What it means
Every business that buys something long-lived has to answer one question: when does that cost hit the profit and loss account? Depreciation answers it for machines and buildings, depletion answers it for mineral deposits, oil fields and timber stands, and amortisation answers it for intangibles such as patents, customer lists and purchased software.
The three are cousins, which is why finance teams often group them into a single line called depreciation, depletion and amortisation. Depletion matters because a mine or a well is a wasting asset, meaning an asset that physically shrinks as you use it.
Charging a fixed yearly amount would misstate a year in which almost nothing was extracted, so the cost is spread per unit removed instead. That ties the expense directly to production volume, which is exactly how the owner thinks about it.
Amortisation matters because most intangibles have a legal or economic life that expires. A 12-year patent, a five-year distribution agreement and a three-year software licence each have a defined window in which they generate value, and the accounting spreads the purchase price across that window.
Intangibles with no foreseeable end, most obviously goodwill, are generally not amortised at all under current standards; they are tested for impairment instead. In practical use, cash flow statements add depletion and amortisation back to profit because neither involves a cash payment in the year it is charged.
That is why investors looking at mining, energy and media businesses reach for earnings before interest, tax, depreciation and amortisation to see the underlying cash generation. Lenders do much the same thing when they size how much debt a resource company can carry.
The nuance that trips people up is that non-cash does not mean free. The cash left the business earlier, when the deposit was bought or the patent acquired, and if the company must keep replacing those assets to stay in business then the annual charge is a fair proxy for a real, recurring cost.
Ignoring it flatters the numbers of exactly the companies that can least afford flattery.
In practice
Real-world examples.
Example
An offshore oil partnership capitalises $60,000,000 of drilling and development costs against proved reserves of 15,000,000 barrels, giving a depletion rate of $4.00 per barrel. Producing 900,000 barrels in a quarter creates a depletion charge of $3,600,000. The partnership reports that charge on its own line so investors can see the cash margin underneath it.
Example
A software company buys a competitor's patent portfolio for $2,400,000 and amortises it over the eight years of legal protection remaining, a charge of $300,000 a year. Reported operating profit falls by that amount each year even though no further cash moves. The finance director explains the gap to the board every quarter.
Example
A timber business capitalises $18,000,000 for a plantation containing an estimated 600,000 cubic metres of harvestable wood, a rate of $30 per cubic metre. Harvesting 40,000 cubic metres in a season produces a depletion charge of $1,200,000, which flows straight into the cost of the timber sold.
Formula
Calculation
Depletion per unit = (Capitalised cost - Estimated salvage value) / Total estimated recoverable units
Depletion expense = Depletion per unit x Units extracted in the period
Amortisation expense (straight line) = Cost of intangible asset / Useful life in years
A quarrying business buys a limestone deposit for $12,000,000 with no expected salvage value, and geological surveys estimate 4,000,000 tonnes are recoverable. Depletion per tonne = $12,000,000 / 4,000,000 = $3.00 per tonne. In its first year the business extracts 250,000 tonnes, so depletion expense = 250,000 x $3.00 = $750,000.
The same business paid $900,000 for a ten-year extraction permit, an intangible asset. Straight-line amortisation = $900,000 / 10 = $90,000 per year. The combined non-cash charge for the year is $750,000 + $90,000 = $840,000. With revenue of $4,200,000 and cash operating costs of $2,600,000, cash generated before tax is $1,600,000, and reported operating profit is $1,600,000 - $840,000 = $760,000.Case study
Seen in the real world.
Cobblestone Quarries is an illustrative, entirely fictional gravel producer created to show how these charges behave. It paid $20,000,000 for a pit estimated to hold 5,000,000 tonnes, giving a depletion rate of $4.00 per tonne. In its first year it extracted 400,000 tonnes and booked $1,600,000 of depletion, leaving $18,400,000 of unrecovered cost on the balance sheet.
Midway through year two a fresh survey concluded that only 4,000,000 tonnes remained, not the 4,600,000 the original estimate implied. The rate was recalculated as $18,400,000 / 4,000,000 = $4.60 per tonne, applied from that point forward rather than restating the prior year. The same 400,000 tonnes of extraction now cost $1,840,000, an increase of $240,000 with no change in cash spending.
That $240,000 mattered because Cobblestone's bank covenant was written on reported operating profit rather than cash flow. The finance director had to renegotiate the covenant definition, and the episode taught the board a lesson many resource businesses learn the hard way: reserve estimates are assumptions, and assumptions move the reported numbers.
Watch out
Common mistakes.
- Treating depletion as a discretionary charge that can be skipped in a bad year, when in fact it is driven mechanically by the units extracted and is required in any compliant set of accounts.
- Using the words depreciation and amortisation interchangeably in board papers, which confuses readers about whether the underlying asset is a physical machine or a patent with an expiry date.
- Reading a large amortisation charge as evidence of weak trading, when it often just reflects intangibles picked up in a past acquisition and says nothing about this year's operating performance.
Questions
People also ask.
Is depletion actually a cash cost?
Not in the year it is charged, but the cash went out earlier when the resource was acquired or developed, so it represents real money already spent.
Can goodwill be amortised?
Under the main accounting frameworks goodwill is not amortised; it is tested for impairment at least annually and written down only if its value has fallen.
What happens if the reserve estimate changes?
The remaining unrecovered cost is divided by the revised remaining units to give a new rate applied going forward, and prior years are normally left alone.
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