Depletion
Depletion is a method of calculating the cost allocation for extracting natural resources from the bowels of the earth (timber, minerals, and oil).
Depreciation, amortization and depletion are non-cash expenses. Such expenses gradually reduce the cost of an asset through scheduled deductions to income. Depletion differs in that it is the gradual exhaustion of natural resources reserves, while wearing and tearing of depreciable assets or aging of intangible assets are not.
How Depletion works
Depletion helps to determine the value of assets in the balance sheet and financial statements. This value is reflected in the income statement through expenses over a certain period of time.
When natural resource costs are capitalized, the costs are systematically scheduled into different time periods of time depending on the extracted resources. The costs are kept on the balance sheet until the expense is recognized.
Recording Depletion
It is necessary to consider each stage of production separately to calculate the distribution of costs for the use of natural resources. Capitalized costs that are depleted over several accounting periods are the depletion base. It is influenced by 4 main factors:
Acquisition. This is the cost of leasing or buying land potentially rich in resources.
Exploration. This is the cost of digging and working on rented or purchased land.
Development. This is the cost of preparing the land for the extraction of natural resources (drilling wells, pipelining).
Restoration. This is the cost of restoring the land after mining operations are completed. The land should be restored to its original condition.
Percentage Depletion method
There are different methods to calculate depletion costs. One of them is the percentage depletion method, which provides a fixed percentage of gross revenue (sales minus costs) to distribute costs. For example, if a natural resource is extracted for $10 million and the fixed percentage is 15%, then $1.5 million of capitalized natural resource costs are depleted.
This method is not commonly used, because it requires a large number of estimates.
Cost Depletion method
The depletion method by cost. This is the second method of calculating depletion. The object base, the number of recoverable reserves and the number of units sold are the basis for the cost depletion calculation. The object base is divided among the total number of units recovered. When natural resources are extracted, they are recorded and deducted from the object base of the property.
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).
Reporting requirements
Internal Revenue Service (IRS) requirements state that in timber dealing, a cost method should be used to calculate cost depletion.
For mineral production (also, gas and oil wells) in natural deposits, the IRS requirements consider the method that gives the highest deduction.
In this case, the percentage depletion method does not meet the requirements because it covers the gross income and marginal taxable income of the property, not the quantity of the natural resource extracted.
