What is Depletion and How is Depletion Rate Calculated?

Depletion is the process of lowering the cost value of a natural resource asset in predetermined increments. Depletion as a strategy aids businesses in precisely determining the value of assets on the balance sheet and properly documenting expenses on the income statement. It also allows for the depletion in accounting costs to become capitalized over extended time periods. You have to consider the costs in each phase of production and which costs can be counted as extraction expenses. Depletion helps find the natural resources, which is the company’s assets and get recorded on the company’s balance sheet.

  1. Depreciation and amortization are non-cash expenses progressively reducing an asset’s cost value through regular charges to income.
  2. The estimated amount of a natural resource that can be recovered will change constantly as assets are gradually extracted from a property.
  3. Any opinions, analyses, reviews or recommendations expressed here are those of the author’s alone, and have not been reviewed, approved or otherwise endorsed by any financial institution.
  4. Both of these procedures are used to calculate the periodic value of the asset/resource in question.
  5. Depletion, like depreciation and amortization, allows businesses to charge various costs to expense over time.

Energy companies that sell natural resources can claim to account for the gradual depletion of energy. There can be hundreds of different terms and phrases to understand when it comes to accounting. Depletion rate, for example, plays an integral role when extracting natural resources. In accounting, depletion refers to the expensing of a company’s cost of a natural resource. Ultimately, it means moving a natural resource’s cost from the company’s balance sheet to the company’s income statements as the natural resource is being sold. Depletion expenses are non-cash in nature and may be used in sync with depreciation and amortization.

Cost depletion

Jami Gong is a Chartered Professional Account and Financial System Consultant. She holds a Masters Degree in Professional Accounting from the University of New South Wales. Her areas of expertise include accounting system and enterprise resource planning implementations, as well as accounting business process improvement and workflow design. Jami has collaborated with clients large and small in the technology, financial, and post-secondary fields.

As a company uses the resource, they’re also depleting the availability of the asset along with the number of future sales. When a land purchase or lease is completed as anticipated, the acquisition expenditures are converted to exploration costs. An accrual accounting approach used to apportion the cost of taking natural resources from the earth. The resulting net carrying amount of natural resources still on the books of a business do not necessarily reflect the market value of the underlying natural resources. Rather, the amount simply reflects an ongoing reduction in the amount of the original recorded cost of the natural resources. For example, if a large piece of machinery or property requires a large cash outlay, it can be expensed over its usable life, rather than in the individual period during which the cash outlay occurred.

Depreciation, Depletion, and Amortization (DD&A): Examples

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. This is a system of accounting in which the expenses of natural resources are allocated to depletion during the asset’s life cycle. The land base, gross recoverable reserves, and the number of units sold are all factors in determining price depletion. According to the IRS Newswire,[2] over 50 percent of oil and gas extraction businesses use cost depletion to figure their depletion deduction. Mineral property includes oil and gas wells, mines, and other natural resource deposits (including geothermal deposits). For that purpose, property is each separate interest businesses own in each mineral deposit in each separate tract or parcel of land.

AccountingTools

The objective of depletion is to match the cost of the natural resources that were sold with the revenues from the natural resources that were sold. Also, it varies from wear and tears in that it relates to the progressive depletion of natural resource reserves, as opposed to the wear and tear of depreciable assets or the aging life of intangibles. In addition, Pensive Oil estimates that it will incur a site restoration cost of $57,000 once extraction is complete, so the total depletion base of the property is $600,000. The general formula for cost depletion substitutes future investment for the initial investment.

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Pensive’s geologists anticipate that the well will access 400,000 barrels of proved oil reserves; hence the unit fee will be $1.50 per barrel of oil extracted ($600,000 base / 400,000 barrels). As assets are gradually removed from a site, the projected amount of natural resources that may be recovered changes continually. The overall expense of underground digging on leased or acquired property is referred to as exploration. Certain firms use the full-cost strategy to capitalize on all expenditures incurred as a consequence of both successful and failed natural resource research initiatives.

Natural resources cannot be depreciated over time because they do not have a useful life like fixed assets. The extraction costs increase is always accompanied by the natural resource amount decrease. All three terms are used in the oil and gas industry, where the term DD&A has arisen to refer to all three types of expense recognition. DD&A is used somewhat differently, depending upon whether an organization is employing the successful efforts method or the full cost method.

Osman has a generalist industry focus on lower middle market growth equity and buyout transactions. Any opinions, analyses, reviews or recommendations expressed here are those of the author’s alone, and have not been reviewed, approved or otherwise endorsed by any financial institution.

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