Question

Describe cost depletion and percentage depletion. Why is the percentage depletion method permitted?

Short answer

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.

Step-by-step solution

Step-by-Step SolutionStep 1: Meaning of Depletion

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.

Explaining the cost depletion and percentage depletion

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.