Percentage Depletion

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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

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...
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