes or deposited to separate bank accounts till maturity. Also, the interest accumulated from the investments is treated as revenue.

Depreciation is one of the main objectives behind creating a sinking fund. Assets are depreciated over their useful life, and simultaneously a stockpile is also accumulated. Later, this particular stockpile is used to buy new assets. Henceforth, the following accounting entries are formulated: