Basically, there is only a very small difference between a sinking fund and a savings account as both involve setting aside an amount of money for the future. The main difference is that the former is set up for a particular purpose and to be used at a particular time, while the savings account is set up for any purpose that it may serve. Basically, the sinking fund is created to make paying off a debt easier and to ensure that a default won’t happen because there is a sufficient amount of money available to repay the debt. Though most bonds take several years to mature, it is always easier and more convenient to be able to reduce the principal amount long before it matures, consequently lowering credit risk.
In either situation, the gain or loss has tax implications for the investor. These amounts appear on tax forms and either raise the amount of taxes paid by the investor or lower the amount of taxes . As well, for companies these amounts appear on financial statements.
Business Case Studies
This means your company will benefit from the future bond interest payments and also realize the bond’s redemption price upon maturity. Your firm’s accounting records must show capital gains being realized over the years, in the form of the difference between the face value and the discounted amount at which the bonds were purchased. 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. A sinking fund refers to the collection of cash or other assets set apart from the firm’s other assets which are used only for a specified purpose.
The company would classify the bond sinking fund as a non-current asset on its balance sheet. -In the equity section, unrealized holding gains and losses are reported in accumulated OCI . Realized gains and losses, dividends, and interest income are included in earnings.
For the first interest payment, the interest expense is $469 ($9,377 carrying value × 10% market interest rate × 6/ 12 semiannual interest). The semiannual interest paid to bondholders on Dec. 31 is $450 ($10,000 maturity amount of bond × 9% coupon interest rate × 6/ 12 for semiannual payment). The $19 difference between the $469 interest expense and the $450 cash payment is the amount bond sinking fund on balance sheet of the discount amortized. The entry on December 31 to record the interest payment using the effective interest method of amortizing interest is shown on the following page. To illustrate how bond pricing works, assume Lighting Process, Inc. issued $10,000 of ten‐year bonds with a coupon interest rate of 10% and semi‐annual interest payments when the market interest rate is 10%.
- Solve for the ordinary sinking fund annuity payment (\(PMT\)) using Formulas 9.1, 11.1, and 11.2 (rearranging for \(PMT\)).
- However, it is important to remember that there is a certain limit to how many bonds can be bought back before the maturity date.
- 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.
- See Table 3 for interest expense and carrying value calculations over the life of the bond using the straight‐line method of amortization .
Therefore, creditors or lenders also positively view such a fund and the company. If a company maintains such a fund, it lowers the default risk for the borrowers.