Depreciation, Depletion, Amortization, And Income Tax

INTRODUCTION The meaning of cash flow has already been defined as after-tax earnings available for use by the corporation or business. It is therefore apparent that a significant part of mineral economic evaluation is concerned with correct and accurate computation of taxable income under existing tax laws, and the proper treatment of tax allowances and deductions. The various methods of depreciation, depletion, and amortization are all means whereby the investor can earn back or recover, before taxes are imposed, the investments made for purposes of doing business or for the production of income. Each of these three types of tax deduction are applied to different investment items such as property, equipment, buildings, research, etc. The cost of buildings, equipment, machinery, and transportation equipment are representative of capitalized business costs that must be recovered by depreciation over the life of the asset. The property investment costs of acquiring natural resources such as minerals, oil and gas, and standing timber are examples of investment costs that may be recovered by depletion. Several other capitalized business costs, such as research expenses and trademark expenses, may be recovered by amortization. The term "capitalized" means that the in- vestment cost is not deducted as an operating expense in the year that it is incurred, but is spread out over a period of years through depreciation, depletion, or amortization deductions according to lawful schedules. Of course, any capitalized cost can only be deducted once. The other costs of doing business which are not capitalized, such as labor and operating costs, are said to be "expensed," i.e., they are written off for tax purposes in the year they occur. DEPRECIATION Depreciation, according to US tax law, is a deduction from taxable income permitted as a "reasonable allowance for the exhaustion, wear and tear of property out of its use or employment in a business." The original cost of the property is the usual basis for determining depreciation. Since depreciation write-off is applied over the useful life of the asset, the first step is to determine the estimated useful life or its allowable depreciable life. These two lives may or may not be the same. No average life is applicable to all types of depreciable assets under different conditions or in different types of business. It is the taxpayer's responsibility to determine the useful life of the asset according to his own operating conditions and experience, within the guidelines set by the US Internal Revenue Service (IRS). The Class Life Depreciation Range (ADR) System permits the taxpayer to choose from a range of depreciable lives at 20% below or above the present guideline life. The second step required in calculating depreciation is to determine an estimated salvage value for the asset. The salvage value is an estimate, made at the time of acquisition, of the amount of money which can be realized by the sale of the asset at the end of its useful life. The four depreciation methods most widely used in the US are: (1) the straight-line method, (2) the declining balance method (double declining balance), (3) sum of the years - digits method, and (4) units of production method. Straight-Line Depreciation Method The straight-line depreciation method is the simplest for calculating depreciation. The depreciation for each year is determined by subtracting the estimated salvage value from the first cost of the asset and dividing the result by the years of life. The method gives equal annual deduction over the depreciable life. Salvage value equal to or less than 10% of the first cost may be ignored. [first cost - salvage Straight line = years of life ] Declining Balance Depreciation Method Declining balance depreciation, or double declining balance (DDB) as most frequently applied, is used for accelerating depreciation in the early years of the asset and is the fastest depreciation method allowed by the US Internal Revenue Service. The declining balance