• Thu. Apr 25th, 2024

A Primer on Sinking Funds

ByClare Louise

May 21, 2023
A Primer on Sinking Funds

The practise of “sinking funds,” or putting money aside throughout the year to cover a certain expense, is not exactly novel. The reality is that this is something that the vast majority of us do on a daily basis. So, the big question: what are sinking funds, exactly? Can money that is earmarked for a sinking fund be considered an operating asset? Our comprehensive guide to sinking funds in accounting will help you answer these and many more questions.

However, what precisely are “sinking funds?”

The word “sinking funds” refers to money that has been set aside to repay a bond or an obligation. In practise, the account holder will regularly deposit a set amount of money into the sinking fund to cover the debt connected to the account. Companies typically employ sinking funds to repurchase bonds (or bond portions) issued in the past before their maturity date. A loan arrangement that includes a sinking fund clause eliminates the risk of default because principal and interest payments will always be covered.

What are the advantages of employing sinking money in accounting?

There are many benefits linked with using sinking money. To begin, they can help make your business more appealing to potential investors. Potential investors’ concerns can be allayed by the inclusion of sinking fund arrangements. This is because having a lot of debt can send the wrong message to investors, but sinking fund provisions alleviate this concern. Financial security can also be preserved with the help of the sinking fund concept in accounting. They guarantee that you will have the funds to meet your financial commitments and to repurchase bonds, so improving your creditworthiness and increasing the possibility that you will be offered more preferential interest rates.

Can money that is earmarked for a sinking fund be considered an operating asset?

Even though sinking funds are shown as an asset on your balance sheets, they are not considered current assets (assets that are expected to be converted to cash within one year) because your business cannot use them as a source of working capital. Assets that can be easily turned into cold hard cash within a year are called “current assets.”

What’s the main difference between an emergency fund, a reserve account, and a sinking fund?

Although sinking funds may seem similar to reserve accounts and emergency funds, there are significant differences between the three that you should be aware of. Remember that sinking funds in accounting exist solely for the purpose of retiring a bond or other form of debt. Reserve accounts, on the other hand, include money that has been saved for a number of reasons, such as the acquisition of permanent assets or the settlement of unforeseen expenses. Although the purpose of both sinking funds and emergency funds is to ensure that your business can continue operating in the event of a disaster, the two funds serve different purposes.

Traditionally, businesses have used a “sinking fund” to put money away on a regular basis in order to retire a bond or repay a debt. If the company establishes a sinking fund, it will have a smaller out-of-pocket payment when the loan matures. However, the same method can be used by people to put money aside for unforeseen costs or large purchases without resorting to utilising credit or draining an emergency fund. Individuals, not just businesses, can benefit from the time-tested saving method of sinking funds.