It should be pointed out that the kind of debt—i.e., the long-term obligation—for the settlement of which the sinking fund method is often employed, is almost invariably an indication of the need of a larger capital fund. Recognition of this is frequently evidenced by the provisions of the trust agreement requiring the payment into the sinking fund out of profits of the periodic contributions. This forces the ultimate increase of capital to be made by the owners. Two other alternatives are open, viz.: borrowing again at the maturity of the debt—a refunding operation—and securing additional capital through the sale of stock. Conditions of the financial market at the time the funds are needed, the policy of the concern as to the admission of other owners, and the relative bargaining strength of the two parties to the loan—these are determining factors in the financial policy to be adopted.
Accounting for Sinking Fund
The various problems met in accounting for the sinking fund will now be discussed. First among these is the manner of showing its status on the balance sheet. This may be done in four different ways. Here, also, the chief problem involved is an accounting problem only so far as it concerns the best manner of setting forth truthfully the facts of financial policy.
1. The sinking fund, then, under suitable title, may appear only among the assets. As to financial policy, this indicates the creation of a distinct fund of assets for the purpose of the sinking fund but it does not show definitely the way in which they are being provided. They may be secured by cutting down certain assets previously carried in larger amount than is now deemed necessary; by a reinvestment of profits; or by the sale of additional capital stock. The balance sheet is silent as to what method is being employed.
2. The balance sheet may record the sinking fund status among the assets as a definite fund and also among the items of net worth as a sinking fund reserve. As to financial policy this not only indicates the creation of a fund of assets, but shows that this was accomplished by a withholding of profits from the stockholders and a reservation of them for this very purpose.
3. There may appear on the balance sheet as the only evidence of a sinking fund policy the sinking fund reserve among the net worth items. This shows a reservation of profits for this purpose and therefore their investment in the business. The reserve is not a covered reserve, however, no definite assets being set apart as representing these profits, or, if set apart, as having been already applied to the cancellation of a portion of the debt. This latter phase is explained more fully on page 458 following. Unless the assets have been applied in this way, the balance sheet gives no assurance to the creditors that funds will be available for the settlement of their claims at maturity. It may be that the reserved profits are being used for further extensions of plant and so will not be easily available at maturity of the obligations. Again they may be invested in increased stocks of current assets and so be readily available. Only an analysis of the balance sheet will show the financial policy that is being pursued.
4. There may be no record of the sinking fund transactions shown on the balance sheet. This might come about through the cancellation of some portion of the debt by the conversion of assets. The balance sheet, except by comparative analysis, carries no indication of the way in which it is accomplished. It may be that it is being done at the expense of current activities—a poor policy—or through the withholding of owners’ profits. The balance sheet is non-committal.
Whatever method indicates the policy being followed with regard to the sinking fund is the one which should be employed. So far as possible indefiniteness of expression as well as nomenclature should be avoided; not only does an indefinite statement fail to show the policy but it may be misleading.
The Sinking Fund on the Balance Sheet
In drawing up the balance sheet, the sinking fund assets usually appear under the caption “Investment of Sinking and Other Funds.” Occasionally one finds the Sinking Fund account treated as a debit valuation account, being shown as a deduction from the Bond account. Such treatment indicates the amount of bonded indebtedness not yet provided for by the sinking fund—an item of hardly enough importance to justify its separate showing, particularly when an easy comparison, under any other method, will give the same information. The cancellation of assets against liabilities or of liabilities against assets is not good accounting practice. Where, however, the trust agreement provides for the investment of the sinking fund cash in the company’s own bonds and the cancellation of these bonds as purchased instead of holding them in the fund for the sake of their income accretions, the bonds so canceled would, of course, be deducted from the amount previously outstanding and only the present liability for bonds be shown. There is no objection to showing this deduction on the face of each balance sheet, as it thus shows the amount redeemed during the current period. If the company’s own bonds are purchased but kept live, it is better to show the sinking fund among the assets. All sinking fund reserves should, of course, be listed in the net worth section of the balance sheet.