The law recognizes the distinction by requiring in the case of depreciating assets that the decrease in value must be made good before the payment of dividends—i.e., dividends cannot be paid out of capital—while in the case of assets subject to depletion it is recognized that some portion of the dividends paid may represent a return of the capital originally invested in the undertaking.
If the latter is the policy pursued, there will be no liquidating dividends at the time of the break-up of the undertaking, inasmuch as the regular dividends have already included a return of all or some portion of the capital. If, however, it is a matter of business policy to continue the enterprise elsewhere when the present natural stores are exhausted, then the dividends should represent only profits. During the process of operation, assets in other forms which represent the capital investment of the undertaking are retained in the business. This is accomplished on the books by a charge to each period’s operations of such an amount as represents the depletion of the stores of product prepared for the market during that period and by a credit to a depletion reserve account or direct to the property or stores account.
Basis of Depletion Charge
The amount of the period’s depletion charge is reckoned by comparing the amount of product worked during the period with the total estimated amount owned. Whatever value was taken for the original purchase, that value becomes the basis for the annual or periodic depletion charge. There is, of course, a large element of speculation in some estimates of this kind. In the case of timber, the original amount purchased is easily determinable with fair accuracy by cruising; the amount cut each period is a matter of record. The ratio of the amount cut to the original amount is the portion of the original value or cost of the timber tract to be written off periodically. In the case of a mine or pit, the estimate cannot be made with an equal degree of accuracy. Competent engineers do make calculations of the amounts of available ores with sufficient certainty to warrant the expenditures of vast sums in the purchase of properties. If their estimate avails for this purpose, it can with equal certainty be made the basis for the periodic depletion charge. Nice questions arise in this connection when the property is being operated under a lease or on a royalty basis.
Application of Income Tax to Wasting Assets
Under the 1916 income tax law specific provision was made for allowing depletion and the manner of handling it is prescribed. First, for such a charge to be allowed as a deduction, it must be recorded on the books. Secondly, as soon as the depletion reserve equals the capital investment no further deduction can be made—all else is pure income. If, however, it is desirable to carry on the books as an asset the estimated amount of product still remaining in addition to that written off, it may be done, the offsetting credit being to income, which must be shown as income on the tax return for the year in which it was brought onto the books. This new value may be depleted until wiped off the books.
The law as now operated bases value of the asset subject to depletion on the value existing as on March 1, 1913, or at cost or purchase price if acquired subsequent to that date. Because the book values on March 1, 1913 seldom agreed with the estimated values, it was necessary to adjust these by charging the asset, plant, or mining property and crediting an account called “Property Surplus” with the amount of the adjustment where the estimate showed more than the book value. When dividends are paid, if it is the policy to return capital as well as profits, the charge should be made partly against operating surplus for the profits share, and partly against property surplus for the capital share.
Depreciation on Buildings and Machinery of a Wasting Asset
In addition to the depletion charge, proper allowance should be made for depreciation of the other fixed assets, such as buildings, machinery, and the like. The limit of their service life is evidently the working life of the venture, which must be estimated. If there is still operating value in the equipment at that date, this is covered by the higher salvage value taken into account when fixing the depreciation charge.
Unusual Risks