Using The Depletion Deduction To Minimize Oil And Gas Tax Liability

Using The Depletion Deduction To Minimize Oil And Gas Tax Liability

calculate depletion expense

Accumulated Depreciation is credited when Depreciation Expense is debited each accounting period. Depreciation, depletion, and amortization (DD&A) is an accounting technique that enables companies to gradually expense various different resources of economic value over time in order to match costs to revenues. The Michigan Mining Company has acquired a coal mine for a cost of $4,500,000.

When you claim depletion after cutting timber on your land, you can only use the cost depletion method. In this case, you must estimate the value of the timber on the date you acquired the land, then multiply this number by the percentage of your timber you sold during the year.

The Revenue Act of 1913 allowed oil companies to write off 5 percent of the costs from oil and gas wells beginning March 1 of that year. If you are an independent producer or royalty owner, see Independent Producers and Royalty Owners next. For information on the depletion deduction for wells that produce natural gas that is either sold under a fixed contract or produced from geopressured brine, see Natural Gas Wells, later. Reasons for adjusting your basis would include any costs that had been capitalized to the account, or if you had previously recovered a portion of your basis. The easiest way to obtain an updated estimate of your timber volume is to have the forester helping you with the sale determine the total volume of merchantable timber in addition to marking the timber for the sale. To calculate depletion, most companies use the units-of-activity method.

calculate depletion expense

Let’s assume a company Argus Co. secures natural gas exploration rights. The cost estimates for the site and natural reserves information with no project salvage value are given. The company estimated a total of 2 million cubic feet gas and current period exploration online bookkeeping remained at 300,000 cubic feet. Depreciation is on tangible assets where as depletion is on non-renewable resources. Depreciation is the deduction of the asset value due to aging, whereas depletion is the actual physical reduction of the company’s natural resources .

The balance in the Accumulated Depletion – Land account would be a credit balance of $175,000 ($50,000 from year one and $125,000 from year two). The Land account does not change and still has a debit balance of $300,000.

Are Depreciation And Amortization Included In Gross Profit?

Divide the cost of the asset by the amount of natural resources it contains. One way to record depletion expense of $5,000,000 is to debit depletion expense for $5,000,000 and credit accumulated depletionmine for $5,000,000. The depletion method being an accounting entry has some limitations too. The IRS requires a landowner to compare two methods when determining the depletion deduction, and to use the method which provides the largest deduction. The time it takes to use up about 80% of the mineral reserves at a given rate. Percentage depletion is a federal tax deduction for depreciation related to the business of extracting nonrenewable resources from the earth.

  • Total cost subject to depletion is the net cost assignable to the natural resource plus the exploration and development costs.
  • To figure the property’s basis for depletion, subtract all the following from the property’s adjusted basis.
  • Unlike depreciable assets, natural resources do not wear out (i.e. depreciate) with passage of time but they actually loose value when the resource is being extracted.
  • Gross income from the property does not include lease bonuses, advance royalties, or other amounts payable without regard to production from the property.
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If it does apply, then you must find out the estimated total of oil and gas reserves on your property, and then depreciate your cost basis based on the percentage of annual production versus the total reserves. With percentage depletion, accountants assign a fixed percentage to their company’s gross revenue. For example, if a company extracts $50,000 worth of minerals with a fixed percentage of 10%, they would deplete $5,000 of capitalized costs in order to get the natural resources. However, with cost depletion, companies charge the cost of an asset to expense over a set period, making this process similar to depreciation. Depletion is the process of allocating the depletable cost of natural resources to expense as individual units of the resource are extracted. Depletable cost equals the total cost of natural resources less any salvage value remaining after the company finishes extracting them. Depletion expense is generally calculated using the units‐of‐activity method.

What Does Depletion Expense Mean?

The net amount in your accounting books for natural resources might not reflect their actual market value. The amount reflects the reduction of the natural resource cost the accountant originally recorded. The fundamental difference between natural resources and depreciable assets is that a single company rarely uses an entire natural resource.

When the costs associated with natural resource extraction have been capitalized, the expenses are systematically allocated across different time periods based upon the resources extracted. The costs are held on the balance sheet until expense recognition occurs. The percentage depletion method is one method of calculating depletion cost. To allocate costs, the calculate depletion expense percentage depletion method assigns a fixed percentage to gross revenue. Percentage depletion is one of the best tax benefits available tooil and gas investors. Imagine being able to reduce your current income by 15% just because the IRS said you could. Like most things related to oil and gas accounting, calculating percentage depletion can be challenging.

calculate depletion expense

If net income is less than 15% of gross income, the deduction is limited to 100% of net income . 65% of your taxable income from all sources, figured without the depletion allowance.


They had extracted 210,000 tons of coal from the mine up to Jan 31, 20X5 and sold all but 13,000 tons of the coal extracted from the mine, with in Jan 20X5. Calculate the depletion expense on the mine for the month ending Jan 31, 20X5. Depletion is the process of adjusting the value of a natural resource asset so that it accounts for the removal of the natural resources during the asset’s life. Depletion differs from depreciation in that it is not linked to any length of time and changes based on the amount of resources removed. Unlike cost depletion, percentage depletion is not limited to the depletable base of the property and can be deducted as long as the property generates income. Percentage depletion is not allowed for foreign oil and gas producers, domestic retailers, and domestic refiners.

Adjusted basis is the basis at end of year adjusted for prior years depletion in cost or percentage. It automatically allows for adjustments to the basis during the taxable year. Many companies choose to use the cost method rather than the percentage method because the percentage method relies on more estimations. Capitalized to the Building account would be the $5,000 for building permits to construct a new building and the $500,000 to construct a new building for a total of $505,000.

calculate depletion expense

Charging off depletion expense helps management and other stakeholders to determine actual profits earned during an accounting period. Depreciation, depletion, and amortization (DD&A) is an accounting technique associated with new oil and natural gas reserves. Companies engaged in mining or extracting identify their depletion expense methods and comment on period expenses in the management discussion and analysis (MD&A) sections of their quarterly and annual filings.


Lydia can now update the value of her land by debiting the Depletion Expense account and credit the Accumulated Depletion – Land account. The Accumulated Depletion – Land account is considered a contra-asset account and will offset the asset ‘Land’ on her balance sheet.

The Depletion Rate

For those using the cash method of accounting, the units sold during the year are the units sold for which payment was received. For those using the accrual accounting method, the units sold during the year are the units sold based on inventories and method of accounting for inventory. The number of units sold during the tax year does not include any for which depletion deductions were allowed or allowable in earlier years. The cost basis of a property is usually determined upon its acquisition .

What Is The Depletion Deduction?

The carried over amount is added to the depletion allowance for the next year. Depletion can only be used for natural resources, while depreciation is allowed for all tangible assets. Unlike depreciation, cost depletion is based on usage and must be calculated every period. Depreciation, depletion, and amortization (DD&A) are accounting techniques that enable companies to gradually expense resources of economic value.

What Is Depletion In Accounting?

Depletion is an accrual accounting technique used to allocate the cost of extracting natural resources such as timber, minerals, and oil from the earth. Like depreciation and amortization, depletion is a non-cash expense that lowers the cost value of an asset incrementally through scheduled charges to income. However, if the well proves out, and you are eligible to use the cost depletion method, you may be able to apply depletion to your lease bonus payment. For other types of minerals, you can apply either the percentage and cost method of depletion. According to the IRS Newswire, over 50 percent of oil and gas extraction businesses use cost depletion to figure their depletion deduction. Mineral property includes oil and gas wells, mines, and other natural resource deposits .

The real value of the Land account is the $300,000 minus its associated Accumulated Depletion account of $50,000 for an end-of-year value of $250,000. accounting When a company purchases a piece of machinery, the value of the machine decreases as it is used until it eventually reaches its salvage value.

It is an accounting technique where you allocate the costs of natural resources to depletion over the period making up the assets life. To calculate cost depletion, you take the property basis, units total recoverable, and accounts number of units sold. As you extract natural resources, they are counted and removed from the basis of the property. The cost depletion method only applies if you established assets = liabilities + equity a separate cost basis for the mineral portion of your property when you acquired it. In other words, when you purchased, inherited or received the property as a gift, the minerals must have been valued separately from the surface land. If you simply bought the land for farming, for example, or inherited it without establishing the mineral value, then this method doesn’t apply to you.


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