Under this methord annual depreciation is not deducted from asset but sinking fund is created wit the annual depreciation . Apart from it amount of annual deprecation is invested every year outside the business. At the end investment is sold and the proceed is utilized to purchase a new asset to replace the old one .

Under depreciation fund method or sinking fund method, a fund is created with the amount of annual depreciation. An amount equal to annual depreciation is invested each year in government papers or in some other gilt-edged securities outside the business. The income earned from investment is deposited into the fund and immediately reinvested. This process is carried out throughout the life of the asset and at the end of its life a sum equal to the cost of the asset is accumulated in the fund. Then the whole investment is sold and a new asset is acquired with the sale proceeds.

The special feature of this method is that the sum required to buy the new asset is available from depreciation or sinking fund. As a result, the working capital of business is preserved. Sinking fund method is specially applicable to costly machines in large scale industries.