Sinking Fund Definition, Types, and Example

bond sinking fund balance sheet

The company would have also had to pay five years of interest payments on all of the debt. If economic conditions had deteriorated or the price of oil collapsed, Exxon might have had a cash shortfall due to lower revenues and not being able to meet its debt payment. https://www.quick-bookkeeping.net/business-accounting-policy-manual/ If the bonds issued are callable, it means the company can retire or pay off a portion of the bonds early using the sinking fund when it makes financial sense. The bonds are embedded with a call option giving the issuer the right to “call” or buy back the bonds.

After all, the company may be in good shape today, but it is difficult to predict how much spare cash a company will have in 10 years’ time. For example, let’s say Cory’s Tequila Company (CTC) sells a bond issue with a $1,000 face value and a 10-year life span. The bonds would likely pay interest payments (called coupon payments) to their owners each year. In the bond issue’s final year, CTC would need to pay the final round of coupon payments and also repay the entire $1,000 principal amount of each bond outstanding. It is listed as an asset on a balance sheet but it is not used as a source of working capital so cannot be considered a current asset.

The bond sinking fund is categorized as a long-term asset within the Investments classification on the balance sheet, since it is to be used to retire a liability that is also classified as long term. It should not be classified as a current asset, since doing so would skew a company’s current ratio to make it look far more capable of paying off current liabilities than is really the case. A sinking fund is a means of repaying funds borrowed through a bond issue through periodic payments to a trustee who retires part of the issue by purchasing the bonds in the open market. The sinking fund provision is really just a pool of money set aside by a corporation to help repay previous issues and keep it more financially stable as it sells bonds to investors. If a company utilizes a sinking fund in relation to a bond issue, the sinking fund is listed as a long-term (noncurrent) asset on the balance sheet.

As a result, the company is usually seen as creditworthy, which can lead to positive credit ratings for its debt. Good credit ratings increase the demand for a company’s bonds from investors, which is particularly helpful if a company needs to issue additional debt or bonds in the future. A sinking fund is a fund containing money set aside or saved to pay off a debt or bond. A company that issues debt will need to pay that debt off in the future, and the sinking fund helps to soften the hardship of a large outlay of revenue. A sinking fund is established so the company can contribute to the fund in the years leading up to the bond’s maturity. The corporation is required to make regular deposits into the bond sinking fund, which is likely managed by an independent trustee.

  1. It should not be classified as a current asset, since doing so would skew a company’s current ratio to make it look far more capable of paying off current liabilities than is really the case.
  2. The amount, which represents a part of the capital raised by a corporation through the sale of various securities to investors, is known as the issue price.
  3. By paying off a portion of its debt each year with the sinking fund, the company will face a much smaller final bill at the end of the 10-year period.
  4. These monies are then invested by the trustee and eventually are used to pay the interest and principal of the bond.

When a company agrees to set up a bond sinking fund, this implies that it originally raised cash for a specific purpose that has a termination date, and so does not intend to roll forward the debt with a replacement bond issuance. The implication is that company management is using its funds in a conservative manner, rather than pushing a liability further into the future. This action also implies that the company may not find it necessary to issue bonds again in the future.

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Since the money in the sinking fund is restricted for a long-term purpose, it cannot be used to pay its short-term liabilities. Therefore, the sinking fund is not a current asset nor is it part of the corporation’s working capital. A company could set aside cash deposits to be used as a sinking fund to retire preferred stock.

bond sinking fund balance sheet

In some cases, the stock can have a call option attached to it, meaning the company has the right to repurchase the stock at a predetermined price. If interest rates decline after the bond’s issue, the company can issue new debt at a lower interest rate than the callable bond. The company uses the proceeds from the second issue to pay off the callable bonds by exercising the call feature. As a result, the company has refinanced its debt by paying off the higher-yielding callable bonds with the newly-issued debt at a lower interest rate.

The combination of the required deposits plus the income and gains from the sinking fund’s investments must be used to redeem or retire the corporation’s bonds payable. A sinking fund is generally placed under the control of a trustee or agent who is independent of the entity that established the fund. The amount, which represents a part of the capital raised by a corporation through the sale of various securities to investors, is known as the issue price. The sinking fund is shown under the investment section on the balance sheet of the issuing corporation.

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A corporation’s bond sinking fund appears in the first noncurrent asset section of the corporation’s balance sheet. Since there will be funds set aside to pay off the bonds at maturity, there’s less likelihood of default on the money owed at maturity. The prospectus for a bond of this type will identify the dates that the issuer has the option to redeem the bond early using the sinking fund. While the sinking fund helps companies ensure they have enough funds set aside to pay off their debt, in some cases, they may also use the funds to repurchase preferred shares or outstanding bonds. This mechanism may sound very similar to a callable bond, but there are a few important differences investors should be aware of.

bond sinking fund balance sheet

All such information is provided solely for convenience purposes only and all users thereof should be guided accordingly. Companies that are capital-intensive usually issue long-term bonds to fund purchases of new plant and equipment. Oil and gas companies are capital intensive because they require a significant amount of capital or money to fund long-term operations such as oil rigs and drilling equipment. Sinking funds have appeared throughout best freelance services in 2021 history, mainly as ways for sovereign governments to help repay war bonds and reduce national debts. Some of the earliest mentions date back to middle-ages Italian city-states, but the sinking fund concept is often attributed to efforts by the English crown during the 17th and 18th centuries. A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation.

How Bond Repayment Works

The accounting procedure regarding interest expense recognition and other aspects of bonds is not affected by the existence of a bond sinking fund. Let’s say for example that ExxonMobil Corp. (XOM) issued $20 billion in long-term debt in the form of bonds. The company established a sinking fund whereby $4 billion must be paid to the fund each year to be used to pay down debt. By year three, ExxonMobil had paid off $12 billion of the $20 billion in long-term debt. To lessen its risk of being short on cash 10 years from now, the company may create a sinking fund, which is a pool of money set aside for repurchasing a portion of the existing bonds every year. By paying off a portion of its debt each year with the sinking fund, the company will face a much smaller final bill at the end of the 10-year period.

First, there is a limit to how much of the bond issue the company may repurchase at the sinking fund price (whereas call provisions generally allow the company to repurchase the entire issue at its discretion). The corporation will report the bond sinking fund balance in the investments section of its balance sheet. Potential investors are requiring that ABC establish a bond sinking fund into which ABC will make annual deposits of $500,000. An independent trustee will invest the corporation’s annual deposits with the goal of the sinking fund balance growing to approximately $20 million by the time the bonds come due in 20 years.

This is a collection of cash or other assets (e.g., marketable securities) that is set apart from the firm’s other assets and is used only for a specified purpose. These include repayment of the bond at maturity, early extinguishment of the debt before maturity, and conversion of the bond into common stock. The disadvantage of a sinking fund is that it limits the availability of cash on hand for a business. It can be argued that this is not necessarily a disadvantage as the money in a sinking fund is used to pay off the debt that was raised to facilitate the needs of the business, so a sinking fund is just a measure to prudently manage finances. Also, the sinking fund allows ExxonMobil the option to borrow more money if needed. In our example above, let’s say by year three, the company needed to issue another bond for additional capital.

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No problems arise with discounts or premiums because they have been amortized to zero by the time of the last interest payment just prior to maturity. For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content. For information pertaining to the registration status of 11 Financial, please contact the state securities regulators for those states in which 11 Financial maintains a registration filing.

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