The controller of Newform Oil Company has come to you for advice. Newform recently cleared a forested area and began drilling an oil well on the site. The well is a gusher, and Newform’s geologists estimate that it will produce for at least 10 years. Environmental restoration laws will require Newform to completely reforest and restore the oil well site when the well is taken out of production. An engineering firm hired by Newform estimates that the cost of complying with the environmental requirements will be $8,000,000. For financial accounting purposes, Newform intends to amortize the estimated cost over the 10-year expected life. In addition, it plans to put $500,000 per year into an account that should provide the $8,000,000 necessary to perform the restoration.
The controller would like your advice on the deductibility of the costs of restoration. That is, when can Newform deduct the costs and how much can it deduct? Based on the concepts discussed in this chapter, explain what you think is the proper treatment of the restoration costs for tax purposes.