Deprecation, Depletion and Amortization

DD&A stands for depreciation, depletion, and amortization. These terms are associated with tangible assets, resources, and intangible assets, respectively.

DD&A calculations are required for tax relief allowance, cost recovery, and sometimes royalty calculations. They are nearly always necessary for tax computation, regardless of industry or location.

The economic rationale for calculating DD&A is explained below.

For any business to generate revenue, it must first invest in an asset. The use of the asset then generates profit or revenue for the business. This applies to all types of businesses, whether manufacturing or knowledge-based consulting services. For a manufacturing company, its plants, production facilities, and equipment are its assets. For a knowledge-based company, the expertise and skills of its consultants, along with the company's reputation, are its primary assets.

To acquire an asset, an initial expenditure is typically required. This spending is referred to as capital expenditure (CAPEX). In the chapter on Capital Budgeting, we distinguished between capital expenditure and operational expenditure. Capital expenditure results in the creation of an asset. An asset, in accounting terms, is an investment that provides value over multiple periods in the future.

Operating expenditure (OPEX), on the other hand, also involves spending. However, this spending generates value only within the period in which it is incurred.

Let's consider an example to clarify the concept. Imagine you start a cab rental business. You purchase one car and rent it out to customers. In return, the car renter pays a rental fee for using the vehicle. Suppose the car costs you $50,000 on January 1, 20X0 (the first day of your business). Over the year, your rental business generates $20,000 in revenue. Your annual expense for maintaining the rental office is $5,000. At the end of the year, you need to file your tax return for the business. Assume the tax rate is 30% on the profit.

The question arises: how much tax do you need to pay to the tax authorities? What is your profit for the year? What is your cash flow for the year?

To determine this, calculate your pre-tax profit as follows:

Pre-tax profit = Gross rental income from car – office expense – cost to buy the car

                      = $20,000 - $5,000 - $50,000

                      = -$35,000

You might conclude that you made a loss of $35,000 and therefore do not owe any tax to the tax authorities.

However, the tax authorities may contact you, requesting tax payment or imposing a fine. Confused by this, you seek clarification on how you could owe tax when you actually incurred a loss.

The tax authorities explain that according to the tax code and accounting rules, you appear to have made a profit. The taxable income is calculated as follows:

Total rental income = $20,000

Less office expense = $5,000

Less depreciation for the car = $5,000

Taxable income (or taxable profit) = $20,000 - $5,000 - $5,000 = $10,000

Thus, a 30% tax needs to be paid on a taxable profit of $10,000 for the year.

Tax liability = 30% x $10,000 = $3,000

So, where did you go wrong in calculating your taxable profit, and why? What you calculated was not your taxable profit but your pre-tax cash flow. This reflects the actual cash impact on your bank account before tax. Taxable profit is an accounting term that may not align with cash flows.

Here is the logic behind depreciation. When you purchased the car at the beginning of the year for your rental business, you created an asset. The car helped generate $20,000 in revenue during its first year of service and will continue to generate income in the future. Therefore, we cannot deduct the entire value of the car in the first year. Instead, we can deduct a portion of the car's value against this year's revenue. Essentially, the value of the car must be allocated over multiple periods during which it will be used. Each period will see a deduction of the allocated portion of the car's value from that period's revenue.

Depreciation is an accounting method used to allocate the portion of an asset's value that has been consumed in generating revenue during a specific accounting period. It distributes the capital cost (assets) over a period of time, known as the "useful life" of the asset. The useful life of an asset is typically predetermined by accounting rules.

Depreciation, along with depletion and amortization, can also be viewed as methods of recovering capital investment from revenue.

Operating costs are expensed, meaning they can be recovered fully in the same period they are incurred, unlike capital investments. Operating expenditures are used to generate revenue within the same period they are spent and do not create future revenue, unlike capital expenditures.

It is important to note that large expenses are not always capital expenditures. Whether an expenditure is considered capital depends on its usage.

For example, if you run a car dealership, the cars purchased and sold are classified as inventory, not capital expenditures. The cost involved will be expensed in the period the car is sold as costs of goods sold.

Having understood the concept and economic rationale of depreciation, let’s move on to depletion and amortization. Mathematically, these concepts all involve distributing the cost of an asset over its useful life. Assets or capital are generally classified as 'tangible', 'intangible', or natural resources/rights for the exploitation of natural resources. When dealing with tangible assets, the distribution of cost over the asset's useful life is termed 'depreciation'. For intangible assets, it is called 'amortization'. For natural resources, this process is referred to as 'depletion.'

Examples of tangible assets include buildings, machinery, pipelines, facilities, and platforms. Intangible assets include service costs, drilling costs, some research and development expenditures, trademarks, and patents. Costs associated with acquiring exploration or development licenses or bonuses paid for mineral rights may be recovered through depletion.

Tax calculation allows certain costs to be deducted (or recovered) against gross revenue. These allowable deductions are generally called 'allowances'. In calculating allowances, only a portion of the capital cost is permitted rather than the entire capital cost. Ideally, the allowed portion of the capital cost (depreciation) should reflect the usage of the capital/asset in that specific period. The depreciation amount included in the allowance for tax relief is usually referred to as 'Capital Allowance.'

Depreciation can begin from the day the capital expenditure is incurred (when the asset is purchased), from the date the asset is actually put to use, or from the start date of production.

The straight-line method is a straightforward way to calculate depreciation. It distributes the capital cost evenly over the asset's lifespan, which is determined by tax code or asset type. Depreciation value remains constant across all periods.

For example, consider an offshore project facility costing $103 million with a useful life of 20 years. At the end of its useful life, the salvage value is $3 million. The salvage value is the amount received from selling or scrapping the asset at the end of its life. The asset's value used over the 20-year period is $100 million ($103 million - $3 million). Using the straight-line method, equal value is allocated each year over 20 years, resulting in annual depreciation of $5 million ($100 million / 20 years).

Depreciation Pool additions, as shown in the table above, represent the amount of depreciable capital expenditures (Capex) added to the depreciation pool during each period. The amount depreciated will be 20% of the ‘_Depreciation Pool – Opening Balance_’. The Depreciation Pool – Opening Balance is the amount of Capex in the depreciation pool that has not yet been depreciated, which includes the closing balance of the previous period plus the current period's addition of depreciable Capex.

As indicated, the depreciation pool balance does not reach zero; therefore, Capex will not be fully depreciated using this method.

The Double Declining Balance method of depreciation is similar to the regular Declining Balance method, but with a rate that is twice what is specified. For instance, if the rate is 5%, then a rate of 10% will be applied for depreciation.

At the end of the first year, the amount depreciated is $10 million (calculated as 2 x 5% x ($103 million - $3 million)). Consequently, the remaining asset value at the end of the first year is $93 million. In the second year, depreciation will be calculated as (2 x 5%) x (($103 million - $3 million) - $10 million).

The remaining asset value will continue to decrease each year, and eventually, the amount of depreciation calculated using this method will fall below the amount calculated using the straight-line method. At that point, the depreciation method will switch from double declining balance to the straight-line method.

For example, if the initial double declining rate is 5%, the actual depreciation rate would be based on 10% of the remaining asset value. This result is compared with the straight-line depreciation value each period. Given a declining rate of 5%, which is equivalent to a 20-year lifespan (1/5), the straight-line depreciation would be fixed at $5 million per year (assuming an asset value of $103 million with a $3 million salvage value). When the depreciation amount based on 10% falls below $5 million in any given period, the method switches to straight-line depreciation.

This method is commonly known as the Units of Production (UOP) method of depreciation. In this approach, the value of the asset allocated to a specific period depends on the amount of production during that period in proportion to the total possible production over the life of the field or project.

For example, if the production in a period represents 7% of the total reserves, then the depreciation for that period will be 7% of the asset's value. Assuming the asset data remains consistent with previous calculations, the depreciation for this particular period will amount to $7 million (= 7% x ($103 million - $3 million)). If the production in the subsequent period is 8%, then the depreciation amount for that period will be $8 million.