When a revenue reserve created out of divisible profits is invested outside the business and is represented by such investments, it is called “reserve fund”. According to the Companies Act, the term “reserve fund” should be used to denote such a revenue reserve which is represented by specifically earmarked investments. The Companies Act makes it obligatory on the part of a company to invest the amount of the “reserve fund” in readily realisable and earmarked assets. But it is not obligatory in other cases.
(b) Reserves and Reserve fund: Distinction The following points of distinction may be noted between reserve fund and reserves:
1. The amounts of the reserves remain part of the capital employed in the business. But the amounts of the reserve fund are invested outside the business and hence do not increase the working capital of the business.
2. Since the amounts of the reserves are employed in the business, it cannot be readily available in case of need. But the amounts in the reserve fund are invested in readily realisable assets and hence they can be easily converted into cash in case of need.
(a) What do you mean by Sinking Fund ?
(b) What is the purpose of creating such a fund ?
(c) Distinguish between a Sinking Fund and Reserve Fund.
(a) Definition The term “Sinking Fund” refers to such a fund which is created by the regular investment of such a sum of money as, with compound interest earned thereon, will accumulate to a given sum at the end of a stated period.
(b) Purpose The purpose of creating such a fund is :
(i) to reduce a liability (e.g. redemption of debentures);
(ii) to replace a wasting asset;
(iii) to replace a depreciating asset; or
(iv) to renew a lease. In short, the purpose of creating a Sinking Fund is to provide for the repayment of some definite liability in future or for the replacement of an asset.
(c) Differences between Sinking Fund and Reserve Fund The Sinking Fund differs from the Reserve Fund in the following respects:
(i) A Sinking Fund is created for a definite purpose, whereas a Reserve Fund has no such definite purpose. A Reserve Fund is created to meet any general anticipated contingency.
(ii) The amounts in the Sinking Fund are invested outside the business. But the amounts in the Reserve Fund may be invested in the business or may be kept inside the business. Sinking Fund to Pay a Liability and Sinking Fund to Replace an Asset
Distinguish between a Sinking Fund to pay or reduce Sinking Fund to replace an asset.
The differences between a Sinking Fund to pay or reduce a liability and Sinking Fund to replace an asset are as follows:
1. A Sinking Fund to pay or reduce a liability is made as an appropriation of profits, i.e., by debiting the Profit and Loss Appropriation Account. Hence it can be created only when the business earns profits. But a Sinking Fund to replace an asset is a charge against profit. It is to be made even when the business incurs a loss. Hence it is debited to the Profit and Loss Account.
2. In case of the former, after the expiry of the period, the investments are sold and the liability is paid with the cash realised. But in the case of the latter, the cash realised by the sale of investments is utilised in replacing an asset.
3. In case of Sinking Fund to pay a liability, after the liability is redeemed any surplus in this account may be distributed among the shareholders or may be transferred to the General Reserve Account. But in case of Sinking Fund to replace an asset, when the asset is replaced the Sinking Fund no longer exists as it is transferred to the original assets to close the account.