HD UC-NRLF $B ^5 lb? Depletion of Mines in Relation to Invested Capital A paper read at Conference on Mine Taxation, Annual Convention of the American Mining Congress, Denver, Colorado, November i6, 1920 Wm.B.Gower, C.P.A. Member American Institute of Accountants 20 Exchange Place New York 'IFT THE LIBRARY OF THE UNIVERSITY OF CALIFORNIA HENRY RAND HATFIELD MEMORIAL COLLECTION PRESENTED BY FRIENDS IN THE ACCOUNTING PROFESSION HENl ^HRKELEy CALIF< Depletion of Mines in Relation to Invested Capital In the system of Federal taxation adopted in 1917 and continued since for the purpose of raising the im- mense sums required by the war emergency, the concept of invested capital plays a most important part. The definition of invested capital, in both the Revenue Acts of 1917 and 1918, has encountered much criticism because it rejected present day valuation, and substituted for such real values an artificial concept. Not only that: but this artificial concept of invested capital is rendered more diflicult by reason of its expression through the medium of accounting ideas and terminology. Accounting is not an exact and settled science, and accounting principles and practice involve many uncertainties, many disputed ques- tions, and many divergent usages, customs and methods. The mining industry has had its share, and perhaps more than its share, of these disputed questions relating to invested capital. None of these questions, however, has been more disputed than the proper adjustment of the original basic invested capital of a corporation engaged in mining, which is required by reason of removal of minerals from the property from the commencement of operations down to the taxable year. The question, con- cisely expressed, is as to the effect of depletion upon in- vested capital. For the purpose of this adjustment of the invested capital of a mining corporation, the bureau of internal revenue has adopted a basic principle and rule which has encountered unanimous dissent and opposition from the mining corporations to which it has been applied. The occasion is opportune, therefore, to examine this rule, to show its workings, and to expose its fundamental error. Inasmuch as the rule rests primarily upon accounting propositions, the burden of refuting the rule depends mainly upon accounting considerations. The present dis- cussion Is confined largely to these considerations, leaving the strictly legal and statutory objections to the rule for later discussion by others. The broad principle underlying the rule adopted by the bureau Is that every unit of mineral removed from a mining property from the commencement of operations down to the taxable year impairs the original cost-value or original invested capital value of the mine, at a con- stant rate per unit, necessarily. Invariably, and regard- less of actual conditions, facts and valuation of the mining property. The bureau declares that its rule rests upon accounting principles established for the computation of the surplus and undivided profits of mining corpora- tions. The formal declaration Is as follows: Art. 839. Surplus and Undivided Profits: Allow- ance for Depletion and Depreciation. — Depletion, like depreciation, must be recognized In all cases In which It occurs. Depletion attaches to each unit of mineral or other property removed, and the denial of a deduction In computing net Income under the Act of August 5, 1909, or the limitation upon the amount of the deduction allowed under the Act of October 3, 1913, does not relieve the corporation of its obligation to make proper provision for depletion of Its property in computing its surplus and undivided profits. In order that we may visualize and understand this rule clearly. It is well to Illustrate by an actual case and definite figures. The company referred to owns and operates a large copper mining property in Arizona. It was incorporated twenty years ago with a capital of $3,000,000, although at the time of incorporation the mine was worth many times this nominal capitalization. Under the treasury regulations administering the excess profits tax law of 1917 the company was allowed to establish the value of the ore bodies definitely known to exist at the time of Incorporation in the year 1900, In order that the excess of this value over the aggregate par of the shares of stock issued for the property might be included in invested capital as paid-in surplus. It was established that the commercial value of the ore bodies definitely known to exist at that time was at least $26,- 500,000, and this sum was allowed as the basic invested capital of the company. During the period from January, 1900 to March 1, 1913, this company mined about 400 million pounds of copper, and simultaneously developed a much greater quantity by extensions of its ore bodies. The value of the mining property at March 1, 1913, was fixed by the Valuation Unit of the bureau, for purposes of deple- tion, at $41,500,000. Between March 1, 1913 and the beginning of the taxable year 1917 the company mined about 200 million pounds of copper, equivalent to about one-fifth of the quantity estimated to be in the property on March 1, 1913. At the beginning of the taxable year 1917 the company had an accumulation of surplus earnings, in excess of $16,000,000, derived mainly from the operation of its mining property. Under the rule adopted by the bureau, it is claimed that this company's invested capital for the taxable year 1917 should be reduced by over $11,000,000 for alleged impairment of the original paid-in capital of $26,500,000. This deduction of $11,000,000 from the invested capital was reached by multiplying the number of pounds of copper mined during the seventeen years between January, 1900 and December, 1916 (approx. 600 millions) by a constant unit rate of 1.8457 cents per pound. This unit rate was obtained by dividing the original capital value of the mine ($26,500,000) by the number of pounds of copper estimated to have been in the mining property in 1900, based upon the figures available as of March 1, 1913. We see then, by the actual case above cited, that the ^ administrative rule adopted by the bureau is based upon the proposition that, although the commercial value of the mining property increased during the 17 year period by nearly 50%, it is necessary to deduct $11,000,000 from the invested capital in order to recognize impairment of the original invested capital value of the mining property, which is regarded as having occurred during this identical period. By this rule $11,000,000 of actual profits are deducted in order to recognize an impairment of original commercial value which is wholly imaginary. We have seen, by the citation heretofore made from the regulations, that the bureau justifies its rule by de- claring that it represents a fundamental accounting prin- ciple in the computation of surplus and undivided profits of mining corporations. The bureau contends that its rule embodies a permanent and established profit account- ing rule for mines. It must be remembered that invested capital consists, broadly speaking, of two main elements; first, the original paid-in capital; second, the accumulated surplus earnings. It was open to the bureau, in making its rule for the recognition of the efiect of depletion upon invested capital of mining corporations, to attack the first element, the paid-in capital. The bureau decided, how- ever, against this course, and concentrated its attention upon the second element of invested capital, namely, the surplus earnings. It is most important to keep in mind that the bureau's rule is an attack on the status of the surplus earnings, and its justification is proclaimed as resting upon an established profit accounting rule for mines. It makes no difference that the surplus earnings may have been distributed as dividends: for the attack is then merely diverted to the paid-in capital, on the ground that the amounts so distributed were not wholly "profits" but included a partial liquidation of such capital. It becomes important, therefore, to arrive at a correct understanding of, and to reaffirm, certain established accounting rules which are fundamental in determining the true profits of mining. (We are not now referring to the ascertainment of present-day taxable income from mines, but to true profits, which is an entirely different affair.) The bureau has decided that profits of mining computed during a generation past pursuant to our accepted accounting rules were incorrectly computed; that the custom was unsound, and the teaching of the ac- countancy manuals on the subject of mining profits at fault. It has decided that the profits from mining during these bygone years must be recomputed under a new set of accounting rules which the mining industry never thought of adopting in those days, which it has not adopted today, and which may never be accepted. The bureau has decided that the undistributed mining profits, whether accumulated recently or accumulated over a long term of years must be adjusted to conform to new ideas. The practical effect of all this procedure is to attack the status of the surplus earnings of mining corporations shown by their books and accounts, an authorized element of in- vested capital in the profits tax laws of 1917 and 1918. By means of this procedure the mining corporations have been deprived of scores of millions of dollars of invested capital, and their profits taxes increased correspondingly. The hypothesis upon which the bureau has proceeded is that no reckoning of the true profits of mining, past, pres- ent and future, is valid unless a portion of each yearns revenues is assigned towards the wiping out of the original cost or the original capital value of the mining property. The underlying principle is declared to be that depletion of the original cost or original capital-value attaches to each unit of mineral removed, at a constant rate per unit. The method relied upon is to provide annually such pro- portion of the original cost or original capital value of the mine as the year's output of minerals bears to the total es- timated original mineral contents of the mine. This formula is considered to apply to all mineral deposits regardless of the actual condition and value of the mine at the end of the accounting period. The formula is con- sidered to apply to all mineral deposits without regard to any restoration of the ore reserves comprehended in the original cost or original capital value which may have re- sulted from exploration and development work carried on contemporaneously with extraction and removal of miner- als. The formula is considered to apply to all mineral deposits even though, as is usually the case, it is impossible to estimate the original mineral contents of the mine with any degree of accuracy, until most of the contents have been removed. It is possible that for a certain small class of mining properties this hypothesis adopted by the bureau embodies a logical method for determining the true profits from min- ing, whether past, present or future. The small class of mines referred to contains deposits in which the character and extent of the valuable content is known and determin- able at the time of acquirement, and forms the basis of the purchase. But, for the great bulk of mining properties, In which the character and extent of the valuable content can- not be determined with any degree of certainty until many years have elapsed, the method is neither logical nor practicable. It is not germane to the question, however, how far the bureau's hypothesis and method may be defended on logical grounds, and by a priori reasoning. The question Is not a speculative, but a practical, one; not what ought to he the rule for testing the true profits of mining, but what is. The mining corporations whose surplus earnings are attacked as an element of Invested capital to the extent of millions of dollars; who are now told that during all these years their books and accounts have been kept incorrectly; that their true profits have been wrongly computed each year by hundreds of thousands of dollars, and that their ac- countants were wandering in darkness, will require a good deal of convincing. They will scarcely be consoled for their loss when the bureau tells them that the long-pre- vailing rules under which mining profits were reckoned were unsound and invalid; that while such rules were the basis of all profit accounting required by legislatures, courts and business men, nevertheless they were erroneous In principle and method; and that it Is time to revise all this profit accounting of past years and put it on a correct foun- dation. For it seems that, according to the bureau, these profit accountings of past years were tainted with an ele- ment of original capital; and this element of original capi- tal is to be removed by actuarial calculations of "pure" income, so that no trace shall remain. True, the original cost or capital-value of the mineral deposit may be wholly Intact, and the mine operator unable to understand why he must provide out of his profits for the "recovery" of some- thing which he has not lost. True, also, this "recovery" Is to be figured by means of mathematical computations rest- ing upon very uncertain and variable data. Apparently, however, the perfection and durability of the logical and actuarial structure does not depend upon its very sandy foundation. The fact is that the reckoning of the profits from mining is distinguished by a peculiar principle and by special rules which have been recognized during a long term of years not only by the lay mind, but by legislators, by the courts and by accountants, and which are totally at variance with the bureau's hypothesis. It is important not only to under- stand this peculiar principle and these special rules for de- termining the periodic true gains or losses from mining, but also to realize that they were confirmed by the au- thority of a memorable group of decisions of the Supreme Court, which settled the questions once and for all. The leading case, Stratton^s Independence V. Howhert (231 U. S., 399), was decided in December, 1913, and the sub- sequent cases in the group at various times in 1916, 1917 and 1918, upon the principles upheld in the Stratton case. It is equally important to bear in mind that nothing in recent tax legislation has impaired the validity of the prin- ciples upheld by the court in these cases, and that the true profits and losses from the operations of mining property (as distinguished from present day net taxable income) must be reckoned today by the same principles. Before considering the fundamental principles upon which the accounting rules for determining the true profits of mining rest, it is necessary to explain the three peculiar characteristics of mining which have caused the accounting practice. They have been stated concisely and lucidly by the Supreme Court in the leading case: "The peculiar character of mining property is suffi- "ciently obvious. Prior to development it may pre- "sent to the naked eye a mere tract of land with "barren surface, and of no practical value except for "what may be found beneath. Then follow excava- "tion, discovery, development, extraction of ores, re- "sulting eventually, if the process be thorough, in the "complete exhaustion of the mineral contents so far "as they are worth removing. Theoretically, and ac- "cording to the argument, the entire value of the "mine, as ultimately developed, existed from the be- "ginning. Practically, however, and from the com- "mercial standpoint, the value — that is, the exchange- "able or market value — depends upon different con- "siderations. Beginning with little, when the exist- "ence, character and extent of the ore deposits are 7 "problematical, it may increase steadily or rapidly "so long as discovery and development outrun de- "pletion, and the wiping out of the value by the prac- "tical exhaustion of the mine may be deferred for a "long term of years." {Stratton^s Independence V. Howbert, 231 U. S., 399.) ex Thus we see that the three peculiar features which have determined the special accounting rules are (1) the im- possibility of determining the existence, character and ex- tent of the ore bodies until many years have elapsed; (2) the distinction between the original cost or original com- mercial value of the mine, and the true intrinsic or latent value ultimately disclosed by exploration and development; and (3) the fact that removal of minerals does not neces- sarily imply a shrinkage in the original cost or original commercial value of the mining property; on the contrary, the commercial value may increase coincidently with re- moval of minerals by reason of discovery and development outrunning depletion. Out of these peculiar characteristics there arose special rules in the reckoning of profits from mining differing sharply from the rules for ascertaining the profits of com- mercial enterprises generally: First: In the reckoning of earnings from mines, the en- tire revenues derived from mining constitute income and profits, without any deduction whatever for original cost or original commercial or market value of the mineral deposit, as the case may be. The wiping out of the origi- nal cost or commercial value, through the exhaustion of the mine, is considered and booked as a loss of capital, and is entirely separate and distinct from a loss of profits. The cost or the commercial value of ore or minerals removed during the operation of a mining property may not be booked in the accounts as an ordinary and neces- sary expense of mining, nor as part of the cost of goods sold, nor as depreciation, nor as a charge against profit or loss, directly or indirectly. Second: The foundation of the mine accounts is the original cost of the mineral deposit if acquired for cash, or 8 POSTSCRIPT The discussion at Denver upon the relation of deple- tion of mines to invested capital which took place in the Conference on Mine Taxation after the reading of this article, resulted in the adoption by the American Mining Congress of the following resolution: "Whereas, the Bureau of Internal Revenue, having under the 1909 Tax Law contended that the net proceeds of mines constituted profits and were all taxable without any deduction for depletion, basing such contention on the general practice of the mining industry at that time, and having succeeded in establishing that view in the courts, "Be it resolved, that it is the sense of this Congress that the rule now adopted by the Bureau of Internal Revenue in ascertaining the invested capital of mining corporations by which a deduction is made from profits for each unit of minerals removed since the commencement of mining operations down to the year 1916, regardless of actual con- ditions, actual facts and valuations of the mining property, is inconsistent and unfair; and, "It is further resolved, that this Congress take steps to present its reasons to the Bureau of Internal Revenue supporting an abrogation of such rule." New York, Nov. 22, 1920. its exchangeable or market value if acquired in exchange for stock of the purchasing company. When any shrink- age or impairment of this original cost or original com- mercial value occurs, it should be entered in the accounts as a loss of capital. Such shrinkage or impairment is a question of fact, which can be established only by means of a valuation, and which depends mainly upon the charac- ter and extent of the delimited ore reserves in the mine at the date of acquisition, and at the date of valuation. So long as the commercial value of the mine is at least equal to its original cost or original commercial value; and so long as the known ore reserves are at least equal in character and extent to those known originally, the ac- counts do not provide for the wiping out of the original cost or original commercial value. The removal of minerals from a deposit implies a shrinkage of economic or intrinsic capital-value, but does not necessarily or even usually connote a shrinkage of original cost-value or original commercial-value, for fre- quently the removal of minerals is offset by discovery and development of ore bodies not previously known and de- limited. The shrinkage of economic or theoretical capital- value, as distinguished from impairment of original cost- value or original commercial-value, is not recognized in mine accounts. I. One of the chief difficulties in determining profits arises in connection with writing off or amortizing the capital value of assets which waste in the process of producing income, but which may last over a long period of years. The assets referred to may be regarded generically, as sources out of which income emerges; not only inherently wasting material assets such as plant, machinery, buildings, etc., and the proprietorship of natural resources such as mines, but also the right to an income, such as leaseholds, annuities, royalties, etc. The source of all incomes is sub- ject to a process more or less akin to waste, and no source of income may be regarded as perpetual. Theoretically, therefore, an annual appropriation out of the net receipts is required for the replacement of the capital used in earn- ing the income. The process may be described as eliminat- ing from profits the element of capital. Practically, how- ever, there are Insuperable difficulties in eliminating from every income every element of capital. The sources of in- come are so many and so varied that general principles suitable on all occasions and in every set of circumstances cannot be laid down and followed. The problem^ involves the question as to when and in what cases a deduction is permissible; upon what basis the deduction shall be com- puted; whether or not a time limit to the recognition of wastage should be set; finally, whether changes in the value of the asset occurring during its use affect the question. It is not necessary in this place to discuss these highly controversial and much debated questions, or to concern ourselves with theoretical definitions of "capital," "in- come," "profits," etc. The reckoning of income and profits is at best an estimate, an approximation — it is not a mathe- matical abstraction, nor the result of theoretically perfect rules rigorously applied. Income must be, and can only be, what is usually and commonly regarded as income. In that practical world with which alone the accountant must deal, there is no place for fine-drawn distinctions and involved mathematical computations, in determining what are profits. In the case of mining, however, although the asset which produces the income (the mine itself) must necessarily waste in the process, we are able to avoid the difficult questions which arise in connection with the wiping out of the original cost or original capital value of the mining property, as a charge against revenues in order to ascer- tain the profits, for the reason that a special rule prevails, owing to the peculiar nature of mining. The special rule is that the entire revenues derived from mining are to be regarded as profits, within the technical accounting mean- ing of the term, and that no deduction whatever may be made from these revenues in order to recover the original cost of the mine, or its original exchangeable or market value at the time when it was acquired. The ultimate loss which arises from the wiping out of the original cost or original market value by the exhaustion of the mineral deposit Is a loss of capital, which loss is considered separate and distinct from a loss of profits. Even though, as a 10 practical matter, the entire revenues derived from the working of the mine from the commencement until it is entirely exhausted, must necessarily contain an element of capital corresponding to the original cost of the mineral deposit, or its original commercial value, this element of original capital is of an exceptional character which may not be eliminated from the revenues in order to leave technical profits. This accounting principle and rule for the reckoning of mining profits has prevailed invariably in cases decided under British income tax laws. It was the accepted view in this country under Federal income tax laws of 50 years ago, and in more modern State income tax laws. It is the accepted view in the Western States where the value of a productive mining property for purposes of tax assess- ment is computed by capitalization of average profits. It was the principle and rule accepted by Congress when the excise tax law of 1909 was passed, in which a tax was levied upon the "entire net income" of corporations. Under this Act, as interpreted by the Supreme Court, the legis- lative purpose was to tax the conduct of business of cor- porations organized for profit by a measure "based upon the gainful returns from their business operations" {Doyle V. Mitchell Brothers Company, 247 U. S., 179). The prevailing rule was recognized by the Supreme Court in the decision handed down on December 1, 1913, V in the Stratton case, where it was said: "It is true that the revenues derived from the "working of mines result to some extent in the ex- "haustion of the capital * * * yet such earnings are "commonly dealt with in legislation as income." This fundamental rule which governs the ascertainment of profits from mining, by which no allowance out of revenues may be taken in respect of wastage of the original capital value of the mine, was repeated and reaffirmed in 1916, 1917 and 1918 in Fon Baumhach v. Sargent Land Company, 242 U. S., 503; Goldfield Consolidated Mines Company v. Scott, 247 U. S., 126; United States v. Biwabik Mining Company, 247 U. S., 116; Stanton v. Baltic Mining Co,, 240 U. S., 103, and Doyle v. Mitchell Brothers Company, 247 U. S., 179. 11 In Doyle v. Mitchell Brothers Company (247 U. S., 179) in which it was held by the Supreme Court on May 20, 1918, that in order to determine the loss or gain in the cutting of standing timber and the manufacture of lumber therefrom during 1909 to 1912 there must be withdrawn from the gross proceeds an amount sufficient to restore the capital value of the timber which existed at the commencement of the period under consideration, the Court refuted the argument that these gains should be determined by the same principle as the profits from min- ing, and stated that the two cases presented '*only a super- ficial analogy." Under ordinary circumstances, and in times when no income or profits taxes are in effect, the special rule whereby the profits derived from mining are calculated without any deduction for the original cost or original market value of the mine, does not work any particular hardship, and its interest is rather speculative and theo- retical than practical. When, however, income and profits taxes come to be assessed, the long prevailing rule may work injustice to many proprietors of mining property, and place them at a disadvantage compared with other industries. This hardship and injustice was recognized by the Supreme Court in the Sargent Land Company case, and inspired its opinion of January 15, 1917, that in assess- ing income taxes a fair argument from equitable considera- tions arises for relief from the severity of the prevailing accounting principle and rule for the ascertainment of the profits from mining: In this case it was said: "A fair argument arises from equitable considera- ^^tions, that owing to the nature of mining property, "an allowance in assessing income taxes should be "made for the removal of the ore deposits from time "to time." In recent years Congress has been impressed with such "fair argument from equitable considerations," and for the purpose of mitigating the hardship of the established accounting rule, a concession was made in the income tax law of 1913, as follows: "In the case of mines a reasonable allowance for "depletion of ores and all other natural deposits, not 12 *'to exceed 5% of the gross value at the mine of the ''output for the year for which the computation is "made." In many cases the concession offered by the foregoing clause of the 1913 law was quite inadequate when meas- ured by the actual depletion of the mineral stock; yet the Supreme Court upheld the law, and approved the Idea that the reckoning of taxable Income was correct, even though an inadequate allowance was made for the ex- haustion of the ore bodies. {Stanton v. Baltic Mining Co., 240 U. S., 103.) This was a consistent decision; for under the established principle and rule all the mine revenues were essentially and technically profits, and any allowance granted therefrom by Congress was gratuitous, a statutory benefit and relief, not an Inherent right. In the 1916 Income tax law the statutory benefit and relief to the mining Industry was continued, but the re- strictive formula was less rigorous. Under that law there might be a reasonable allowance for the loss of capital, "not to exceed the market value In the mine of the product thereof which has been mined and sold during the year." In the Revenue Act of 1918 the statutory benefit and relief to the mining Industry was greatly enlarged: the restrictive formula disappeared, and the scope of the capital sum to be recovered by these allowances was expanded to admit new discoveries of ore bodies. The progressive Improvement In the position of the mining corporations made by the Income tax laws of 1913, 1916 and 1918 was the result of concessions made to the Industry by Congress, whereby Increasingly liberal allow- ances were granted to cover the loss of capital known as depletion. These concessions, however, were expedients for counteracting the severity of Income taxes which would be levied, otherwise, upon the profits of mining computed under an accounting principle and rule which had long prevailed, and which regarded all mine revenues as profits, and none as assignable to recovery of original cost or capital. These concessions, expedients of tax legislation do not impair the validity of the accounting principle and rule. They are designed to counteract Its effect. It is true that, a generation ago, the prevailing account- 13 ing principle and rule whereby the annual profits from mining were reckoned without any deduction for original cost or original market value of the mineral deposit, encountered a measure of opposition from writers on accountancy. These writers could see no logical reason for the rule, and insisted "that the mining company can no more legitimately treat the net annual receipts as net profits than can the merchant neglect the cost price of his commodity, or the manufacturer disregard the factory cost of his product in his estimate of profits." The trouble with this reasoning is that it relies exclusively upon analogy, and an analogy which the Supreme Court has well char- acterized as ^'superficial." It does not take into con- sideration the peculiar nature of mining, so concisely and lucidly pointed out by the Supreme Court in the citation heretofore made from the Stratton case. The great majority of investments in mineral deposits do not even remotely suggest the conditions or exhibit the characteristics of an ordinary purchase of a stock of materials for con- sumption in productive processes, etc. The objections which the accounting writers of a genera- tion ago entertained to the authorized rule for computing the annual profits from mining without any deduction for original cost of the mineral deposit were strengthened by technical reasons. They were accustomed to the general rule whereby all changes in the book value of certain assets, implying changes in the net wealth which had occurred during the accounting period, must be reflected in the profit and loss account during the period. They could see no reason why a shrinkage in the cost-value of a mining property should be excepted from the general rule; and could see no reason why the profits of the period should not be charged with any such shrinkage which took place during the period. Here again, their reasoning was based upon analogy; an analogy which did not exist, essentially, owing to the peculiar characteristics of mining. Later, the technical accounting difficulty arising from the concept of a loss of original capital, separate and distinct from a loss of profits, was solved by Professor Hatfield in his standard work on "Modern Accounting," Chapters XI and XII on the subject of "Profits." Realizing that 14 the general rule requiring changes in the book value of certain assets to be reflected in the current profit and loss account is not without exceptions, he posed the main question thus : "Can capital be lost, without having such a technical loss as must appear in the debit of the Profit and Loss account?" (p. 199). Accountants are familiar with Professor Hatfield's analysis and settlement of this question, and we need not go over the old ground. He found no difficulty in accept- ing the idea that there can be a loss in the value of capital assets which would affect only the Capital accounts, and would leave the profits of the year undisturbed. Nor did he find any special difficulty in disposing of such capital losses in the Balance Sheet : "If law requires or permits the reduction of nominal capital stock, and that is done, the loss is deducted immediately from the Capital account" (p. 220). If, on the other hand, the legal steps necessary to reduce the nominal capital have not been taken, the shrinkages in original cost or original value of the assets are to be shown under separate caption as "Loss on Capital Account," or "some other descriptive term may be used, the only require- ment being that it be not misleading" (p. 221). In commenting upon Professor Hatfield's treatment of this subject of capital losses, and the proper way of show- ing them in the accounts and the balance sheet, a recent text-book advanced the suggestion that while "the best practice compels the showing of impairment items as direct deductions from capital," yet, "if a surplus has been ac- cumulated out of previous profits, such surplus constitutes part of the capital, and provides the logical place for setting up the charge." This suggestion cannot be ad- mitted, however, in the case of a corporation; for the premise upon which the argument rests will not bear examination. The argument is based wholly upon the proposition that surplus "constitutes part of the capital"; but this proposition does not hold in the case of a corpora- tion, except in a loose sense. The term "surplus" is 15 here used In its sense of profits withheld from distribution by appropriate corporate action. But, the status of such reserved profits is entirely different from that of the permanent and fixed capital, both legally and in the accounting sense. The surplus is not immovably fixed in the business, nor does It constitute part of the permanent capital of the corporation. It may be turned back into undivided profits account, if the directors so decide; or it may be distributed as dividends by appropriate action. 11. Under long established practice in the industry no entries are made in the accounts affecting the original cost or original commercial value of a mining property unless there is an actual Impairment of such original commercial value established by an actual valuation. So long as the original cost or capital-value is maintained intact, that is to say, so long as the known ore reserves remain at least equal to those known originally, no entries are required. The general rule is that in stating the accounts of a given year any shrinkage of original cost-value or original capital- value of the mine which has actually occurred should be shown; but such shrinkage of capital, is a question of fact, dependent mainly upon the comparative extent and char- acter of the delimited ore reserves at the date of acquisi- tion, and at the date of valuation. That actual impairment of the original cost-value or original capital-value of a mining property, established by a valuation, must take place before any necessity arises for a provision In the accounts towards wiping out the original value Is not only universal practice in the mining industry, but is admitted by the text-writers who have touched on the subject. The rule is even extended to cover cases where an actual shrinkage of original capital- value of the mining property Is suspected, but cannot be demonstrated by precise tonnage and valuation figures. "Where the amount of shrinkage Is known, It must "appear in the accounts. But where the accuracy of "a valuation is specious, where the only ascertainable ^^value is the original cost. It may be less harmful for "the balance sheet to show the cost, indicating that "it does not represent the present value,** {Hatfield, Modern Accounting, p. 222.) 16 In 1904 a prominent accounting practitioner in a paper read at the St. Louis Congress of Accountants, and after- wards quoted in certain text-books, appeared to take issue with the universal practice and the accepted accounting rule whereby extraction of minerals from a mine was disregarded in the accounts unless an actual impairment of cost-value or original capital-value had taken place, estab- lished by a valuation. This writer argued that provision should be made for exhaustion of sub-soil products even though the quantity "known to be in a definite tract at the end of the period is largely in excess of that which had been discovered at the beginning of the period." Un- fortunately for the success of his argument, it was an- nounced as resting upon a premise which does not bear examination. Further, it admitted the very necessity of valuation which it was designed to combat: "The product taken out of the land becomes stock "in trade as soon as it is extracted, and whatever the "land was worth before its extraction, it is clearly ^^worth an appreciable amount less thereafter." Dick- inson, Accounting Practice and Procedure, p. 174. The above premise relies, first, upon the fancied analogy between ores extracted from a mineral deposit, and the stock in trade of a merchant or manufacturer. This analogy has already been disposed of as worthless and unsound in most cases, or as the Supreme Court terms it "superficial." The premise next relies upon the sup- position that the extraction of minerals from a mine in- variably reduces the "worth" of the property, and it is fair to assume that the word "worth" was used in its ordinary significance of exchangeable or market value. It is well known, however, that the extraction of minerals from many mining properties, year by year, does not result, either invariably or even usually, in a shrinkage in commercial value. On the contrary, the commercial value of the mining property frequently increases, steadily and rapidly, during a long term of years while extraction is proceeding, for the reason that discovery and development of new ore bodies proceeds simultaneously. The necessity for the valuation of a mineral deposit as an indispensable prerequisite to the booking of any 17 shrinkage in the original cost-value or original capital- value, a necessity supported by universal mining practice and admitted by the text-writers, is a phase of the much discussed question whether changes in the market value of assets during their use have any bearing upon the writing off or amortizing of the capital value of assets which waste in the process of producing income. The general rule is well established, by custom and accounting teaching, that in the case of inherently wasting material assets such as plant, machinery, buildings, etc., any changes in value during their use are ignored, and the writing off or amortizing of such capital values proceeds without regard to valuation. Natural resources such as mines, however, constitute a well-known exception to the general rule, as we have shown. This exception is not admitted by the bureau, as we have seen. On the contrary, the bureau has adopted a rule whereby the original cost-value or original commercial value of a mining property must be wiped out in the ac- counts, in all cases, continuously and progressively as ex- traction of mineral units takes place, regardless of valua- tion, and regardless of changes in value which may have occurred during the accounting or taxable period. It is commonly said that the bureau relies upon the decision of the Supreme Court in Doyle v. Mitchell Brothers Company (247 U. S., 179) for justification of the principle that changes in value of the mineral deposit during the account- ing or taxable period may be ignored, and the depletion allowance made even though the value has increased. The decision in that important case, however, neither supports nor condemns the principle mentioned, for the reason that it was not an issue in the case. The Court decided that the timber company, in determining its gains or losses during a specified period, was entitled under the circum- stances alleged to a deduction from its gross revenues "to restore the capital value that existed at the commencement of the period under consideration." One of the conditions which the plaintiff proved, apparently, was that no change in market value of stumpage or timber lands occurred during the accounting period; and the decision of the 18 Court took this circumstance into account expressly in its conclusion. The Court said: ^'There having been no change in market values ^^during these years, the deduction did but restore to "the capital in money that which had been withdrawn **in stumpage cut, leaving the aggregate of capital ^^neither increased nor decreased!^ It is, of course, useless to speculate what the decision of the Court would have been if, during the taxable period under review, the value of the timber which had been cut had been restored by newly created values, such as higher market prices, or increment or growth in the substance. It is evident, therefore, that the reasoning in Doyle v. Mitchell Brothers Company supports rather than weakens the established accounting rule whereby no entries are made in the accounts affecting the original cost-value or original commercial value of a mining property, unless and until there has been an impairment of such basic investment es- tablished by an actual valuation, III. In this discussion we must keep clearly in mind, that the essential question is what, if any, adjustment of invested capital of a mining company is required in respect of miner- als extracted and sold from the commencement of mining operations down to the taxable year. We have seen that the bureau in approaching this sub- ject has focussed its attention upon the surplus earnings of the mining company accumulated during the years prior to the taxable year, an authorized element of invested capi- tal. The bureau has proceeded upon the hypothesis that revenues derived since the commencement of operations from the extraction of minerals are not "true" profits unless a portion of such revenues has been assigned towards re- covery of the cost of the mine, or its original invested-capi- tal value. We have shown that this theory is untenable, for it is in conflict with custom and firmly established accounting principles under which true profits from mining must be reckoned without any deduction whatever for this purpose. The mine revenues, without any deductions for depletion of the mineral stock, being true profits, and the accumulations 19 of such profits being admissible as invested capital, no ad- justment thereof in respect of minerals extracted and sold since the commencement of operations is permitted. It follows that any adjustment of invested capital re- quired by the gradual exhaustion of the mining property can be made only in the capital account itself. We have shown that, in the case of mining property, no adjustment of the capital account in respect of removal of minerals is permitted by the accounting rule until there occurs a shrink- age in the value of the mining property as a whole below the cost or original commercial value thereof, established by an actual valuation. In disregard of this principle, how- ever, the depletion rule adopted by the bureau for adjust- ment of the cost or invested-capital value of the mining property ignores actual conditions, rejects valuation, and adopts the theory that every unit of mineral extracted from the mine from the commencement of operations connotes, necessarily and invariably, an impairment of paid-in capital. The conflict between the rule adopted by the bureau and the established accounting practice arises from the effort of the bureau to expand into permanent and universal ac- counting principles, and apply retroactively, the statutory provisions for depletion allowances granted by recent in- come tax laws. Under the income tax laws of 1916, 1917 and 1918, as we have seen. Congress granted relief to the mining industry from the hardship of the accounting rule which reckoned profits from mining without any deduction for recovery of original cost or capital value of the mine. The relief so granted took the form of "reasonable" allow- ances, to be based on cost or fair market value at March 1, 1913, according to circumstances, and under rules and regu- lations to be prescribed by the department. The bureau decided, in interpreting the intent of Congress, and in ex- ercising the discretionary and administrative powers granted to it by Congress, that an administrative rule for computing annual allowances for depletion should be adopted which allows a definite rate for each unit of mineral extracted and sold during the year, and which ignores actual valuation of the mine and periodic appraisals. We see, then that the fundamental distinction between the permanent accounting rules for booking depletion, on 20 the one hand, and the administrative tax rule for the ascer- tainment of present-day depletion allowances, on the other, is that the former requires and is based upon periodic valua- tion of the mining property, whereas the administrative tax rule disregards such valuation. The established accounting rule prevails as the permanent and universal method of keeping the mining accounts, of ascertaining the impairment of paid-in capital, and determining the true profits derived from mining operations. The administrative rule prevails as the authorized rule for ascertaining present-day deple- tion allowances for purposes of income and profits taxes. Each of the two rules has its distinctive purpose and its special justification. The accounting rule is justified by es- tablished custom, precedent and authority. The administra- tive rule is justified as giving efiect to the intent of Congress as expressed in the particular tax laws to which it is applied. Further: it is justified by practical considerations incident to tax administration. It is evident from the wording of the depletion clauses of the 1916 and 1917 income tax laws that Congress did not intend the annual allowances to be reckoned under the permanent accounting rule for booking depletion, which rests upon real impairment of the cost-value established by actual valuation of the mining property. The depletion clauses of those laws contain a proviso to the effect that, after the authorized capital sum shall have been recovered tax-free through such allowances, *'no further allowance shall be made." This expression would have no meaning if Congress had intended the annual depletion allowances to be determined under the accounting rule. The words may be interpreted as contemplating the possibility of a depletion rule, for purposes of tax administration, under which the annual depletion allowances, on the one hand, and the original cost or original capital-value of the mineral deposit, on the other, need not expire simultaneously, as they must do under the permanent accounting rule which requires periodic appraisals. The recent income tax laws, in using such a broad and general term as "reasonable allowances" for depletion, and in directing the Treasury to formulate rules and regula- tions, gave to the bureau the widest latitude in adopting 21 administrative rules. Under this broad power the bureau rejected the accounting rule and has adopted for adminis- trative purposes what is probably the only workable rule. For it is evident that the permanent accounting rule by re- quiring an annual valuation of the mineral deposit in order to determine depletion, involves all the practical difficulties inseparable from such appraisals; and its adoption as a basis for administering a tax measure would have raised well nigh insuperable administrative difficulties. The depletion rule adopted by the bureau in 1917, while suitable and valid for its purpose of administering recent income and profits tax laws, has no validity apart from that purpose. The rule is an artificial product of income tax administration, which has no bearing or effect upon permanent principles of accounting, or upon the established accounting rules for ascertaining the true profits or losses derived from mining. Much less may the administrative de- pletion rule be regarded, as the bureau appears to regard it, as embodying accepted accounting principles which may be applied to a revision of the profit accountings of mining corporations for a generation back, for the purpose of re- moving an imaginary taint of original capital from the residue of their past profits, and by this means deprive them of scores of millions of dollars of invested capital. Income and profits, as was said by the Supreme Court in the Stratton case, must be, and can only be what are "com- monly dealt with in legislation" as income and profits. They are to be determined by considerations which have their in- fluence upon men of affairs, and not by actuarial calculations of ''pure" income, or subtle mathematical abstractions. ****** In the foregoing discussion we have dealt broadly with the concept of true profits from mining, as an element of invested capital. It must be kept in mind, however, that since 1912 there has been a statutory concept of mine in- come, which differs from true profits from mining, various allowances having been granted by Congress in the tax measures. The effect of these allowances upon invested capital is not within the scope of this article. New York, October 15, 1920. 22 •^ OT CA1^««^^'^ LIBRARY This book « Dl!f '^ JIV^ MJIODISCORC Sti(^5'94 M513277 "I