Sinking Fund Method of Depreciation with Detailed Example

The sinking fund method of depreciation is a technique where businesses set aside a fixed annual amount and invest it to build a fund that will replace an asset at the end of its useful life. Unlike standard depreciation methods, which only reduce an asset's book value, it also ensures that future replacement costs are planned.

This approach is especially useful for high-value assets such as machinery, transport vehicles, ships and industrial equipment where replacement costs are high and predictable.

What is the sinking fund method of depreciation?

The sinking fund method is a depreciation technique in which a fixed amount is set aside every year and invested in interest-earning securities. These annual contributions are invested as they are made, and interest accrues from the first deposit to the fund.

The objective is not only to account for the decline in the asset’s value but also to ensure sufficient funds are available when the asset needs to be replaced. This method is often used for assets requiring substantial capital expenditure.

Linking depreciation to asset replacement planning makes it a practical tool for both accounting and financial management.

How the sinking fund method works and how to calculate it

In the sinking fund method, a fixed amount is deposited each year into a sinking fund to replace the asset at the end of its useful life. These annual deposits come from revenue and earn compound interest over time. The accumulated fund at the end of the period equals the asset's total depreciable amount.

Use the following formula to calculate uniform annual deposit

A = (P - S) × [i / ((1 + i)ⁿ - 1)]

Where:

A = Uniform annual deposit (fixed amount deposited each year)

P = Initial cost of asset

S = Salvage/residual value

P - S = Total depreciation amount (depreciable value)

i = Interest rate per year (compounded annually)

n = Useful life in years

The depreciation expense Dₘ consists of two components:

• Fixed deposit (A), which is the same amount every year
• The interest earned, which increases each year as the fund balance grows

Interest Earned = Opening Balance × i

Calculate depreciation expense for year m using the formula: 

Dₘ = A × (1 + i)⁽ᵐ⁻¹⁾

Or

Dₘ = A + i × (Opening balance)

Where:

Dₘ = Depreciation expense for year m

A = Annual fixed deposit

i = Interest rate per year

m = Year number

Example of applying the sinking fund method in practice

A transport company purchases a delivery truck for ₹20,00,000. The truck is expected to have a salvage value of ₹2,00,000 after five years, and the sinking fund is assumed to earn 6% annual interest. The company sets aside a fixed annual amount to build a fund that will cover the truck’s depreciable value (₹18,00,000) by the end of five years.

Calculate the uniform annual deposit (A)

Depreciable amount (P - S) = ₹20,00,000 - ₹2,00,000 = ₹18,00,000

A = (P - S) × [i / ((1 + i)ⁿ - 1)]

A = ₹18,00,000 × [0.06 / ((1 + 0.06)⁵ - 1)]

A = ₹18,00,000 × [0.06 / (1.338226 - 1)]

A = ₹18,00,000 × 0.177396 = ₹3,19,313.52

Rounded off, the company must invest ₹3,19,314 every year.

Calculate depreciation expense for each year

Depreciation expense has two components each year:

• Fixed Deposit (A): ₹3,19,314 (same every year)
• Interest Earned: Opening Balance × 6% (increases each year)

Formula: Dₘ = A + i × (Opening balance)

Year 1 (m=1):

Opening Balance: ₹0

Fixed Deposit: ₹3,19,314

Interest Earned: ₹0 × 6% = ₹0

D₁ = ₹3,19,314 + ₹0

Depreciation Expense: D₁ = ₹3,19,314

Year 2 (m=2):

Opening Balance: ₹3,19,314 (from Year 1 closing)

Fixed Deposit: ₹3,19,314

Interest Earned: ₹3,19,314 × 6% = ₹19,159

D₂ = ₹3,19,314 + ₹19,159

Depreciation Expense: D₂ = ₹3,38,473

Year 3 (m=3):

Opening Balance: ₹6,57,787 (from Year 2 closing)

Fixed Deposit: ₹3,19,314

Interest Earned: ₹6,57,787 × 6% = ₹39,467

D₃ = ₹3,19,314 + ₹39,467

Depreciation Expense: D₃ = ₹3,58,781

Year 4 (m=4):

Opening Balance: ₹10,16,568 (from Year 3 closing)

Fixed Deposit: ₹3,19,314

Interest Earned: ₹10,16,568 × 6% = ₹60,994

D₄ = ₹3,19,314 + ₹60,994

Depreciation Expense: D₄ = ₹3,80,308

Year 5 (m=5):

Opening Balance: ₹13,96,876 (from Year 4 closing)

Fixed Deposit: ₹3,19,314

Interest Earned: ₹13,96,876 × 6% = ₹83,813

D₅ = ₹3,19,314 + ₹83,813

Depreciation Expense: D₅ = ₹4,03,127

Here is the complete depreciation schedule:

At the end of five years, the accumulated fund reaches approximately ₹18,00,000, matching the truck's depreciable value.

As a result, the transport company does not need to arrange a lump-sum amount for replacement. Instead, the cost is spread evenly over five years, helping preserve working capital and reducing reliance on loans to replace the truck.

Benefits of the sinking fund method

The sinking fund method offers several advantages for businesses that depend on costly long-term assets.

• Dedicated replacement fund: Contributions to the sinking fund create a dedicated pool for asset replacement when needed.
• Interest earnings: As the fund accumulates, it earns compound interest, which helps reduce the overall cost of replacing the asset.
• Better cash flow planning: Large replacement costs are spread over time through smaller annual contributions, making them easier to manage within regular budgets.
• Financial discipline: Regular annual contributions encourage planning for asset replacement rather than delaying financial preparation.
• Reduced borrowing pressure: Since funds are built up gradually over the asset’s life, businesses are less dependent on loans or urgent financing at the time of replacement.

When the sinking fund method may not be ideal

The sinking fund method is useful for asset replacement planning, but it is not always suitable for every business situation.

• Complex to calculate: Compared to other depreciation methods, the sinking fund method involves more complex calculations, making it harder to understand and apply in practice.
• Dependent on fund performance: Its effectiveness depends on investment returns. If interest rates fall or returns are lower than expected, the accumulated fund may not be enough to cover replacement costs.
• Ongoing monitoring required: The fund needs continuous tracking throughout the asset’s life, which adds administrative effort for businesses.
• Not aligned with Ind AS 16: Under Indian Accounting Standard (Ind AS) 16, depreciation should reflect the pattern of economic benefit consumption. The sinking fund method does not follow this principle, making it unsuitable for statutory financial reporting.

Conclusion

Replacing an asset can be as challenging as acquiring it in the first place. The sinking fund method of depreciation helps businesses prepare for this by systematically setting aside and investing a fixed amount each year, ensuring funds are available when high-value assets need to be replaced. This reduces future financial pressure and supports more stable long-term planning.

To better control depreciation tracking and asset management, businesses can use TallyPrime to maintain accurate records of asset values and depreciation in a single system, enabling clearer financial decisions and stronger investment planning.