Sinking fund method of depreciation

The sinking fund method of depreciation is used when an organization wants to set aside a sufficient amount of cash to pay for a replacement asset when the current asset reaches the end of its useful life. As depreciation is incurred, a matching amount of cash is invested, with the interest proceeds being deposited into an asset replacement fund. The interest deposited into this fund is also invested. By the time a replacement asset is needed, the funds needed to make the acquisition have accumulated in the associated fund. This approach is most applicable in industries that have a large fixed asset base, so that they are constantly providing for future asset replacements in a highly organized manner.

However, the sinking fund method requires the use of a separate asset replacement fund for each asset, so it can result in an unusually complex amount of accounting. Another problem is that investment rates will vary over the life of the asset, so the amount accumulated in the fund will probably not match the asset's original cost. Also, the replacement price of the asset may have changed (up or down) over its life, so the funded amount may exceed or be short of the actual purchase requirement.