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Difference between Depreciation,

Depletion and Amortization

All assets with an estimated useful life eventually end up being exhausted. Different
types of assets such as fixed, intangible & mineral assets are systematically reduced
within their useful life. Difference between depreciation, depletion and amortization
depends on the type of asset in question.

Depreciation, Depletion and Amortization are three primary ways to apply such
reductions in assets. To begin with, here is a quick reference table;

It is to spread or allocate the cost of a tangible fixed asset over its estimated
economic useful life. In other words, it may be seen as a reduction in the cost of a fixed
asset due to normal usage, wear and tear, new technology, and other related reasons.
Example – A company charging 10% depreciation on all their buildings, 25%
depreciation on laptops, etc.

Related Topic – Why is Depreciation not charged on land?

Prorating cost of an “Intangible Asset” over the period during which benefits of this
asset are estimated to last is called Amortization. The concept of amortization is also
used with leases & debt repayment.

Amortization is for Intangible assets whereas depreciation is for tangible fixed assets.
Examples of intangible assets are copyrights, patents, software, goodwill, etc.

When dealing with a natural resource also referred as a mineral asset the concept of
depreciation or amortization cannot be applied. “Depletion” is a form of a systematic
reduction in the value of a natural resource based on the rate at which it is being used.

For example – A coal mine has 10 Million tonnes of coal and the coal extraction is
happening at the rate of 1 Million tonnes per year. In this case, depletion rate would be
10% p.a. since at this rate of extraction the coal mine is being depleted at 10% per year.

How we count it

Depreciation” of capitalized well equipment cost (over a stated life or on the unit of
production basis),

“Depletion” of capitalized property acquisition costs (on a unit of production basis), and
“Amortization” over 60 months of certain other costs, such as intangible drilling costs
that are not immediately deducted

Full Cost Method

 All property acquisition, exploration and development costs, even dry hole costs, are
capitalized as oil and gas properties.

 These costs are amortized using a unit-of-production method based on volumes produced
and remaining proved reserves.

 The net unamortized capitalized costs of oil and gas properties less related deferred income
tax MAY NOT exceed a ceiling consisting primarily of a computed present value of projected
future cash flows, after income taxes, from the proved reserves.
Successful Effort Method

 Only the cost of successful efforts is capitalized.

 Cost of exploratory dry holes, geological and geophysical (G&G) costs in general, delay
rentals, and other property carrying costs are expensed.

 The net unamortized capitalized costs are amortized on unit-ofproduction method, whereby
property acquisition costs are amortized over proved reserves and property development costs
are amortized over proved development reserves.
Successful Effort vs Full cost
Historical Cost Accounting Methods

The four basic types of costs incurred by oil and gas companies in exploration and production
activities must be accounted for using one of two generally accepted historical cost methods:
the successful efforts method or the full cost method. In connection with the four basic costs,
the fundamental accounting issue is whether to capitalize or expense the incurred costs. If
capitalized, the costs may be expensed as expiration takes place either through abandonment,
impairment, or depletion as reserves are produced. If expensed as incurred, the costs are
treated as period expenses and charged against revenue in the current period. The primary
difference between successful efforts and full cost is in whether a cost is capitalized or
expensed when incurred. In other words, the primary difference between the two methods is in
the timing of the expense or loss charge against revenue. The other basic difference between
the two accounting methods is the size of the cost center over which costs are accumulated
and amortized. For successful efforts, the cost center is a lease, field, or reservoir. In contrast,
the cost center under full cost is a country. The cost center size has implications in computing
depreciation, depletion, and amortization (DD&A) and also in computing ceiling and
impairment writedowns (chapters 6, 7, and 9).

Under successful efforts, a direct relationship is thus required between costs incurred and
reserves discovered. Consequently, under successful efforts, only exploratory drilling costs that
are successful, i.e., directly result in the discovery of proved reserves are considered to be part
of the cost of finding oil or gas and thus are capitalized. Unsuccessful exploratory drilling costs
do not result in an asset with future economic benefit and are therefore expensed. In contrast,
because there is no known way to avoid unsuccessful costs in searching for oil or gas, full cost
considers both successful and unsuccessful costs incurred in the search for reserves as a
necessary part of the cost of finding oil or gas. A direct relationship between costs incurred and
reserves discovered is not required under full cost. Hence, both successful and unsuccessful
costs are capitalized, even though the unsuccessful costs have no future economic benefit.

Specifically, successful efforts treats exploration costs that do not directly find oil or gas as
period expenses, and successful exploration costs as capital expenditures. Under full cost, all
exploration costs are capitalized. Under both methods, acquisition and development costs are
capitalized and production costs are expensed. Although development costs could include an
unsuccessful development well, all development costs are capitalized under successful efforts
because the purpose of development activities is considered to be building a producing system
of wells and related equipment and facilities, rather than searching for oil and gas. Table 2–1
shows the accounting treatment of these costs under successful efforts compared to full cost.

Concession and PSC

The two main families of fiscal system are:

1) “Concessionary” systems (more commonly known these days as Royalty/Tax (R/T) systems)

2) “Contractual Based” systems {which include both Production Sharing Contracts (PSCs) and
Service Agreements (SAs)
Concession system
1.2) Production Sharing Contracts (PSCs/PSA)

 Production sharing agreements (PSAs) are a common type of contract signed between a
government and a resource extraction company (or group of companies) concerning how much
of the resource (usually oil) extracted from the country each will receive..

 “A contractual agreement between a contractor (Oil/Gas Company) and a host

government(or its NOC) whereby the contractor bears all of the exploration costs and risks and
the development and production costs in return for a stipulated share of the production
resulting from this effort”.

 In PSAs the country's government awards the execution of exploration and production
activities to an oil company. The oil company bears the mineral and financial risk of the
initiative and explores, develops and ultimately produces the field as required. When
successful, the company is permitted to use the money from produced oil to recover capital
and operational expenditures, known as "cost oil". The remaining money is known as "profit
oil", and is split between the government and the company, typically at a rate of about 80% for
the government, 20% for the company. In some PSAs, changes in international oil prices or
production rate can affect the company's share of production.

 PSAs could be a transitional phase or a permanent feature of the petroleum regime (as for
example in Syria and Egypt).

 PSA allows investor participation while retaining national ownership of shares of petroleum
produced:-  Production shares  Participating interests by NOC

 PSA passes risk to the investor  PSA is familiar to petroleum industry

Where are PSC’s used?

The concept of production sharing is ancient and widespread.

Farmers in the USA have been familiar with the concept for decades.

The concept of the PSC as far as the oil and gas industry is concerned was conceived in
Venezuela in the mid 1960s.

The first modern PSC was signed in 1966 between IIAPCO and Permina, Indonesia’s NOC at
the time. India, China, Kazakhstan, Libya, Nigeria, Algeria, Angola,

Mauritania, Egypt, Trinidad & Tobago and Russia.

1.2.1) Key Modern Elements of PSA/PSC

 Independent environmental impact studies

 Development Plan for regulatory approval

 Contractor incurs all exploration and development costs

 Cost recovered from agreed percentage of gross production

 Profit oil/gas shared on some basis taking account of cost and price changes.

 Contractor proceeds from PSA usually liable to income tax  PSA provides for fiscal stability

 State can participate in the Contract through subsidiary company

1.2.4) Summary: The Production-Sharing Agreement (PSA)

 Terms of PSAs can be replicated in tax and royalty regimes, but PSAs allow variation of
economic terms for an area without amendment of fiscal legislation

 State can retain and dispose of its share of petroleum or make marketing arrangements with

 State not obliged to find budget funds for costs unless it elects to take working interest

 PSAs can be “ring-fenced” or not, depending upon the state’s preference for early revenue or
maximum pace of development

 A “Model” PSA provides a standard framework for competitive bidding over areas to be
 “Pay on behalf” arrangements for Contractor’s income tax provide built-in fiscal stability

 Combination of PSA with tax permits investors to obtain tax credits at home; minimizes cost
to host country revenues.