Describe cost depletion and percentage depletion. Why is the percentage depletion method permitted?
Percentage depletion has arisen, in part, from the difficulty of valuing the natural resource or determining the discovery value of the asset and of determining the recoverable units.
Depletion is defined as a reduction in the quantity of a production factor due to the manufacturing process. Companies generate new products by combining current goods and services. When old items are turned into new products, it is termed a production process.
The process of methodically charging the capitalized costs of a natural resource to operations, less residual land values, is known as cost depletion. The goal of this process is to match the resource's cost to its income. The conventional approach for calculating a depletion fee for each unit removed is to divide the total cost less residual value by the projected number of recovered units. An adjustment to the unit fee will be required if the estimate of recovered units changes.
Proportion depletion is a process permitted by the Internal Revenue Code that involves allocating a particular percentage of gross income to operations in order to arrive at taxable income. Because it is unrelated to the asset's cost and is allowed even when the property is fully depleted under cost depletion accounting, percentage depletion is not considered a universally recognized accounting principle. For practically all natural resources, applicable rates ranging from 5% to 22% of total revenue are indicated.
The difficulty of evaluating the natural resource or estimating the discovery value of the item, as well as calculating the recoverable units, has contributed to percentage depletion. Although there have been various reasons for preserving percentage depletion, one of the most compelling is its utility in driving the hunt for new resources. Providing an incentive for the continued search for natural resources is judged to be in the national interest. Percentage depletion is no longer authorized for many businesses, as stated in the textbook.
(Depletion, Timber, and Unusual Loss) Conan O’Brien Logging and Lumber Company owns 3,000 acres of timberland on the north side of Mount Leno, which was purchased in 2005 at a cost of $550 per acre. In 2017, O’Brien began selectively logging this timber tract. In May 2017, Mount Leno erupted, burying the timberland of O’Brien under a foot of ash. All of the timber on the O’Brien tract was downed. In addition, the logging roads, built at a cost of $150,000, were destroyed, as well as the logging equipment, with a net book value of $300,000.
At the time of the eruption, O’Brien had logged 20% of the estimated 500,000 board feet of timber. Prior to the eruption, O’Brien estimated the land to have a value of $200 per acre after the timber was harvested. O’Brien includes the logging roads in the depletion base.
O’Brien estimates it will take 3 years to salvage the downed timber at a cost of $700,000. The timber can be sold for pulp wood at an estimated price of $3 per board foot. The value of the land is unknown, but must be considered nominal due to future uncertainties.
(Depreciation Computation—Addition, Change in Estimate) In 1990, Herman Moore Company completed the construction of a building at a cost of $2,000,000 and first occupied it in January 1991. It was estimated that the building will have a useful life of 40 years and a salvage value of $60,000 at the end of that time.
Early in 2001, an addition to the building was constructed at a cost of $500,000. At that time, it was estimated that the remaining life of the building would be, as originally estimated, an additional 30 years and that the addition would have a life of 30 years and a salvage value of $20,000.
In 2019, it is determined that the probable life of the building and addition will extend to the end of 2050, or 20 years beyond the original estimate.
(Error Analysis and Depreciation, SL and SYD) Mike Devereaux Company shows the following entries in its Equipment account for 2018. All amounts are based on historical cost.
|Jan 1||Balance 134,750||June 30||Cost of 23,000 equipment sold (purchased prior to 2018)|
|Aug. 10||Purchases 32,000|
|12||Freight on Equipment purchased 700|
|25||Installation costs 2,700|
|Nov. 10||Repairs 500|
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