A sinking fund is built up aggregating the following: (i) a certain fixed amount being set aside annually and (ii) compound interest received by investing the amounts set aside and the interest. A sinking fund may be created either to: (a) replace fixed asset or (b) for payment of a liability at a future date.

The essential points of difference between the two are:
(a) the amount set aside annually is a charge against the profit and loss account for sinking fund built for replacing an asset. Hence profit and loss account is debited; on the other hand, profit and loss appropriation account is debited for creating a sinking fund to repay a liability, e.g., redemption of debentures.

(b) At the end of the estimated useful life of the asset, the sinking fund investments are realized to repay to liability and in this way liability account and sinking fund investment accounts are closed. The balance in Sinking Fund Account is transferred to General Reserve Account except the amount of gain credited to Sinking Fund Account on account of sale of investments at a profit.

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