Percentage Depletion

When accounting students study income tax accounting, the first concept they learn is financial accounting and income tax accounting will produce different amounts of revenue and expenses. The net income reported on financial statements will differ from the net income reported to the Internal Revenue Service. The difference is created by temporary and/or permanent tax differences. Temporary tax differences are caused by timing; these differences will eventually reverse themselves.

Permanent tax differences, as the name suggests, will not be reversed. An example that most students are familiar with would be interest income earned on municipal bonds. However, many students are not familiar with the permanent tax difference that can be created by percentage depletion. This paper will give students a basic understanding of depletion, the historical background of percentage depletion, why percentage depletion was added to the tax code and the benefits and costs of using percentage depletion. DISCUSSION

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To understand how a permanent tax difference is created by percentage depletion, the student needs to understand that there are two methods for calculating the depletion of mineral property: cost depletion and percentage depletion. Cost depletion is the GAAP method for financial accounting. However, for tax accounting owners of oil and gas wells have the option of using percentage depletion as described by IRS Publication 535 which states “For mineral property, you generally must use the method that gives you the larger deduction. ” IRS Publication 535 gives a detailed description of how to calculate cost and percentage depletion.

To help clarify the IRS code, Joe Scarfarotti, a revenue accountant from SM Energy Company and member of Council of Petroleum Accountants Societies, explained the basic calculations for the two methods of depletion. Cost depletion is calculated as cost times the Unit of Production (UOP) rate. For this calculation, cost is defined as the capital investment made to acquire the mineral rights. UOP is defined as annual production (barrels of oil or BO) divided by the sum of annual production plus year-end reserves. He gave the following example: Capital Cost:\$1,000,000

UOP Rate:1,000 BO/1,000 BO + 9,000 BO = 10% Cost Depletion:\$1,000,000 X 10% = \$100,000 The cost depletion accumulates until 100% of the capital cost is expensed. Percentage depletion is based on a percentage of the gross revenue from the property. For oil and gas wells, the rate is 15%. The percentage cannot be more than 100% of the net income from the property. For example, we will say 15% of the gross revenue of the above property is \$120,000 and the net income of the property is \$105,000. The smaller of the two will be used. For this property, the percentage depletion is \$105,000.

In this case, the producer will chose to use percentage depletion for tax accounting. In this example, cost depletion of \$100,000 is used for financial accounting and percentage depletion of \$105,000 is used for tax accounting. There is a \$5,000 difference that will not be reversed in the future. This is a permanent tax difference that reduces taxable income. It should be noted here that the use of percentage depletion is limited to independent producers and independent producers are limited to applying percentage depletion to 1,000 BO per day of their total production or the equivalent of 6,000 MCF per day for gas wells.

Why does percentage depletion exist? According to the Independent Petroleum Association of America (IPAA), percentage depletion became a part of the tax code in 1926 to encourage drilling. In recent years, the net income limitation has been suspended for marginal wells. In 2009 federal budget proposals would have repealed the percentage depletion, thus eliminating this tax difference. As can be expected, the IPAA lobbied to keep the percentage depletion allowance. According to the IPAA “percentage depletion remains an important factor in the economics of American oil and natural gas production. The IPAA goes on to state that independent producers are the predominant producers of marginal wells, which account for 85% of domestic oil wells and 75% of domestic gas wells. Marginal wells, also referred to as stripper wells, produce less than 15 BO per day. These wells contribute 20% of domestic oil production and 12% of domestic gas production (U. S. Energy Information Administration). The IPAA also reminded Congress that marginal wells are expensive to operate and revenue barely covers operating costs.

Percentage depletion allows the operator to retain more of the marginal well’s revenue. Obviously the goal for the oil and gas producer is to make more money and using percentage depletion will help the producer reach that goal. The goal of permanent tax differences is to encourage desirable behavior or discourage undesirable behavior. For example, buy municipal bonds and the government will not tax your interest income because the government encourages this behavior. Fines and penalties paid for infractions of regulations are not allowed as expense deductions.

Government will not reward bad behavior. Percentage depletion was meant to encourage drilling and to keep marginal wells producing. The statistical data provided by the US Energy Information Administration support the conclusion that this tax policy is working. While the benefit of this permanent tax difference is apparent, costs associated with percentage depletion are harder to determine. The article “The Performance of Government in Energy Regulations”, published in 1979 in The American Economic Review, suggests that government interference in the energy industry may not be beneficial.

According to the article’s author, Walter J. Mead, the percentage depletion along with the provision made for expensing intangible drilling cost did indeed lead to increased drilling and production. However, from his viewpoint increased production had negative consequences. Increased production led to lower oil prices which in turn led to the perception by the public that oil and gas were cheap commodities to be consumed excessively. In his opinion, these two tax policies were major contributors to the energy crisis of the 1970s. Clearly Mr.

Mead does not find much benefit to the percentage depletion method as public policy. From the perspective of financial accounting, percentage depletion is not consistent with GAAP. If it were, the method of depletion would be consistent for both financial and tax accounting. However, it is not in the scope of this paper to discuss the FASB’s opinions on oil and gas accounting standards. Oil and gas accounting is a specialized type of accounting that requires several years of study and experience to understand. The most relevant fact is that cost depletion is aligned with the concept of full-cost accounting.

It provides for the expensing of the capital acquisition cost of mineral properties. Percentage depletion does not have a cost basis and thus is not a full-cost accounting method. CONCLUSION From the oil and gas accountant’s perspective, would a cost-benefit analysis show that using cost depletion for financial accounting and percentage depletion for tax accounting is cost-effective? An informal poll of accountants in the industry indicates that the answer is yes. Much of the record-keeping necessary for calculating percentage depletion is already in place.

New technology has allowed producers to create databases that can access daily, weekly, monthly and annual production volumes with just a few keystrokes. Data can be queried by well, by field, by state, not only for production but also for revenue, capital expenditures and operating expenses. Thus the benefits far outweigh the cost. Mr. Mead makes an interesting argument against tax policies favoring oil and gas producers. These policies increased supply, which led to lower prices, which led to greater demand. Eventually demand could not be met by domestic supply.

But today oil sells for over \$100 a barrel, leading to a shift in consumers’ attitudes about energy. People want homes that conserve energy and cars that get 50 miles to the gallon. And while we are saving energy, we’d also like to become less dependent on foreign oil. More domestic production equals less dependence on foreign oil. Finally, one last word about who gets to use percentage depletion. Who are the independent producers? They are non-integrated oil companies. An integrated oil company is “a business entity that engages in the exploration, production, refinement and distribution of oil and gas” (Investopedia).

Non-integrated oil companies do not engage in the downstream portion of the industry, the refinement and distribution of oil and gas. Independent producers can range from small sole proprietorships to corporations with several hundred employees. Independent producers are not “big oil”. Any perception that percentage depletion benefits “big oil” is wrong. References Integrated Oil Companies. (2012. ) In Investopedia Financial Dictionary. Retrieved May 1, 2012 from http://www. investopedia. com/terms/i/integrated-oil-gas-company. asp#axzz1tfs

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