Q.Describe the steps for creating Sinking Fund for redemption of debentures.

Steps for Creating Sinking Fund for Redemption of Debentures

A sinking fund is a dedicated reserve created by a company to accumulate sufficient funds over time to redeem its debentures at maturity. The process involves systematic annual appropriations from profits, which are then invested in safe securities.

Step 1: Annual Appropriation to Sinking Fund

Each year, the company transfers a fixed amount from its profits to the Sinking Fund. This amount is calculated using the sinking fund table (based on the required future value, interest rate, and number of years). The journal entry is:

Step 2: Investment of Sinking Fund Amount

The appropriated amount is immediately invested in government securities or other safe, interest-bearing instruments. The entry:

Step 3: Recording Interest on Investments

Interest earned on the sinking fund investments is received and reinvested. The entry:

Then, the interest amount is also reinvested:

Step 4: Sale of Investments at Maturity

At the end of the debenture term, all investments are sold. The proceeds may differ from the book value. Any profit or loss on sale is transferred to the Sinking Fund A/c.

If there is a loss, the Sinking Fund A/c is debited.

Step 5: Redemption of Debentures

The cash accumulated in the bank (from sale proceeds) is used to pay off debenture holders.

| Date | Particulars | L.F. | Debit (₹) | Credit (₹) |

|------|-------------|------|-----------|------------| …

The Concept – Why a Sinking Fund?

When a company issues debentures, it promises to repay the principal on a fixed future date. If the company simply waits until that date, it may not have enough cash on hand – or it might have to sell assets at a loss. A Sinking Fund (also called a Debenture Redemption Fund) solves this by systematically building up a separate pool of money over the life of the debentures.

The accounting logic is straightforward: each year, the company transfers a fixed amount from its profits into a Sinking Fund (a liability reserve). That cash is then invested in safe, income‑earning securities. The interest earned on those investments is also added to the fund. When the debentures mature, the investments are sold, the cash is used to pay off the debenture holders, and the Sinking Fund reserve is transferred back to the General Reserve.

Step‑by‑Step Process

Step 1 – Calculate the Annual Contribution

The company decides (or the debenture trust deed specifies) a fixed annual amount to be set aside. This amount is calculated so that, together with compound interest earned on investments, it will exactly equal the face value of the debentures at maturity. The formula used is:

For example, if ₹10,00,000 of 10% debentures are to be redeemed after 5 years and the sinking fund investments earn 8% p.a., the annual contribution would be:

₹10,00,000 ÷ 5.8666 (FV of annuity of ₹1 at 8% for 5 years) = ₹1,70,456 (approx.)

Step 2 – Journal Entry for Annual Contribution

Each year, the company debits the Profit & Loss Appropriation Account (or Profit & Loss Account) and credits the Sinking Fund Account. This reduces the distributable profit and creates a reserve.

Step 3 – Journal Entry for Investment of the Contribution

The cash set aside is immediately invested in government securities or other safe instruments. The Sinking Fund Investment account (an asset) is debited, and Bank is credited.

Step 4 – Journal Entry for Interest Earned on Investments

The investments earn interest (say 8% p.a.). This interest is received in cash and then also invested back into the fund. Two entries are needed:

First, record the receipt of interest:

Second, reinvest that interest:

Step 5 – Repeat for Each Year

The same pattern repeats every year until the debentures mature. The annual contribution is the same fixed amount, but the interest earned grows each year because the investment balance is larger.

Step 6 – At Maturity: Sell Investments

On the redemption date, the company sells all the sinking fund investments. If the sale proceeds equal the book value, there is no profit or loss. If there is a profit, it is credited to the Sinking Fund Account; if a loss, it is debited.

Step 7 – Redeem the Debentures

The cash received from the sale is used to pay off the debenture holders.

Step 8 – Transfer the Sinking Fund to General Reserve …