Whether saving personally for the down payment on a house or saving at work for the acquisition of a warehouse, the investor determines the timing of the annuity payments. Sinking funds due require a small modification to the headers in the sinking fund due schedule, as illustrated in the table. Recall that the payment occurs at the beginning of the payment interval. 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.
A corporation’s bond sinking fund appears in the first noncurrent asset section of the corporation’s balance sheet. The carrying amount of the bonds at the end of Year 1 equals the proceeds of $190,280. Interest expense for Year 2 at the 10% effective rate is thus $19,028. Given that $40,000 in principal is paid at year end, the December 31, Year 2, carrying amount is $153,308 ($160,000 face amount – $6,692 unamortized discount).
- The total interest earned by Bernard is $64.54 in addition to the $1,935.48 of principal contributions made.
- The reason is the cash in the sinking fund must be used to retire bonds and cannot be used to pay current liabilities.
- 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 bonds are sold at a discount from their face value, and the investors do not receive interest until the bonds mature.
- Interest expense for Year 2 at the 10% effective rate is thus $19,028.
To provide further assurance to bondholders, the sinking fund is typically managed by a neutral third party rather than the bond-issuing company. This third-party company ensures the integrity of the fund, working toward the debt retirement in a systematic manner according to the provisions of the sinking fund. Investors much prefer bonds or debentures that are backed by sinking funds and third-party management because they are less likely to default. The concept behind sinking funds – putting money aside throughout the year to pay for an expense – isn’t rocket science.
Definition of Bond Sinking Fund
This results in current accrued interest expense of $7,500 [$600,000 × 5% × (3 months ÷ 12 months)]. Adding this amount to the current portion of principal results in a total direct labor efficiency variance calculator reported current liability of $307,500 ($300,000 + $7,500). The Alberta Capital Finance Authority (ACFA) issued a $200,000 face value bond with five years until maturity.
The $80,000 gain is the difference between the carrying amount ($4,980,000) and the amount paid $4,900,000 ($5,000,000 × 98%). Issuing, buying, and selling bonds results in financial obligations and accounting responsibilities. For instance, your firm is about to issue marketable bonds to finance a major venture in the near future. These bonds require a sinking fund provision to ensure investor confidence.
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Find out the answer to these questions, and many more, with our comprehensive guide to sinking funds in accounting. The sinking fund is shown under the investment section on the balance sheet of the issuing corporation. The accounting procedure regarding interest expense recognition and other aspects of bonds is not affected by the existence of a bond sinking fund. 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.
Example of Reporting a Sinking Fund on the Balance Sheet
An expected present value technique ordinarily is used to estimate the fair value of the ARO. In this question, the fair value of the acquired ARO is meant to be approximated by the discounted cash flow estimate ($68,000). Debt issue costs customarily are amortized using the interest method over the term of the bonds.
The corporation will report the bond sinking fund balance in the investments section of its balance sheet. The investments section appears immediately after the current asset section. A bond sinking fund is a corporation’s noncurrent asset that is restricted for the purpose of redeeming or buying back its bonds payable. Bonds that require a bond sinking fund will mean less risk for the bondholders. A sinking fund adds an element of safety to a corporate bond issue for investors.
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. Sinkable bonds typically have a provision allowing them to be repurchased at par plus the prevailing market interest rate. Companies that are capital-intensive usually issue long-term bonds to fund purchases of new plant and equipment.
bond sinking fund definition
If so, this can have a countervailing impact on the effective interest rate that investors are willing to pay, since there is some uncertainly about whether their bonds will be retired early, and at what price. By purchasing the bond at a discounted price of $9,475.79 and holding it until maturity, when it has a redemption price of $10,000, Baseline Industries earns a $524.21 capital gain. It receives $1,800 in bond payments, gains $524.21, and realizes nominal net income of $2,324.21.
The term “pre-funding” means that income taxes are not applicable to the principal repayments. 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. This section introduces how to spread the capital gain or capital loss on a bond across different time periods.
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. The contract calls for 5 equal annual payments with the first due immediately. Ordinary annuity tables assume the first payment occurs at the end of the first time period. Accordingly, the present value of an annuity due of $1 for 5 periods can be calculated by taking the present value of an ordinary annuity of $1 for 4 periods and adding $1. Hence, either a special table for an annuity due or the method described above can be used in this situation.
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. The AMORT function is designed only for ordinary amortization, but you can easily adapt it to sinking funds due. These changes are similar to the adaptations required for amortization schedules due. The partial sinking fund schedule for the third year is shown in the table above. ACFA contributed $35,979.92 to the fund and earned total interest of $3,943.58.
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A separate trustee would hold the cash for the company, which is why it is labeled as restricted cash. The company would classify the bond sinking fund as a non-current asset on its balance sheet. The face amount of the bonds is $200,000 (200 bonds × $1,000 face amount).
In other applications, any type of annuity is possible, whether ordinary or due and general or simple. When an investor purchases a bond, they expect to receive interest payments and also get back their principal when the bond matures. However if no reservation has been made to retire the bond at maturity (which is also known as “pre-funding”), and if the issuer defaults on its obligation to make timely repayment, then it can result in a default.