Depletion is an accrual accounting technique used to allocate the cost of extracting natural resources such as timber, minerals, and oil from the earth.
Like depretiation and amortization, depletion is a non-cash expenses that lowers the cost value of an asset incrementally through scheduled charges to income. Where depletion differs is that it refers to the gradual exhaustion of natural resource reserves, as opposed to the wearing out of depreciable assets or aging life of intangibles.
Depletion for accounting and financial reporting purposes is meant to assist in accurately identifying the value of the assets on the balance sheet and recording expenses in the appropriate time period on the income statement.
- Depletion is an accrual accounting method used to allocate the cost of extracting natural resources such as timber, minerals, and oil from the earth.
- When the costs associated with natural resource extraction have been capitalized, the expenses are systematically allocated across different time periods based upon the resources extracted.
- There are two basic forms of depletion allowance: percentage depletion and cost depletion.
To calculate what expenses need to be spread out for the use of natural resources, each different phase of production must be taken into consideration. The depletion base is the capitalized costs depleted across multiple accounting periods. There are four main factors that affect the depletion base:
- Acquisition: Costs associated with purchasing or leasing the property rights to land that the company believes has natural resources.
- Exploration: Expenses linked to digging under the land that was leased or bought.
- Development: The costs necessary to prepare the land for natural resource extraction, such as tunneling or developing wells.
- Restoration: Expenses associated with restoring the land to its original condition after completion.
One method of calculating depletion expense is the percentage depletion method. It assigns a fixed percentage to gross revenue — sales minus costs — to allocate expenses. For example, if $10 million of oil is extracted and the fixed percentage is 15%, $1.5 million of capitalized costs to extract the natural resource are depleted.
The percentage depletion method requires a lot of estimates and is, therefore, not a heavily relied upon or accepted method of depletion.
Cost Depletion Method
The second method of calculating depletion is the cost depletion method. Cost depletion is calculated by taking the property’s basis, total recoverables reserves and number of units sold into account. The property’s basis is distributed among the total number of recoverable units. As natural resources are extracted, they are counted and taken out from the property’s basis.
For example, the capitalized costs of $1 million yields 500,000 barrels of oil. In the first year, if 100,000 barrels of oil are extracted, the depletion expense for the period is $200,000 (100,000 barrels * ($1,000,000 / 500,000 barrels)
The Internal Revenue Services (IRS) requires the cost method to be used with timber.1 It requires the method that yields the highest deduction to be used with mineral property, which it defines as oil and gas wells, mines and other natural deposits, including geothermal deposits.
Because the percentage depletion looks at the property’s gross income and taxable income limit, as opposed to the amount of the natural resource extracted, it is not an acceptable reporting method for certain natural resources.
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