Depreciation, depletion, and amortization (D&A) are a set of strategies used to charge some costs to expense gradually over time. Depreciation is the deliberate, progressive drop in the recorded value of a tangible item over its useful life. Depreciation is used to extend expense recognition for fixed assets over the time period when a company intends to earn income from such assets. Amortization is the same notion as amortization, but it refers to the consumption of an intangible asset over the course of its useful life.

In the oil and gas sector, amortization refers to the continual expensing of properties, wells, and equipment so that it is included in the cost of the oil and gas produced. The physical reduction of a natural resource is referred to as depletion. Because there are no cash outflows when these charges are incurred, they are all classified as non-cash expenses.

In the oil and gas business, all three phrases are used interchangeably, and the term DD&A has evolved to encompass all three types of expense recognition. DD&A is used in somewhat different ways depending on whether a company uses the successful efforts technique or the full cost method.

Accrual accounting allows businesses to report capital expenses in periods that correspond to the utilization of a connected capital asset. In other words, it allows businesses to match their expenses to the income they helped generate.

For example, if a major piece of machinery or property necessitates a significant cash outlay, it can be expensed across its useful life rather than at the specific period in which the cash outlay happened. This accounting technique is intended to provide a more realistic portrayal of the business’s profitability.

For energy companies, DD&A is a standard operating expense. Energy analysts and investors should be aware of this expense and how it relates to cash flow and capital expenditure.

Depreciation

Depreciation is the reduction in the value of tangible assets. Tangible assets have a physical form as well as a specific lifespan. Production equipment, office equipment, and other sorts of property are examples of physical assets. They are also known as Property, Plant, and Equipment (PP&E).

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The economic meaning of depreciation is that an asset ages and loses some of its market value year after year. Because the asset has been used by the firm, depreciation is reported as an expense on the Income Statement, and this is a cost that should be accounted for when evaluating the company’s profitability.

The worth of assets does not reach zero at the end of their existence, but rather a specific salvage value. This is either what the corporation sells the asset for when it is no longer useful, or the money the company makes by selling it to be salvaged for parts in some situations.

Depletion

Depletion reduces an asset’s cost value incrementally through regular charges to income. The difference is that it refers to the slow depletion of natural resource reserves rather than the wear and tear of depreciable assets or the aging life of intangibles.

Miners, loggers, oil and gas drillers, and other enterprises involved in natural resource exploitation frequently employ depletion expenses. Companies with an economic interest in the mineral property or standing wood may deduct depletion expenses as the assets are utilized. Depletion can be calculated on a cost or percentage basis, and corporations must normally pick the method that affords the greater tax reduction.

Amortization

Amortization is similar to depreciation, however, it refers to the decrease in the value of intangible assets rather than actual assets. Intangible assets are assets that do not have a physical form but nonetheless bring value to a business. Brand recognition, intellectual property, copyrights, franchise rights, and patents are examples of intangible assets.

Many of these assets have a usable life, therefore their value diminishes as the end of their useful life approaches. It is important to remember that only intangible assets with finite lifespan (such as software licenses) are amortizable. Because intangible assets, like as a company’s brand, have an endless life, they are not amortized.

Assume a company pays $30,000 for a vehicle. The vehicle’s useful life is projected to be eight years. This year, how much should be charged as an expense? We know that the automobile cost $30,000, but only a portion of that amount can be assigned to the current period.

Instead, the following will take place. The company will record a $30,000 asset on its Balance Sheet, reducing its cash by $30,000.

The asset’s value will then decline year after year as it becomes older and obsolete. The company will need to use a depreciation technique to determine how much the asset’s value will be lowered each year.

If a firm employs all three of the above expensing procedures, depreciation, depletion, and amortization (DD&A) will be reflected in its financial statements. On the income statement, a single line with the monetary amount of charges for the accounting period appears.

Explanations may also be provided in the footnotes, especially if the depreciation, depletion, and amortization (DD&A) charge varies significantly from one quarter to the next.

A balance-sheet entry is also produced. The monetary number indicates the entire amount of depreciation, depletion, and amortization (DD&A) since the assets were purchased. Assets lose value over time, which is reflected in the balance sheet.

How is D&A connected to Fixed Assets?

Fixed assets are tangible assets that are expected to be owned by the company in the long term. Buildings, factories, machines, and cars are examples of such assets. These are the inverse of current assets (inventory, cash, accounts receivable, and so on), which are held by the company for less than a year.

D&A has an impact on fixed assets via the Depreciation component. This is displayed on the Balance Sheet when the Net Book Value is recorded. In our example, we computed the annual depreciation of a $30,000 automobile using the straight-line method to be $3,000. If the asset has been in our control for more than two years, we shall record its Net Book value as follows on the Balance Sheet:

$30,000 – (2x$3,000) = $24,000

When using the activity-based method, this figure changes slightly:

$30,000 – (2x$3,600) = $22,800

Higher D&A leads to lower fixed assets unless investments in fixed assets are made. Therefore, by looking at those two metrics over time, we can deduce:

1. If the company is growing. In this case, fixed assets are growing even though there is a high D&A. This means that new investment is higher than depreciation, hence the productive capacity of the firm grows.
2. If the company is downsizing. In this case, fixed assets are being reduced closer to their salvage value every year as new investment is not made. Either that or investment is made but it is not enough to outweigh the depreciation of the company’s fixed assets.