Depreciation, Depletion, and Amortization Explained

In its footnotes, the energy giant revealed that the slight DD&A expense increase was due to higher production levels for certain oil and gas producing fields. Charlene Rhinehart is a CPA , CFE, chair of an Illinois CPA Society committee, and has a degree in accounting and finance from DePaul University. Let us discuss what these terms and the key differences between them are. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years.

This is an advantage because, while companies seek to maximize profits, they also want to seek ways to minimize taxes. In accounting the terms depreciation, depletion and amortization often involve the movement of costs from the balance sheet to the income statement in a systematic and logical manner. The value of various types of asset decreases over the years for various reasons. This accounting method allocates cost to a tangible asset over its useful lifespan. Finally, Amortization is a form of depreciation that applies to intangible assets that you cannot touch or feel, such as goodwill.

Understanding Depreciation

Then, the number of extracted units is multiplied by the depletion charge to calculate the yearly depletion cost. The cost depletion method will require calculating the total resource endowment. It is the available resources (converted into a dollar amount) before extraction.

For example, expenses and income get recorded in the period concerned instead of when the money changes hands. You wouldn’t charge the whole cost of a new building in the acquisition year because the life of the asset would extend many years. Depreciation typically relates to tangible assets, like equipment, machinery, and buildings.

Amortization versus Depreciation

The company can also scrap the equipment for $10,000 at the end of its useful life, which means it has a salvage value of $10,000. Using these variables, the accountant calculates depreciation expense as the difference between the asset’s cost and its salvage value, divided by its useful life. This method requires an estimate of the total units an asset will produce over its useful life. Depreciation expense is then calculated per year based on the number of units produced. This method also calculates depreciation expenses based on the depreciable amount.

• This percentage is then multiplied by the gross yearly income of the company to calculate the depletion charge for the year.
• In its footnotes, the energy giant revealed that the slight DD&A expense increase was due to higher production levels for certain oil and gas producing fields.
• Depletion method of depreciation is mostly used by the companies that have assets that are natural resources like oil, gas, coal, mines, quarries or other wasting assets.
• However, you have to use that cost to calculate the depletion over the time you produce it.

The depreciation rate is used in both the declining balance and double-declining balance calculations. The definition of depreciate is “to diminish in value over a period of time”. The term amortization is used in both accounting and in lending with completely different definitions and uses. Instead, the company has to calculate the drilling cost and allocate it as it makes a profit from selling the oil it produces.

Examples of Natural Resources Assets Requiring Depletion

A Fixed Asset is a long-term asset (or non-current asset), one that a business will hold for longer than a year. These are permanent, tangible items the business intends to own long-term (more than a year). These Fixed Assets may be referred to as Property, Plant, and Equipment assets or PP&E.

Therefore, the oil well’s setup costs can be spread out over the predicted life of the well. For example, if a company buys a vehicle for $30,000 and plans to use it for the next five years, the depreciation expense would be divided over five years at $6,000 per year. Each year, depreciation expense is debited for $6,000 and the fixed asset accumulation account is credited for $6,000.

Depreciation Vs Depletion Vs Amortization

A loan doesn’t deteriorate in value or become worn down over use like physical assets do. Loans are also amortized because the original asset value holds little value in consideration for a financial statement. Though the notes may contain the payment history, a company only needs to record its currently level of debt as opposed to the historical value quickbooks online 2020 less a contra asset. This accounting technique is designed to provide a more accurate depiction of the profitability of the business. Depreciation is the devaluing of tangible assets, like equipment, air conditioners, vehicles, computers, flooring, etc. You cannot deplete tangible assets, but the depletion of resources can cause depreciation.