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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.
As an investor, you need to understand the implications a sinking fund can have on your bond returns. Sinking fund provisions usually allow the company to repurchase its bonds periodically and at a specified sinking fund price (usually the bonds’ par value) or the prevailing current market price. 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 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.
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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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Where does a bond sinking fund appear on the balance sheet?
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.
Since only $8 billion of the $20 billion in original debt remains, it would likely be able to borrow more capital since the company has had such a solid track record of paying off its debt early. Lower debt-servicing costs due to lower interest rates can improve cash flow and profitability over the years. If the company is performing well, investors are more likely to invest in their bonds leading to increased demand and the likelihood the company could raise additional capital if needed. To ensure the repayment of the principal, some bond agreements require that the issuing corporation create and maintain a sinking fund.
Setting aside money to pay off debts is a prudent financial decision for companies to manage their obligations when debt comes due. Companies that don’t, may struggle to find the capital to make good on their outstanding debt obligations. Typically, corporate bond agreements (also called indentures) require a company to make periodic interest payments to bondholders throughout the life of the bond, and then repay the principal amount of the bond at the end of the bond’s lifespan. The articles and research support materials available on this site are educational and are not intended to be investment or tax advice.
- As a result, the company is usually seen as creditworthy, which can lead to positive credit ratings for its debt.
- Maturity date refers to the final payment date of a loan or other financial instrument.
- To ensure the repayment of the principal, some bond agreements require that the issuing corporation create and maintain a sinking fund.
- A company could set aside cash deposits to be used as a sinking fund to retire preferred stock.
However, if no reservation has been made to retire the bond at maturity, such as a sinking fund (or “pre-funding”), then the issuer can default on its obligation to make timely repayment. Also, if interest rates decrease, which would result in higher bond prices, the face value of the bonds would be lower than current market prices. In this case, the bonds could be called by the company that redeems the bonds from investors at face value. The investors would lose some of their interest payments, resulting in less long-term income. A sinking fund is typically listed as a noncurrent asset—or long-term asset—on a company’s balance sheet and is often included in the listing for long-term investments or other investments.
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.
Example of Reporting a Sinking Fund on the Balance Sheet
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.
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. 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.
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 what is trade discount journal entry examples calculator 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.
