Depreciation is intuitive. A truck wears out, and the books record the wearing out. Depletion is the same idea applied to something people find harder to picture, which is a reservoir emptying.
Every barrel sold is inventory that will never be replaced from that property. Todd Muslow CPA audited that calculation at KPMG LLP before he owned it as Chief Accounting Officer of O’Brien Resources, LLC. It is one of the larger numbers on an energy company’s income statement and one of the least examined.
Two Calculations Wearing the Same Name
Cost depletion recovers actual investment. Take the adjusted basis in the property, divide by estimated recoverable reserves, multiply by units sold this period. The result is the deduction, and it stops when basis reaches zero.
Percentage depletion works differently. It applies a statutory percentage to gross income from the property, subject to limits tied to net income from that property and to overall taxable income. It is available to independent producers and royalty holders rather than to integrated companies.
The difference that surprises owners is what happens at the end. Cost depletion exhausts. Percentage depletion, under current law, can continue past the point where basis is gone, which means deductions on a property fully recovered years earlier.
The Books and the Return Part Company
Financial statements prepared under generally accepted accounting principles use cost depletion on a units of production method. Percentage depletion is a tax concept and does not belong on the income statement.
That creates a permanent difference rather than a timing difference, and it feeds directly into the deferred tax calculation. Todd Muslow CPA points out that companies with a single set of books and a tax preparer working from the trial balance frequently get this wrong in both directions.
The deduction on the return should be the greater of the two calculations, computed property by property. Not company wide. Not on an estimate applied across the portfolio because running it by property took too long.
Everything Depends on the Reserve Estimate
Cost depletion has a denominator, and that denominator is an engineer’s judgment about how much is down there. Reserve estimates get revised, sometimes materially, and a revision changes the rate going forward.
The revision is prospective. You do not restate prior periods because the engineer’s view of the reservoir improved. You recompute the rate on remaining basis over remaining reserves and carry on.
Which means the accounting depends on documentation that lives outside accounting. Todd Muslow CPA has watched companies book a depletion rate for years without anyone connecting it back to the report it came from.
Where the Errors Actually Are
Basis is the first one. It includes leasehold acquisition costs, capitalized intangible drilling costs where the expensing election was not made, and geological and geophysical costs with their own amortization rules. Getting basis wrong makes every subsequent year wrong.
The property unit definition is the second. Depletion is computed by property, and what counts as a separate property has rules that owners tend to resolve by drawing lines on a map. That is not the test.
The third is simply staleness. A rate set at the beginning of a well’s life and never revisited will drift away from reality as reserves are reestimated and basis changes with additional capitalized costs.
Todd Muslow CPA of Shreveport, Louisiana, is a partner of Muslow+Agnew Group, LLC and works with closely held businesses on financial reporting, taxation, and consulting. He recommends a documented recomputation each year, tied to the current reserve report, with the workpaper kept where a reviewer can find it.
The reviewable version of this is a single workpaper per property showing basis, the reserve figure with its source, the units sold, both calculations, and the one selected. Anyone can follow it. That is the test. If the schedule cannot be followed by a person who was not there, it is not documentation.
Depletion is not a plug. It is a measurement of something real that is leaving the ground and never coming back, and the books should be able to prove it.