Creation of a sinking fund for redemption of borrowings

A limited company has raised funds from certain financial institutions like the LIC,GIC etc. by issuing debentures and through other forms of borrowings. The company proposes to create a sinking fund to redeem these borrowings so that sufficient funds are available at the time of their redemption. In this context, the querist has sought the opinion of the Expert Advisory Committee on the following issues:

(i) Can a sinking fund be created for redemption of previous years’ borrowings? If so, whether it can be created out of current years’ profits only or even by transfer of funds available under General Reserves?

(ii) Whether the entire profits can be appropriated to the sinking fund or there are any restrictions in this regard?

(iii) How this fund can be created if a particular year’s profit is insufficient to meet that year’s sinking fund requirements?

(iv) Whether the amounts to be appropriated to sinking fund shall be on actuarial basis or on the basis of a uniform lumpsum every year?

Opinion December 27, 1983

1.The Committee notes that creation of a sinking fund for redemption of borrowings is an appropriation of profits in respect of which there is no specific legal requirement. The Committee is therefore of the view that the management of a company has full discretion to decide the quantum of the transfer of profits to such fund, subject of course, to any other statutory requirements regarding appropriation of profits, e.g., Capital Redemption Reserve created u/s 80 of the Companies Act for the redemption of preference shares and transfer of profits to reserves in accordance with Companies (Transfer of Profits to Reserves) Rules, 1975. In this context it may also be noted that the expression ‘Fund’ should be used only if the said account is “represented by specifically earmarked assets” (Para 6.15 of the Guidance Note on Terms Used in Financial Statements issued by the Institute of Chartered Accountants of India) otherwise the term “ Reserve” should be used.

2.On the basis of the above, the Committee’s opinion is as follows:

(i) Sinking fund can be created to redeem borrowings made in previous years by (a) appropriating current year’s profits, or (b) making a transfer from reserves otherwise available for distribution as dividends e.g. General Reserves or (c) a combination of both.

(ii) The entire profits of the year can be appropriated to the sinking fund provided there are no other legal or contractual obligations having precedence in appropriation of profits.

(iii) In case profits of a year are insufficient to meet that year’s sinking fund requirements, the fund can be created by (a) transferring funds from reserves otherwise available for distribution as dividend e.g. General Reserves, or (b) carrying forward the shortfall to the next year, or (c) a combination of both.

(iv) It is not clear what the querist means by the expression ‘actuarial basis’ in this context. However, uniform lumpsum amount can be transferred to the fund every year. It is that sum which when invested at a certain rate of interest every year will equate it with the amount repayable on redemption. Sinking Fund Tables are available to facilitate this computation.