SINKING FUNDS AND OTHER FUNDS 1. The theory of the sinking fund.—Corporate bondholders require the assurance that the amount due to them will be paid at maturity. To accomplish this, the indenture provides that a certain annual sum shall be set aside at periodic intervals, which, when invested and reinvested at an assumed rate of interest, will amount to the principal of the debt at the ma turity thereof. The fund set aside is usually placed in the hands of trustees, a trust company ordinarily being designated for this purpose. Detailed pro visions are made in the indenture with reference to the investment of the fund and the -retirement of the debt. The phraseology used in the majority of in dentures, "the sinking fund shall be set aside out of profits," necessitates a charge against revenue and a credit to a sinking fund reserve for the amount of the instalment. At the same time an equivalent amount of cash or other assets is set aside out of the general funds of the company. When the bonds mature, the sinking fund investments are converted into cash and the cash used to retire the indebtedness. The inden ture frequently provides that the sinking fund shall be invested in the very bonds which are to be re deemed; the agreement may also stipulate the price to be paid in repurchasing the bonds. In some cases the bonds which are to be retired from the fund are drawn by lot, and cease to bear interest after the date of drawing. It will be seen, therefore, that the sink ing fund reserve has simply $erved the purpose of withholding from stockholders a certain portion of the profits during the life of the bonds, and that after the retirement of the bonds it reverts to surplus, from which it was miginally created.
2. The sinking fund reserve a charge against sinking fund reserve practically oper ates as a depreciation reserve, by compelling the cor poration to reinvest a certain portion of its profits in assets. The setting aside of the cash in the sink ing fund constitutes, in its last analysis, a partial , payment on the debt. The profits represented by the sinking fund reserve will ultimately find their way into fixed property investment, and thus serve to keep intact the original investment of the company.
Therefore if the sinking fund reserve is large enough to take care of the accrued depreciation on physical property, the company is under no compulsion to pro vide in addition a reserve for depreciation. If both reserves have been created simultaneously, income has been charged twice for tlie same thing.
Inasmuch as depreciation is a legitimate charge against the current income account, contributions to the sinking fund reserve are a charge against income if no depreciation reserve is provided. If, however, a depreciation reserve is also created, contributions to the sinking fund reserve should be charged against surplus, and not against current earnings. It will be seen, too, that where both kinds of reseiwes are created, the depreciation reserve will provide for the loss in physical assets, which are due to wear and tear, while the sinking fund reserve results in an accumu lation of profits represented by assets. The assets will enable the corporation to finance the necessary replacements of its physical property out of its earnings.
It is important to note, in passing, that while both reserves may be created simultaneously, they have nothing in common, and are accumulated on different bases.
3. Funds distinguished from reserve$.—A fund is an asset, and as its name implies, consists of an amount of cash or other assets, set aside from the general funds of the company, for a specific purpose. In contradistinction to a fund, a reserve is a credit account created by setting aside a certain portion of the profits or surplus for some specific or general pur pose.
Not infrequently the reserve serves to measure the amount of its corresponding fund. Thus a sinking fund reserve might be set aside out of profits or sur plus by virtue of the provisions of a mortgage inden ture, and at the same time, cash or other assets equiv alent to the amount of the reserve, might be set aside in the sinking fund.