Chapter 9Part 2 of 4

Accounting for DepreciationFixed assets other than land lose their ability

over time to provide servicesCosts of equipment, buildings, and land

improvements should be transferred to expense accounts in a systematic manner during their expected useful lives. DEPRECIATION

Adjusting entry to record depreciation is usually made at the end of each month or at the end of the year Fixed assets other than land lose their ability over time to provide services

Adjusting EntryAccount Debit Credit

Depreciation expense $7,000

Accumulated depreciation - truck $7,000

DepreciationAccumulated depreciation

Shows the amount that the asset has lost in value since its purchase

Depreciation expenseShows the amount that the asset has lost in value this

period.Factors that cause a decline the ability of a fixed

asset to provide services may be identified as Physical depreciation

Occurs from the wear and tear while in use and from the action of the weather

Functional depreciation Occurs when a fixed asset is no longer able to provide

services at the level for which it was intended.

Factors in Computing Depreciation ExpenseThe fixed asset’s initial costIts expected useful lifeIts estimated value at the end of its useful life.

Depreciation MethodsStraight lineDeclining balanceUnits of production

Straight line MethodProvides for the same amount of depreciation

expense for each year of the asset’s useful lifeAnnual depreciation expense =

Cost – Salvage value Life

Example 1A machine had a cost of $24,000, salvage value of

$2,000 and useful life of 5 yearsAnnual depreciation expense =

Cost – Salvage valueLife

= $24,000 - $2,000 5 years

= $4,400 annual depreciation

Adjusting entryAccount Debit Credit

Depreciation expense $4,400

Accumulated depreciation - truck $4,400

Example 2A machine had a cost of $30,000, salvage of

$5,000 and useful life of 6 years. Compute depreciation under the straight line method?

What is depreciation expense in year 3?

Units of ProductionThis method provides for the same amount of

depreciation expense for each unit produced or each unit of capacity used by the asset

Units of ProductionDepreciation rate per unit = Cost – Salvage value

Estimated units

Depreciation Expense = Depreciation rate x annual units

Example 3A machine had a cost of $24,000, salvage

value of $2,000, estimated total hours of production of 10,000 and annual hours used of 2,100 hours. Compute depreciation for the period under the units of production method.

Example 3Depreciation rate per unit =

Cost – Salvage valueEstimated hour

= $24,000 - $2,000 = $2.20 10,000 hours

Annual depreciation expense = Hourly depreciation rate x annual hours = $2.20 x 10,000 hours = $2,200

Example 4A machine had a cost of $30,000, salvage

value of $5,000, estimated total hours in production of 5,000 and annual hours used of 900 hours. Compute the depreciation expense for the period using the units of production method

Declining Balance MethodProvides for a declining periodic expense

over the estimated useful life of the asset.Book value

= Cost – Accumulated depreciation

Declining Balance MethodSteps

Compute the DB rate = 100/Life of asset For double declining balance

Multiply rate time 2

Depreciation expense = Beg. book value X Rate

Rule: the book value may never by less than the salvage value of the asset

A machine had a cost of $24,000, salvage value of $2,000, estimated life of five year. Compute depreciation

Year Cost Accumulated

Depreciati

on

Book value at

beginning of year

Rate Depreciation

Book value at end of year

1 $24,000   $24,000 40% $9,600 $14,400

2 24,000 9,600 14,400 40% 5,760 8,640

3 24,000 15,360 8,640 40% 3,456 5,184

4 24,000 18,816 5,184 40% 2,073.60 3,110.40

5 24,000 20,889.60 3110.40   1,110.40 2,000  

Example 6: A machine had a cost of $30,000, salvage value of $5,000, estimated life of 6 years. Compute depreciation using the double declining balance method.

Revision of DepreciationRevising the estimates of the residual value

and the useful life is normalUsed to determine depreciation expense in

future periods

Example 7Assumed a fixed asset purchased for

$130,000 was originally estimated to have a useful life of 30 years and a residual value of $10,000. The asset has been depreciated for 10 years by the straight line method.

At the end of ten years, the asset’s book value of $90,000. During 11th year, it is estimated that the remaining useful life is 25 years and that the residual value is $5,000.

Compute depreciation expense for the 11th year using the new information provided.

Example 7Depreciation expense= = $130,000-$10,000 30 = $ 4,000.00 per year before changes

Accumulated Depreciation balance =$4,000 X 10 years = $40,000

Book value = $130,000.00 – $40,000 = $90,000

Example 7New depreciation expense = Book value – new salvage Remaining life = ($90,000-$5,000) 25 = $ 3,400.00 per year for remaining

years

Disposal of Fixed AssetsDiscarding of Fixed Assets

When asset has no residual value and is fully depreciated.

Example 8Asset with a cost of $25,000 and fully

depreciated is discarded

Account Debit Credit

Accumulated Depreciation $25,000

Fixed Asset $25,000

Selling of Fixed AssetsThree things can happen

Sale at book value No gain or loss

Sale below book value Loss is recognized

Sale after book value Gain is recognized

Selling at book valueExample 9:

Asset with cost of $25,000 and Accumulated Depreciation of $10,000 is sold for $15,000 cash.

Account Debit CreditCash $15,000Accumulated depreciation $10,000 Fixed Asset $25,000

Selling price above book valueGain is recognizedExample 10:

Asset with cost $25,000, Accumulated Depreciation of $10,000 is sold for $20,000 cash.

Account Debit CreditCash $20,000Accumulated depreciation $10,000 Fixed Asset $25,000 Gain on disposal of asset $5,000

Selling price below book valueLoss is recognizedExample 11: Asset with cost of $25,000, Accumulated

Depreciation of $10,000 is sold for $12,000 cash.

Account Debit CreditCash $12,000Accumulated Depreciation $10,000Loss on disposal of asset $3,000 Fixed Asset $25,000

Exchanging Similar AssetsOld equipment is often traded in for new

equipment having a similar use.The seller allows the buyer an amount for the

old equipment traded in called TRADE IN ALLOWANCE.

The remaining balance – the amount owed is either paid in cash or recorded as a liability – called BOOT

Gain on exchangesNot recognized for financial reporting

purposes.When trade-in allowance exceeds the

book value of an asset traded in and no gain is recognized, the cost recorded for the new asset can be determined in either of two ways:

Cost of new asset = List price + Unrecognized gain Cost of new asset = Cash given + book value of oldNot

recognized for financial reporting purposes.

Example 12New equipment is purchased with a list

price of $5,000, trade in allowance of old is $1,100, cost of old equipment is $4,000, accumulated depreciation $3,200. Record the entry. New equipment is purchased with a list price of $5,000, trade in allowance of old is $1,100, cost of old equipment is $4,000, accumulated depreciation $3,200. Record the entry.

Example 12Account Debit Credit

Fixed Asset – new $800

Accumulated Depreciation $3,200

Fixed Asset – old $4,000

Losses on ExchangeFor financial reporting purposes, losses are

recognized on exchanges of similar fixed assets.

If trade in is less than the book value of the old equipment, there is a loss

Example 14New equipment is purchased with a list price

of $5,000, trade in allowance of old is $700, cost of old equipment is $4,000, accumulated depreciation $3,200. Record the entry.

Account Debit CreditFixed Asset – new $700Accumulated Depreciation $3,200Loss on exchange of asset $100 Fixed Asset – old $4,000

 

Cash flow is the after- tax money that remains available to a company or individual to pay off its debts, invest in new projects or retain for future investment considerations.

DEFINITION OF CASHFLOW:

Gross Revenue- Royalty - Operating Costs – Development Costs – Depreciation– Amortization– Interest======================================Income Before Depletion – Depletion (is put here to compare with 50% of the income before depletion)

=====================================

Taxable Income - Tax======================================Net Income +Depreciation+Depletion +Amortization- Capital Cost======================================Cash Flow

Cash Flow Calculation;

Depletion, Depreciation and Amortization are added back because they are non-cash cost deduction.

They are deductions for tax purposes, allowed by the government to permit businesses to recover the value of assets with limited useful life.

For tax purposes, the fastest method of deducting costs is to “expense” them in the year incurred.

In other words, deduct the costs in full amount from the revenues in the year they incur before you pay taxes.

Only certain costs can be “expensed” though.

The investment costs cannot be expensed. They can be deducted, through depreciation, and amortization over the life of the investment. They are called “capitalized” costs.

2.0 BUSINESS COSTS THAT MAY BE EXPENSED

1) Operating Costs: includes costs for direct labor, indirect labor, materials, parts and supplies used for production, utilities, freight and containers etc.

2) Research and Experimental Costs : includes labor, supplies, etc.

3) Mining Exploration Costs: These costs are expenditures required to delineate the extent and quality of an ore body and may include core drilling, assaying, engineering fees, geological fees, exploratory shafts, pits, drifts, etc.

Some of the costs that can be expensed are:

Exploration costs may either be capitalized into the cost depletion basis or expensed in the full amount in the year incurred by individual taxpayers.

However, corporations may expense only 70% of mining exploration costs in the year incurred with the remaining 30% deducted using straight line amortization over a 60 month period, with the first year deduction proportional to the month such costs are paid or incurred.

3.0 EXPLORATION COSTS:

If exploration expenditures associated with successful ventures have been deducted by the “expense” option, these deductions are subject to recapture as follows:

The taxpayer may elect to forego taking depletion deductions until the cost basic of exploration charges is fully recovered, or the taxpayer may restore a dollar amount equal to the previously expensed exploration charges as income.

If the later amount to the option is elected, the taxpayer may add the additional income amount to the cost depletion basic for the property. Recapture may be avoided by not expensing exploration charges but instead, adding such charges to the cost depletion basic of the property.

These costs are defined as expenditures incurred after the determination has been made that an ore body is economically viable and the decision has been made to develop the property

Development costs may include: Exploration type costs after the decision has been made to

develop a mine. Mining development costs typically include costs for

overburden stripping, underground shafts, drifts, tunnels, raises, adits, etc.

4.0 Mining Development Costs:

These costs are defined as the Cost of drilling oil and gas wells to the point of completion and may include:

– Costs of agreements with operator and drilling contractors.

– Survey and seismic work related to location of a well.

– Road cost to well location to be used during drilling.

– Dirt work on location for pits, etc.

5.0 Petroleum Intangible Drilling Costs (IDC)

– Rig transportation and set-up cots.

– Drilling costs including fuel, water, drilling mud, etc.

– Cost of technical services including engineers, geologists, logging and drill stem test services.

– Cost of swabbing, fracturing and acidizing.

– Cementing of surface casing and main casing (not the cost of casing).

– Reclamation of well site.

Similar to mining development cost, intangible drilling costs may either be capitalized into the cost depletion basis or expensed in full amount in the year incurred by individuals or corporations that are not (An “integrated” petroleum producer refined more than 50,000 barrels of crude oil per year $ 5,00,000 per year).

“Integrated” petroleum producers may only expense 70% of intangible drilling costs in the year incurred and are required to amortize the remaining 30% of the intangible drilling costs straight line over a five year, (60 month) period beginning in the month the costs are paid or started to be incurred.

This provision does not affect the option to expense dry hole intangible drilling costs in the year the dry hole is incurred.

The Term Depreciation is used in a number of different contexts. Some of the most common are:

― Tax deduction or allowance

― Cost of an operation

― A method of funding financing for a plant replacement

― Measure of falling value

1. DEPRECIATION:

In the first context, annual taxable income is reduced by an annual depreciation deduction or allowance that reduces the annual amount of income tax payable. The annual depreciation charge is merely a paper or “book” transaction and does not involve any expenditure of cash.

In the second context, depreciation is considered to be a manufacturing cost in the same way as labor or raw materials are out of pocket cash cost. This is a common application of depreciation for internal company cost accounting purposes.

In the third context, depreciation is considered as a means of providing for plant replacement. However, in rapidly changing modern industries, it is doubtful that many plants will ever be replaced because the processes are likely to have become obsolete during operation.

In the fourth context, a plant or piece of equipment may have a limited useful life, so deducting cumulative depreciation from initial value gives a measure of the asset’s falling value, usually called “book value” or adjusted basis.

In this context, the term depreciation is usually used in the context of a tax allowance.

“Depreciation” represents an estimate of the decline in service potential of the asset over a period of time.

“Depreciation accounting” is the systematic division of the depreciable value of a capital investment into annual allocations over a period of years. The annual depreciation allocations are tax deductible.

Depreciation allowance is a tax incentive to encourage the entrepreneurs for further investments.

Depreciable property generally is a tangible property while amortizable property generally is intangible.

Tangible property generally is any physical property such as machine, building, vehicle etc.

Intangible property generally is paper-type assets such as a copyright, patent, or franchise.

Depreciable property may be personal or real. Personal property is property such as machinery or equipment that is not real estate. Real property is land and generally anything that is erected on, growing on, or attached to land. However, land itself is never depreciable.

Property is depreciable if it meets these requirements:

―It must be used in business or held for the production of income

―It must have a determinable life and that life must be longer than one year

―It must be something that wears out, decays, gets used up, become obsolete, or loses value from natural causes

―It is placed in service or is in condition or state of readiness and available to be placed in service.

If property does not meet all four of these conditions, it is not depreciable.

Depreciation of tangible property placed in service after 1986 is based on using Modified Accelerated Cost Recovery System (MACRS) depreciation for:1) the applicable depreciation method2) The applicable recovery period (depreciation life), and 3) The applicable first year depreciation convention.

MACRS depreciation calculations relate to the following three depreciation methods:

1) Straight Line2) Declining Balance3) Declining Balance Switching to Straight Line.

1.1 DEPRECIATION METHODS:

The fourth method used to a lesser extent for tax deduction purposes but to a greater extent for public shareholder reporting purposes is:

4) - Units of Production

Prior to introducing depreciation methods, three timing conventions that affect the first year depreciation deductions need to be addressed. These conventions are applicable to modified ACRS method.

Applies to property other than residential rental and non-residential real property. All property is deemed to be placed in service in the middle of the year.

Therefore, one half of the first year normal depreciation is allowed in the year that the property is placed in service during the year. (Exception: if more than 40 percent of the property is put into service during the last 3 months of the year, then the “mid-quarter” convention is used.)

1. Half –year Convention in First Year:

Applies to property other than residential rental and no-residential real property.

All property placed in service during any quarter of a tax year is treated as placed in service at the quarter’s midpoint.

This convention gives 87% deductions for property placed in service in the first quarter (10.5 mo/12 mo.),

62.5% deduction for second quarter property,

37.5% for third quarter property, and

12.5% for the fourth quarter property.  

2. Mid- Quarter Convention in First Year:

For residential rental property and non-residential real property, the mid-month first year convention applies.

Qualifying property is deemed to be placed in service during the middle of the month.

The allowable deduction is based on the number of months property was in service.

3. Mid-month convention

S.L.D. is the simplest depreciation method, but also it is slowest depreciation method.

Straight Line Depreciation Per Year = Cost (1/n)

Example;

Assume you purchase a new machine in January of this tax year for $10,000. The estimated life of the machine is 8 years when salvage value is estimated to be $3,000.

Determine the annual allowable depreciation by the straight line method assuming the machine is in the 5 year depreciation category and that the half year convention is applicable in the first year:

2.0 ILLUSTRATION OF DEPRECIATION METHODS

Solution:

The actual estimated asset useful life and salvage value have no effect on depreciation calculation under current tax law.

Depreciation Mid-quarter

Convention Year 1: (10,000) (1/5) (1/2) = $1,000 $ 1750 Year 2 to 5: (10,000) (1/5) = $2,000 $ 2000 Year 6: (10,000) (1/5) (1/2 = $1,000 $ 250 Cumulative Depreciation $10,000

SOLUTION:

Note:that because of the half year 1 convention, it takes 6

years to fully depreciate the asset. Salvage value is neglected in computing the appropriate

depreciation deduction

D.B. applies a depreciation rate from the SL rate of 1/n to 2/n, to a declining balance each year.

150 percent (1.5/n) and 200 percent (2/n) rates are now applicable under U.S. tax law.

D.B. deprec./Year = Declining Balance Rate x Adjusted Basic

where the Adjusted Basic = Initial Cost- Cumul. Depreciation

3. DECLINING BALANCE DEPRECIATION (D.B.)

 Cost = $10,000. Depreciate using 200% Rate Declining Balance method (also called Double Declining Balance method) for n=5 years, first year ½-year convention

The 200% D.B. Depreciation rate is 2 (1/5) per year. Year D.B. Rate x Book Value = Depreciation

1 2/5=0.4x1/2 10,000 $2,000 2 0.4 8,000 $3,200 3 0.4 4,800 $1,920

4 0.4 2,880 $1,152 5 0.4 1,728 691 6 0.4 1,037

Cumulative Depreciation in 5 yrs 8,963 The cost is not totally depreciated in 5 years. It literally takes infinite years to completely depreciate an

asset with declining balance depreciation.

Switching from D.B. to S.L. enable an investor to fully depreciate an asset in the depreciation life.

Example:

In order to fully depreciate an asset over its depreciation life using D.B. Method, it is necessary to switch to S.L. Depreciation.

Switching will occur in the year when the depreciation allowance calculated by the S.L. Method becomes equal or greater than the allowance calculated by the D.B. Method.

Let us consider the previous example to illustrate this concept.

4. Declining Balance Switching to Straight Line Depreciation:

Year Method Rate X Adjusted Value = Deprec S.L.

1 200% D.B 2/5=.4 (1/2) 10,000 2,000 10002 200% D.B .4 8,000 3,200 17773 200% D.B .4 4,800 1,920 1371** 4 S.L 1/2.5 =.4 2,880 1,152 1152 5 S.L =.4 2,880 1,152 6 S.L =.4 2,880 576

It should be clear that from year 4 to year 6 the depreciation allowance through S.L. method will be higher than the allowance through D.B. method.

Units of production depreciation deducts the asset cost over the estimated producing life of the asset (Instead of over a given depreciation life) by taking annual depreciation deductions equal to the product of the “asset cost” or other basis times the ratio of the “units produced” in a depreciation year, divided by “expected asset lifetime units of production.”(such as initial mineral reserves)

This method permits the asset to be depreciated for tax purposes in direct proportion to asset use. Units of production depreciation is allowed as an alternative to expensing mine development costs under US tax law.

Also units of production depreciation is used by mining and petroleum public companies for calculating financial net income and cash flow for shareholders reporting purposes.

5. Units of Production Depreciation

Assume that the $10,000 cost asset is purchased in January of a tax year that corresponds to a calendar year.

Assume the asset is placed into service in December of the same tax year.

The estimated life of the machine is 8 years when salvage value is estimated to be $3,000.

Assume also that the machine is in a 5-year depreciation life category and that the half-year convention is applicable in the first year.

The machine is estimated to produce 50,000 product units over its useful life. If 14,000 product units are expected to be produced in year 1 and 12,000 in year 2, calculate the year 1 and 2 units of production depreciation.

Example:

Year Cost x Depreciation rate = Units of Prod. Depreciation/year

1 $10,000 x (14,000/50,000) = $2,8002 $10,000 x (12,000/50,000) = $2,400

Solution:

The cost of most tangible depreciable property is recovered for tax purposes using the modified accelerated cost recovery system methods.

Cost and recovery methods are treated the same whether property is new or used.

Salvage value is neglected in computing the appropriate depreciation deduction.

6. Modified Accelerated Cost Recovery System (ACRS) Depreciation

Modified ACRS depreciation methods for personal property include 200% declining balance switching to straight line, and 150% declining balance switching to straight line.

These rates are sometimes called “accelerated” depreciation rates because they give deductions faster than with straight line depreciation.

The straight line method of depreciation is required for residential rental real property or non-residential real property purchased after 1986.

Straight line depreciation often is called “S. L ACRS depreciation”.

ACRS depreciable property is often called recovery property. All recover property is depreciated over one of the following lives: 3 years, 5 years, 7 years, 10 years, 15 years, 20 years, 27.5 years or 31.5 years.

The following Table shows the recovery periods (depreciation life) of representative classes of recoverable (depreciable) capital assets.

Table 1: 1986 US Tax Reform Act, Recovery Period for Representative Classes of Recoverable Capital Assets

Property with a median class life

(years) of

Including assets such as Depreciation Life

Depreciation Method

< 4 Special tools & handling devices for manufacturing of products such as food, rubber, plastic, metal products

3 200% D.B

> 4 to < 10 Autos, Light trucks, computers, Typewriters, R&D equipment, etc..

5 200% D.B

10 to < 16 Office furniture, most types of manufacturing equipment, commercial airplanes

7 200% D.B

16 to < 20 Railroad tracks, ships, petroleum refining equipment, etc.

10 200% D.B

20 - 25 Municipal waste-water treatment plants, land improvements, commercial gas pipelines, etc.

15 150% D.B

>25 Municipal sewers, cable and transmission lines, Power plants, water utility plants, etc

20 150% D.B

Residential rental property

27.5 S.L

Nonresidential rental property 31.5 S.L

*Depreciation deductions can also be computed using the S.L method over the applicable recovery period.

New mining machinery and equipment were purchased and placed into service in January of the same tax year for a cost of $100,000. The depreciation life of the equipment is 7 years with an estimated salvage value of $25,000 .

Determine the annual allowable depreciation by the straight line method assuming the machine is in the 5 year depreciation category and that the half year convention is applicable in the first year:

1. Calculate yearly depreciation allowances by applying half year convention.

2. Then assume the equipment is placed into service in the final quarter of the year and recalculate the depreciation allowance.

Use a rate of 200%

Example to illustrate half-year and mid-quarter in the first year.

The equipment is qualified for half-year depreciation. The D.B. rate is 2/7

200% DB to Year Method Rate x Adjusted Basic = SL

Depreciation 1 200% DB 2/7(.5) 100,000 14,781 2 200% DB 2/7 85,715 24,489 3 200% DB 2/7 61,226 17,493 4 200% DB 2/7 43,733 12,495 **5 S.L. 31,238 8,925 6 S.L. 31,238 8,925 7 S.L. 31,238 8,925 8 S.L. 31,238 4,463 Cumulative Depreciation = 100,000

** Switch to SL because   200% DB Method 31,238 x (2/7) = 8,925 SL Method 31,238 /3.5 = 8,925

Solution:

200% DB toYear Method Rate X Adjusted Basic = SL

Depreciation 1 200% D.B. (2/7) (1.5/12) 100,000 3,571 2 200% D.B. 2/7 96,429 27,550 3 200% D.B. 2/7 68,879 19,679 4 200% D.B. 2/7 49,200 14,056 5 200% D.B 2/7 35,144 10,041 6 S.L 1/2.875. 25,103 8,731 7 S.L. 1/2.875 25,103 8,731 8 S.L. 1/2. 875 25,103 7,640 Cumulative Depreciation = 100,000

** Switch to SL because:

200% DB Method 25,103 (2/7) = 7,172 SL Method 25,103/2.875 =8,731 Year 8 depreciation allowance = (1/2. 875) (10.5/12 x 25,103 =7,640

When more than 40 percent of depreciable asset cost is incurred in the last 3 months of a tax year, the taxpayer must use the mid-quarter depreciation convention.

An apartment house was bought and put in service in October for $100,000. Calculate the depreciation allowance over the life of the asset.

Year depreciation = 100,000/27.5 = 3,636.36Monthly depreciation = 3,636. 36/12 =303.03 Month credited Year this year Depreciation 1 2.5 2.5 x 303.03 = 757.57 2 12 12 x 303.03 =3,636.36 3 12 12 x 303.03 =3,636.36 . . . . . . . . 26 12 . = 3,636.36 28 12 . = 3,636.36 29 3.5 3.5 x303.03 = 1,060.60 Cumulative Depreciation =100,000.00

Example to Illustrate mid-month convention in the First Year for Real Property:

Example:

Assume the $10,000 cost asset is incurred in evaluation year 0 and generates annual incomes and operating costs of $8,000 and $5,000 respectively in years 1 through 8, assuming a wash-out of annual operating cost and income escalation.

Year 8 salvage value is projected to be zero.

Since the asset goes into service closer to evaluation year 1 than zero, start depreciation in year 1. Use the effective income tax rate of 40% and calculate the after-tax-investment DCFROR

Year 0 1 2-5 6 7-8

Revenue - 8,000 8,000 8,000 8,000

- Operating Costs - -5,000 -5,000 -5,000 -5,000

- Depreciation - -1,000 -2000 -1000 -

Taxable Income - 2,000 1,000 2,000 3,000

- Tax @ 40% - -800 -400 -800 -1,200

Net income - 1,200 600 1,200 1,800

+ Depreciation - 1,000 2,000 1,000 -

- Capital Cost -10,000

Cash Flow -10,000 +2200 +2600 +2,200 +1,800

Solution:

Present Worth (NPV)= -10,000 + 2,200(P/Fi,1) + 2,600(P/Ai,4)(P/Fi,1) + 2,200(P/Fi,6) +

1,800(P/Ai,2)(P/Fi,6)

 By trial and error, i = DCFROR = 16.82%

DEPLETION METHODS

Depletion is a concept unique to extractive industries.

It is based on the concept that mineral resources are exhaustible as well as difficult to replace.

The owner of an economic interest in mineral deposits, oil and gas wells, or standing timber may recover his cost through federal tax deductions for depletion over the economic life of the property.

Depletion is an additional deduction available for tax calculations. Depletion must be calculated on a mine by mine basis, i.e., a firm cannot consolidate its mines.

There are two methods to calculate depletion: Cost depletion Percentage depletion (also known as statutory)

Depletion must be calculated both ways, and the large sum claimed.

You must compute your depletion each year by both methods and use the one that gives you the greater tax deduction.

You can switch methods from year to year.

Major oil and gas producers may only take cost depletion on oil and gas properties.

Only cost depletion is applicable to timber.  Generally the percentage method is larger.

Cost depletion is determined by the basis in the property applicable to the minerals.

Thus if a firm acquires the mineral right to an undeveloped property for $2 million, this is the cost depletable basis.

Exploration expenditure that are not expensed can be included in this base.

This amount can be written off as the minerals are mined out on a unit-of-production basis.

1. Cost Depletion

For example if the acquired reserves of $2 million are mined over 10 years in equal amounts, the annual cost depletion is $200,000.

Once the basis has been exhausted or reached zero, no further deductions are allowed.

The cost depletable basis is also reduced by any percentage depletion taken on the mine income.

The capitalized cost therefore, that generally go into the cost depletion basis are:

Mineral rights acquisition Lease bonuses Geological and geophysical survey cost and recording Legal and assessment cost.

The IRS (Internal Revenue Service) permits most other capital costs to be depreciated or amortized, and companies do not generally put any costs in the cost depletion basic that are not required to be put there.

Because you will still have percentage depletion which is usually more that cost depletion allowance anyway.

Therefore, you will like to deduct your capital cost by means other than cost depletion.

Cost depletion = (Adjusted Basis) x (Mineral Units Removed & Sold During the yr) / (Mineral Units Recoverable at the Beginning of the year)

Adjusted Basis = Cost Basis + Adjustments – Cumulative Depletion

Example:  

Assume an integrated petroleum company bought an oil property

Mineral right acquisition cost = 150,000 Recoverable oil reserves = 1,000,000 barrels Production in year 1 = 50,000 barrels Production in year 2 = 100,000 barrels Production in year 3 = 50,000 barrels

Year 1: Cost Depletion = 150,000 x (50,000/10 6) = $7,500 = Cum .Depletion

Year 2: = (150,000 – 7,500) x (100,000/950,000) = $15,000 Year 3: Adjusted Basic =[150,000 - (15,000+7500)] x [50,000/(950,000- 100,000)] Since no more additional

= $7,500

SOLUTION:

Percentage depletion does not have a dollar limitation. It is calculated as a percentage of gross income from the mine and varies by type of mineral.

The percentage depletion is calculated as the smaller of: The product of the set of depletion rate for the mineral in

question and its gross income from mining (less royalty), and 50% of the pre-tax income calculated without the depletion

allowance.

No percentage depletion is allowed if income is negative.

2. Percentage Depletion

Gross income from mining is the revenue derived from the sale of concentrates. In general royalties, treatment costs, marketing fees, and transportation charges must be deducted.

For example if a company sells refined copper, the percentage depletion is determined on the revenue less smelting, refining, transportation charges and royalties.

The copper depletion rate is 15%. This amount cannot exceed 50% of taxable income before depletion

Percentage depletion is a specified percentage of gross income after royalties from the sale of minerals removed from the mineral property.

Cost of depletion become zero when the Cumulative depletion exceed the mineral right acquisition cost.

Table below shows the Applicable Percentage Depletion Rates for different types of minerals.

Table: Applicable Percentage Depletion Rates Percentage Mineral Depletion,%(of the Net Revenue) Oil*…………………………………………………..…………………….…15  Sulphur and uranium; and if from deposits in the U.S., asbestos, mica,lead,zinc,nickel,molybdenum, tin, tungsten,mercury, vadadium,and certain other ores and minerals including bauxite…………………………………………22   If from deposits in the U.S., gold, silver, copper, iron ore**, and oil shale…………..………………………………….………..15

Coal**, lignite and sodium chloride……………………………………10

Clay and shale used in making sewer pipe, bricks, or used As sintered or burned lightweight aggregates………………………..7½   Gravel, sand, stone………..…………………………………………………5

Most other minerals and non-metallic cores………………………… 14

*Integrated petroleum producers are not eligible for percentage depletion. Also, the fixed contract pre 2/1/75 natural gas percent depletion rate is 22%

** The percentage depletion rates for coal and iron ore drop to 8% and 12% respectively after the cost depletion adjusted basis has been recovered by allowed percent or cost depletion deductions.

The percentage depletion cannot exceed 50% of taxable income from the property after deductions, except depletion and loss carry forward deductions.

If percent depletion exceeds 50% of the taxable income you are allowed to take 50% of the taxable income before depletion as your percentage depletion deduction.

There is no limitation on the maximum annual cost depletion that can be taken, except that the accrued cost depletion cannot exceed basis of the property.

However, unlike depreciation, percent depletion may be taken after the cost basis in the property has been recovered.

You own an oil property for which you paid $150,000 in mineral rights acquisition last year. Recoverable oil reserves are estimated at 1,000,000 barrels.

50,000 barrels of oil are produced this year and are sold for $29.00 per barrel. Your operating and overhead expenses are $180,000 this year and allowable depreciation is $120,000.

You also expect the same production rate, operating costs, and selling price next year. Calculate the Allowable depletion assuming this time the analysis is for a small producer, eligible for both cost depletion and percentage depletion. Show the cash flow calculation.

Example:

Selling Price = $ 29Severance tax = $ 30,000 this yearOperating Cost = $180,000Depreciation = $120,000Tax rate = 40% Year 1Net Revenue (50,000 bbl @ $29/) 1,450,000

-0perating Costs - 180,000-Severance Tax - 30,000-Depreciation - 120,000Taxable Income before Depletion 1,120,000

-50% Limit for Depletion ( 0.5)(1,120,000) 560,000- Percentage Depletion (0.15)(1,450,000) -217,500- Cost Depletion (from previous example) 7,500

Solution:

Taxable Income 902,500-Tax @ 40% 361,000

Net Income 541,000

+ Depreciation 120,000+ Depletion 217,500

Cash Flow from Sales 879,000

In year 2, if the production and everything else remain the same, the cost depletion will be:

Cost Depletion = (150,000- 217,500) x (50,000/950,00) < 0

There is no cost depletion in the second year. Hence the only option left is the percentage depletion.  

Example:

A company receives $1,500,000/year from an ore containing the co-products of lead, zinc and silver.

$1,000,000 of the revenue is from lead and zinc, and $500,000 from silver.

Operating costs are $700,000 and allowable Depreciation is $100,000. Determine the taxable income assuming the cost depletion basis is zero and that operating costs and depreciation are proportional to revenue from different ores.

3. Depletion When There Are More Than One Mineral

22% depletion rate for Pb, Zn15% depletion rate for Ag Sales Revenue 1,500,000-Operating Cost - 700,000-Depreciation - 100,000Income before depletion 700,000 50% Limit on % Depletion 350,000  Pb, Zn % Depletion (0 .22) x (10 6) -220,000}Ag % Depletion (0.150) (500,000) - 75,000} Select

295,000

Taxable Income $405,000

Solution:

EXAMPLE: 

A corporate investor is considering acquiring and developing a petroleum property believed to contain 1,000,000 barrels of oil.

The petroleum acquisition cost for the property would be

$2,000,000 at year 0.

Petroleum development cost is $800,000 incurred in year 0.

Tangible equipment acquisition cost is $1,000,000 incurred in year 0.

The Modified ACRS depreciation of the $1,000,000 equipment cost will be based on 7-year depreciation life asset, starting in year 1, assuming a half year 1 convention is applicable.

Production is projected to be uniform for each of years 1 and 2 at $200,000 ounces per year.

oil selling price is estimated to be $30.00 per barrel in year 1 and $34.00 per barrel in year 2.

Operating expenses are estimated to be $700,000 in year 1 and $800,000 in year 2.

Royalty to the property owners will be 20% of revenues each year.

Assume the oil is a 15% depletion rate petroleum and that the investor is an “integrated” producer.

Assume amortization of 30% of the petroleum development and exploration starts in year 0 with a half-year deduction.

The effective income tax rate is 40%.

Determine project cash flow for years 0, 1 and 2 assuming the investor does not have other income against which to use negative taxable income in year 0, so it must be carried forward to make project economics “stand alone”.

SOLUTION: depreciation:

Year 1 = $1,000,000 x (0.1429) = 142,900 Year 2 = $1,000,000 x (0.2449) = 244,900

 Cost depletion:

Year 1 Cost depletion: (200,000 ounces produced per yr)/(1 x 106 units in

reserve) x $2 million acquisition cost = $ 400,000.

Year 2 cost depletion: (200,000/800,000) x ($2million - $0.720 million) =

$320,000

Year 0 Year 1 Year 2

Sales Revenue - 6,000,000 6,800,000- Royalties @ 20% - - 1,200,000 - 1,360,000Net Revenue - 4,800,000 5,440,000- Operating Costs - - 700,000 - 800,000- Development - 560,000 - -- Depreciation - - 142,900 - 244,900- Amortization - 24,000 - 48,000 - 48,000Taxable Income before Depletion - 584,000 3,909,100 4,347,100- 50% Limit on % Depletion - 1,954,550 2,173,550- Percent Depletion - - 720,000 - 816,000- Cost Depletion - 400,000 320,000- Loss Forward - - 584,000 -Taxable Income - 584,000 2,605,100 3,531,100- Tax @ 40% - - 1,042,040 - 1,412,440Net Income After tax - 584,000 1,563,060 2,118,660+ Depreciation - 142,900 244,900+ Depletion - 720,000 816,000+ Amortization + 24,000 48,000 48,00+ Loss Forward - 584,000 -- Capital Costs - 3,240,000** - -Cash Flow - 3,800,000 3,057,960 3,227,560

** Capital cost includes $2,000,000 mineral rights acquisition, $1,000,000 depreciable assets, and $240,000 amortizable which is 30% of mining development cost.

It is permissible for a business to deduct each year as amortization a proportionate part of certain capital expenditures.

Amortization permits the recovery of these expenditures in a manner similar to straight line depreciation over five years or a different specified life.

Amortization generally relates to intangible asset costs while depreciation relates to tangible asset costs.

AMORTIZATION

Some of these expenditures may be summarized as follows:

30% of the mining development costs, 60 months for intangible oil drilling costs,

60 months of certain corporation’s expenses under certain conditions;

Cost of the lease acquisition may be recovered by amortization for term of the lease;

60 months or longer of research & experimental expenses, etc.

A total of $30,000 was spent on air pollution control facilities on January 1, 1990 to improve a facility that was constructed prior to 1976. Determine the allowable annual amortization deduction for this equipment for years 1990 – 1994, assuming the investor tax year is the calendar year.

Solution: Since the new facilities go into service in the first month of 1990, a

full year amortization deduction may be taken in the first year, 1990

The annual amortization deductions for 5 years equal:= (1/5) x ($30,000) = $6,000 per year

Example:

Sunk Costs:

Sunk costs are expenditures that have already been made and may or may not be recoverable. They should be ignored when making investment comparisons. Exploration and non-recoverable development costs incurred prior to the date of the analysis are examples of the costs that are excluded.

OTHER IMPORTANT ECONOMIC TERMS: