An insurance reserve might be created out of rev enue for the purpose of enabling a company to carry its own insurance. In this case the reserve would be created by charges to operating expenses. At the same time an insurance fund would be created so that in event of loss by fire the company would have the necessary cash, or its equivalent, to reimburse itself. If this reserve was not specifically invested in assets such as cash or securities, it might perhaps be invested in the very properties that would be de stroyed by the fire. A fund, therefore, is always a debit, while the reserve is always a credit.
4. Sinking funds sinking fund is an amount of cash set aside for the purpose of meeting some debt at its maturity. In the creation of a sink ing fund according to scientific methods, we have a problem consisting of one unknown and two known factors. The known factors are the amount to be accumulated and the number of periods or instal ments. The amount of the periodical instalment is the unknown factor and this is determined by the rate of interest which it is assumed will be earned on the fund. This is usually ascertained from compound interest tables.
When the number of periods and the rate of in terest are unusual, the amount of the sinking fund contribution can be determined by the use of loga rithms.
5. The investment of the sinking periodical instalment set aside under the provisions of the sinking fund agreement is usually paid over to a trustee who is charged with the duty of safely investing it. The trustee reports at regular inter vals to the debtor corporation. The fund may be invested in gilt-edged securities or it may be invested in the very bonds to be redeemed, if the latter can be purchased under favorable conditions.
6. Treatment of interest earned on the sinking interest earned on the sinking fund in vestment is a debit to the sinking fund cash account. The cash will be retained by the trustee and used in the purchase of additional bonds or for investment in other securities. The question as to the disposition of the credit of the interest earned has created some discussion. The credit may be placed in an account called "interest earned on the sinking fund" and will ultimately find its way into surplus. If a sinking fund reserve has been created, it would be better to credit the amount of the interest earned directly to the reserve account.
Some authorities hold that the interest earned may be properly credited to the interest paid on the out standing bonds. The author does not approve of this theory because the interest earned on the sinking fund has nothing to do with the interest on the debt.
7. Sinking fund and reserve fund investments.— 'The method of treating sums set aside for sinking fund purposes in balance sheet has already been discussed. It remains for us to consider here, the question of the valuation of securities in sinking funds and reserve funds. Funds of this character are usually created in connection with a reserve out of cur rent income or surplus. Thus, a sinking fund reserve
might be set up out of income or out of surplus and an equivalent amount of cash set aside in the sinking fund, which would ordinarily be invested in gilt edge securities. An undertaking inight set aside out of its stnplus, a reserve which would control and meas ure the amount of cash which was set aside as a pension fund. In the same manner, an organization -that decided .to carry its own insurance may create an insurance reserve, by charges against income, and at the same time, set aside in an insurance fund, the amount of cash which would otherwise have been paid for insurance premiums. In other instances, how ever, the funds are created without setting aside a portion of the surplus to measure the amount thereof. " It is obvious, of course, that if the portion of the surplus account which has been temporarily locked up in special funds is not "ear marked," the balance standing in the surplus account is not free surplus. Ordinarily investments in special funds of this char acter will be carried at cost. An increase in the Value of the investments is not available until the same are sold, and it is not considered desirable to reflect in the balance sheet fluctuations in the value of investments carried in permanent funds of this character. It might be well, however, to state in the balance sheet, in a parenthetical reference, the market values of in vestment carried in special funds. If the invest ments are sold and the increase in value realized, the profit will be available either for the general purposes of the organization or will be added to the funds, de pending either upon the contractual obligation in curred in the creation of the fund, or in accordance with the wishes of the owners.
If the value of investments carried in special funds has decreased, the decrease should be reflected in the reserve account or in the surplus account, if it seems to be a permanent decrease, or if there is likelihood of loss being sustained on the ultimate realization of the investment. On the other hand, temporary fluc tuations may be ignored.
8. Insurance funds should be adequate to meet connection with insurance funds, it is necessary to see that the amount is adequate to meet the losses that might be sustained. When a cor poration has a number of scattered plants, the insur ance protection need not be so complete as it would have to be if the entire fixed property were located at one point. Many corporations are carrying their own insurance and if the fire hazard is negligible, this may be a profitable proceeding. Nevertheless, the creation of a reserve for insurance without the cre ation of an accompanying fund, which will be in vested in cash deposits or securities, would be danger ous, because the reserve might be invested in the very assets which would be destroyed by a fire.