A PEDAGOGICAL ANALYSIS OF ALTERNATIVE TAX ELECTIONS FOR EXPLORATION COSTS IN THE MINING INDUSTRY Developments in Business Simulation & Experiential Exercises, Volume 13, 1986 159 A PEDAGOGICAL ANALYSIS OF ALTERNATIVE TAX ELECTIONS FOR EXPLORATION COSTS IN THE MINING INDUSTRY Bob G. Kilpatrick, Texas A&M University Larry E. Watkins, Northern Arizona University ABSTRACT Students and faculty typically prefer to deal with situational problems that are easily related to real world settings. This appears to be even more pronounced in upper division and professional graduate programs. This paper provides complex and environ- mentally realistic decision models for use in corporate taxation or extractive industries accounting courses. The models can provide the student with an appreciation for decision making with a significant number of variables, most of which are beyond the control of management, and under uncertainty. The decision models are suitable for analysis using Lotus 1-2-3, Multiplan, Interactive Financial Planning System (IFPS), other comparable softwares, or manual manipulation. INTRODUCTION The mining industry spans three phases in producing a marketable product: the exploration stage, development stage, and the production stage. Exploration encompasses a broad range of activities and may occur prior to or subsequent to acquisition of mineral rights. Exploration costs are typically incurred in connection with the probing of an area of likely mineralization for the purpose of evaluating the desirability of its commercial exploitation. The exploration stage ends when a determination is made concerning the existence of exploitable reserves [1, pp. 93- 94]. The exploration stage is followed by the development stage of the mine. Development activities consist of providing access to the main ore body and building plant and equipment facilities for ore handling. For taxation purposes, one must examine the Code, Regulations, or Revenue Rulings for guidance in distinguishing between stages. However, delineation of the stages is not clear-cut. Determination of the exact stage at which a cost is incurred is important due to various tax elections that are available to the taxpayer. Generally, exploration costs are capitalized as part of the property’s depletable base while development and production expenditures are treated as current deductions in the determination of taxable income. An election is available under Sec. 617(a) of the Internal Revenue Code that allows the taxpayer to deduct exploration costs in the year incurred. The decision process modeled in this paper concerns management’s choice among the available tax elections. Specifically, a discounted cash flow analysis of the different elections is utilized to guide the student to the rational economic election path. SECTION 617(a) ELECTION Taxpayers may elect under Sec. 617(a) to expense all exploration costs incurred on a mine during the year and all subsequent years. This election is made by simply deducting exploration costs on the return. The election applies for the election year and thereafter unless the taxpayer obtains permission to revoke the election. The Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA) requires corporate taxpayers to capitalize, rather than expense, 20 percent of the exploration expenditures incurred after 1984. These capitalized expenditures are written off using ACRS rates for five year property and are eligible for investment tax credit (ITC). RECAPTURE OF DEDUCTED EXPLORATION COSTS When a mine reaches production stage, exploration expenditures which were previously deducted (expensed) under Sec. 617(a) must be recaptured under one of two methods. The first method is to forego depletion deductions until the adjusted exploration expenditures equals depletion foregone. The second method is to include in gross income during the taxable year an amount equal to adjusted exploration expenditures. This is done the year the mine reaches the productive stage. Figure 1 provides a graphic illustration of the election paths for these exploration expenditures. ELECTION PATHS As depicted in Figure 1 there are three election paths: 1) Capitalize all exploration costs (solid line), noted hereafter as PVCAP; 2) elect to expense exploration costs under provisions of Sec. 617(a) and recapture under provisions of Sec. 617(b)(1)(A) (dashed line), noted hereafter as PVE&R; and 3) elect to expense costs under Sec. 617(a) and recapture per Sec. 617(b)(l)(B) (dotted line), noted hereafter as PVE&F. Developments in Business Simulation & Experiential Exercises, Volume 13, 1986 160 MODEL VARIABLES The following variables are utilized in the models: TX = tax rate (assumed constant); ACRSi = deduction of exploration costs (capitalized per Sec. 291 (b)) in period i; Di = depletion taken in period i; E = exploration expenditures; AE = adjusted exploration expenditures (E>AE); r = discount rate; j = period in which production stage is attained; k = period In which adjusted exploration expenditures are recouped via forgoing depletion per Sec. 617(b)(l)(B); n = total periods (j ≤k≤n); C = mineral acquisition costs; and ITC = investment tax credit percentage. ASSUMPTIONS Simplifying assumptions are necessary in an analysis of this nature. The assumptions for the decision models are listed below. 1) Exploration costs are paid at the beginning of the periods. 2) Decisions regarding exploration cost treatment are responsible for all cash flow differentials. 3) All tax induced cash flows (refunds and payments) occur at year ends. 4) Percentage depletion exceeds cost depletion. (This situation would most likely occur with a profitably operating mine as percentage depletion would not be reduced by the 50 percent of net income requirement under Sec. 613(a).) DECISION MODELING The first decision management must make concerning exploration cost tax elections is whether to capitalize or expense these costs. Reducing the decision to a manageable form yields the following models. Developments in Business Simulation & Experiential Exercises, Volume 13, 1986 161 Utilizing these models, the student should easily see that PVE&R provides a larger tax savings than PVCAP. If desired, one could relax the fixed tax rate constraint. If this is done, the optimal choice would not change until marginal tax rates in year j have in- creased by an amount necessary to offset the discounting effect and the benefits from ITC and ACRS. Once preference for PVE&F has been established, it may be appropriate to begin changing the values of the variables. In so doing, the student gains an appreciation for the consequences of changes in discount rates, tax rates, and investment tax credit provision of the tax code, to name a few. EXTENSIONS The previous decision models were predicated on the use of percentage depletion. A more rigorous and realistic learning experience may be had by considering the possibility of cost depletion exceeding percentage depletion. Decision models for this variation have been developed and are only slightly more complex than those presented earlier [1]. Uncertainty could be incorporated in the decision framework with only slight modifications. For example, one could assign subjective probabilities to differing sets of values for the variables and compute their expected values for each election option (PVCAP, PVE&R, and PVE&F). SUMMARY The purpose of this paper was to provide a vehicle by which students in a corporate taxation or extractive industries accounting course can experience the use of models to make rational economic choices, similar to those required of management, concerning certain tax election paths. The models are environmentally sound and can incorporate the variations one would expect a sophisticated management to utilize including uncertainty. The models are readily adaptable to computer assisted analysis using one of several software packages commonly available. REFERENCES [1] Kilpatrick, Bob G. and Larry E. Watkins, “An Analysis of the Alternative Elections for Exploration Costs in the Mining Industry”, Journal of Petroleum Accounting, Summer 1985, pp. 93-109. Table of Contents Volume 13, 1986 How to Use Microcomputers in Human Resource Management Courses What's My Line? An Exercise in Job Analysis, Description and Classification Relationships Between Team Cohesion Dimensions and Business Game Performance Four Factors Affecting Group Performance in Business Policy Simulations Enhancing Strategic Management Goal-Setting Skills in the Business Policy Course Using a Business Simulation in the Principles of Management Course - Learning Outcomes and Perceptions Personal Computers: Drexel's Experience Using Psychological Type to Enhance Negotiation Skills The Effects of Conflict Handling Styles on Negotiation Behavior: An Analysis of an Experiential Exercise An Experiential Test of Bargaining Decisions and Representation Self-Grading of Examination by Students, A Viable Alternative to Traditional Procedures Perceived Instructor Enthusiasm and Student Achievement An Experiential Approach to Teaching Subordinate-Oriented Communication Assessing the Effects of a Computerized Study Guide in Macroeconomic Principles: A Statistical Analysis A Sales Management Simulation for the PC an Integrative Tool for the Sales Management Course Teaching Re-evaluation of Salespersons Through the Use of a Simulation Game A Test of Student Performance and Attitudes and Performance Under Varying Game Conditions Developing and Testing Airways: A Marketing Simulation Experiential Learning Revisited: Some Thoughts on Designing More Adaptive Management Education Programs Developing the Competencies of Creativity and Accurate Self-Assessment Self-View and Norms: Some Longitudinal Laboratory Results Strategic Planning with an Experiential Case The ABSEL Research Consortium: Preliminary Steps and Position Papers An Analysis of ABSEL Conference papers (1974-1985) The Creation and Operation of a Data-base System for ABSEL Research Funding for a Research Consortium on Simulation and Experiential Learning Simulation - Indoctrination or Learning The Dilemma In Evaluating Classroom Innovations Personality Variables on Group Cohesion, Team Participation and Total Learning Justifications for and Problems in Developing and Using Computerized Experiential Activities Management Competency Models and the Life-Long Learning Project: What Role for ABSEL External Validity of Business Games Restructuring the University - An Experiential Exercise The Surrogate Class Exercise Images of Effectiveness: A Classroom Exercise The Algebran Industry: A Tutorial Framework Another Chance: A Multi-Leveled, Macro Business Game for Micro-Computers A Water Quality Management Simulation Game Acquisitions? Divestitures? Progress Report on a Conglomerate Game Enterprise: A Multi-Purpose Management Development Simulation Marketer: A Microcomputer Simulation in a High Tech Industry A Pedagogical Analysis of Alternative Tax Elections for Exploration Costs in the Mining Industry Using of Multiple Microcomputers Application Programs to Teach Fundamental Business Concepts and Practices Demonstrating the Role of Simulation in Strategic Operations Planning: A Case Study in Bank Check Processing Location Analysis The Subjective Side of the Decision Support System: A Pitfall for the Panacea A Group-Based Procedure for Revealing Judgmental Heuristics and Biases An Experiential Exercise in Bayesian Decision-Making Values for Selected Parameters in Physical Distribution Simulation and Games Computerized Business Management Simulations for Tyros The Management Decision Laboratory at New York University An Example: The Use of Management Games on Microcomputers by Computer Novices Enhancing Mainframe Simulation Via Microcomputers: Designing Decision Support Systems Integrating Personal Computers Into a Course as a Decision Support Tool A Decision Support System for Capital Funds Forecasting Performance and Attitudinal Affects of a Decision Support Package in a Business Game Using the Real World: Interviews with Woman Mangers The Cooperatively-Authored Student Handbook International Buying: An Experiential Exercise The Research/Teaching Interface: Turning a Pretest into an Experiential Exercise Building Microcomputer Business Simulations Simulation with Discrete and Continuous Mathematical Modeling An Interpolation Approach to Developing mathematical Functions for Business Simulations The Design of Simulation Models Using Thought Organizers The Assessment Center as a Teaching/Learning Device An Approach to Meeting the AACSB Guidelines for Introducing Skills and Personal Characteristics (SACs) Using an Interclass Simulating and Role-Playing Pedagogy Experiential Learning about the World of Work: A Program for Primary and Secondary School Educators Assessment of Relevant Personal Characteristics of Potential Entrepreneurs