Depletion in Accounting: How It Works, Methods, and IRS Requirements

Cost depletion is calculated by taking the property’s basis, total recoverable 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. 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.

Depletion can be calculated on a cost or percentage basis, and businesses generally must use whichever provides the larger deduction for tax purposes. Cost depletion is an accounting method by which costs of natural resources are allocated to depletion over the period that make up the life of the asset. Cost depletion is computed by estimating the total quantity of mineral or other resources acquired and assigning a proportionate amount of the total resource cost to the quantity extracted in the period. For example, assume Big Texas Oil, Co. had discovered a large reserve of oil and estimates that the oil well will produce 200,000 barrels of oil. If the company invests $100,000 to extract the oil and extracts 10,000 barrels the first year, the depletion deduction is $5,000 ($100,000 X 10,000/200,000). Depreciation, depletion, and amortization (D&A) refers to the set of techniques used to gradually charge certain costs to expense over an extended period of time.

  1. This charge is made in each reporting period, in an amount that reflects the level of asset usage during the period.
  2. In other words, it lets firms match expenses to the revenues they helped produce.
  3. Depletion also lowers the cost value of an asset incrementally through scheduled charges to income.
  4. BJ estimates that there are 500,000 gallons of oil in the reserve on this property.

For tax purposes, the two types of depletion are percentage depletion and cost depletion. 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. 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.

The estimated amount of a natural resource that can be recovered will change constantly as assets are gradually extracted from a property. As you revise your estimates of the remaining amount of extractable natural resource, incorporate these estimates into the unit depletion rate for the remaining amount to be extracted. Depletion can only be used for natural resources, while depreciation is allowed for all tangible assets. Unlike depreciation, cost depletion is based on usage and must be calculated every period.

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. Natural resources like oil, natural gas, and coal are drilled or mined from the ground. It’s impossible to accurately know how much resources are below the earth’s surface before they are extracted. That is why GAAP requires that natural resources be capitalized at cost initially. The purchase price or cost of the resources, mineral rights, and anything needed to prep the area for extraction is then allocated over the period of time they are consumed. For example, if the percentage were 22%, depletion expense would be gross income times 22%.

Composition of the Depletion Base

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.

This accounting technique is designed to provide a more accurate depiction of the profitability of the business. 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 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. Companies engaged in mining or extracting identify their depletion expense methods and comment on period expenses in the management discussion and analysis (MD&A) sections of their quarterly and annual filings.

Accrual accounting permits companies to recognize capital expenses in periods that reflect the use of the related capital asset. In other words, it lets firms match expenses to the revenues they helped produce. Every year after this, BJ will record a depletion expense until the full $1 million of cost is allocated to the asset.

SuperMoney strives to provide a wide array of offers for our users, but our offers do not represent all financial services companies or products. For related information, read about how to account for depletion and other non-cash charges. The amounts of proved reserves and proved developed reserves will differ when a property is still under development, and will be the same amount when the property is fully developed, with all wells drilled. Explanations may also be supplied in the footnotes, particularly if there is a large swing in the depreciation, depletion, and amortization (DD&A) charge from one period to the next. Depletion is the reduction in the quantity of a factor of production as a result of the production process.

Examples of Depletion

After almost a decade of experience in public accounting, he created to help people learn accounting & finance, pass the CPA exam, and start their career. Reserves generally include proven developed reserves and “probable” or “prospective” reserves if there is reasonable evidence to have believed that such quantities existed at that time. For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. Charlene Rhinehart is a CPA , CFE, chair of an Illinois CPA Society committee, and has a degree in accounting and finance from DePaul University. Upgrading to a paid membership gives you access to our extensive collection of plug-and-play Templates designed to power your performance—as well as CFI’s full course catalog and accredited Certification Programs.

This means that the unit depletion charge will increase to $1.61 ($450,000 remaining depletion base / 280,000 barrels). Depletion, for both accounting purposes and United States tax purposes, is a method of recording the gradual expense or use of natural resources over time. Depletion is the using up of natural resources define depletion in accounting by mining, quarrying, drilling, or felling. In the first year, Pensive Oil extracts 100,000 barrels of oil from the well, which results in a depletion charge of $150,000 (100,000 barrels x $1.50 unit depletion charge). Depletion is the reduction in the amount of a natural resource, such as minerals or timber.

Cost depletion

The planned, gradual reduction in the recorded value of a tangible asset over its useful life is referred to as depreciation. The use of depreciation is intended to spread expense recognition for fixed assets over the period of time when a business expects to earn revenue from those assets. Amortization is the same concept, but is applied to the consumption of an intangible asset over its useful life. In the oil and gas industry, amortization is used more broadly to refer to the ongoing expensing of properties, wells and equipment so that it becomes part of the cost of the oil and gas produced. All of these terms are classified as non-cash expenses, since no cash outflows occur when these charges are made.

Analysts and investors in the energy sector should be aware of this expense and how it relates to cash flow and capital expenditure. My Accounting Course  is a world-class educational resource developed by experts to simplify accounting, finance, & investment analysis topics, so students and professionals can learn and propel their careers. Shaun Conrad is a Certified Public Accountant and CPA exam expert with a passion for teaching.

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