What it means
Ordinary depreciation spreads an asset's cost across accounting periods without setting aside any cash. The sinking fund method goes further: an amount equal to the annual charge is invested outside the business, typically in secure government-backed securities, and the interest earned is reinvested in the fund.
The annual charge is not a simple straight-line slice but the level deposit that accumulates to the required amount at the fund's assumed rate of return. Because each deposit earns interest, later years carry larger total credits to the fund as the interest compounds on earlier deposits.
The arithmetic comes from the future value of a level annuity. The deposit equals the amount to be accumulated multiplied by the sinking fund factor, i divided by ((1 + i)^n - 1), where i is the assumed fund return and n the asset's life in years.
Published sinking fund tables give the same factors. The appeal is funding discipline: when the asset wears out, the business sells the investments and buys the replacement without raiding working capital or borrowing.
Utilities and other industries with costly long-lived assets historically fitted that pattern. The drawbacks explain its rarity, since each asset needs its own fund and schedule, replacement costs can drift away from the original estimate, and an unpredictable interest rate makes the deposit math unreliable.
When rates cannot reasonably be predicted, the method is generally undesirable. It should not be confused with the sinking fund behind a sinkable bond.
The bond version retires debt on a schedule; this version funds the replacement of a physical asset through matched investing. The shared name reflects the shared idea of accumulating toward a known future obligation.
The fund and its investments appear alongside the asset at original cost until replacement, so readers can see the provision building up rather than hidden in retained earnings. Companies weighing the method should compare it with simpler depreciation patterns and with simply reserving cash informally, because the accounting benefit is real only if the fund is actually maintained and auditors will expect the investments to exist.
In practice
Real-world examples.
Example
A fictional utility must replace a $100,000 machine in five years. With the fund earning 4%, the annual charge is about $18,463, which compounds to the full replacement cost. The investments sit outside the operating business until the machine is replaced.
Example
A fictional firm records depreciation but never buys the investments. In year five there is an expense history but no cash, which is the sinking fund method in name only. Auditors would expect to see the fund investments, so this firm has a reporting problem as well as a cash problem.
Example
A fictional manufacturer compares methods. Straight-line is simpler, so it reserves cash informally for replacement instead of running a formal fund per asset. The finance director notes that it gives up the matched-investing discipline but saves administration.
Formula
Calculation
Annual deposit = amount to accumulate x i / ((1 + i)^n - 1). For $100,000 over 5 years at 4%, the factor is 0.04 / (1.04^5 - 1), about 0.18463, so the deposit is about $18,463 per year.
Check: $18,463 deposited at the end of each year at 4% grows to about $100,000 after five deposits. The year-end balances are roughly $18,463, $37,665, $57,634, $78,402 and $100,002, with the small excess due to rounding. Total deposits are 5 x $18,463 = $92,315, so interest of about $7,685 makes up the rest of the $100,000. Figures are fictional and simplified; tables and the exact timing convention control real calculations.Case study
Seen in the real world.
This case study is fictional and illustrative. A water utility adopts the sinking fund method for a treatment plant component with a ten-year life, investing each charge in government securities. Midway through, interest rates fall and the fund's return drops below the assumed rate. The accumulated balance now trails the schedule, and the replacement quote has also risen with inflation.
The utility increases its annual charge and documents a new rate assumption. The method still works, but the episode shows why unpredictable rates and drifting replacement costs make it uncommon. The board asks for an annual report that compares the fund balance with the schedule and updates the replacement estimate. The utility and its figures are invented for illustration.
Watch out
Common mistakes.
- Recording the depreciation charge without actually investing the matching amount.
- Assuming the annual charge is a straight-line slice; it is a level annuity deposit set by the fund factor.
- Confusing this asset-replacement method with the bond redemption sinking fund of a sinkable bond.
Questions
People also ask.
What is invested under the sinking fund method?
An amount equal to the annual depreciation charge, usually in secure government-backed securities, with interest reinvested in the fund.
Why is the method rarely used?
It is complex, needs a separate fund per asset, and breaks down when interest rates or replacement costs are unpredictable. Simpler methods are usually preferred.
Does the fund always equal the replacement cost?
Only if deposits and the assumed return hold. Rate shortfalls or cost inflation leave a gap that must be topped up.
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