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 an accrual accounting technique used to allocate the cost of extracting natural resources such as timber, minerals, and oil from the earth. Depletion is the reduction in the amount of a natural resource, such as minerals or timber. From an accounting perspective, it is a charge against the recorded asset value of a natural resource. This charge is made in each reporting period, in an amount that reflects the level of asset usage during the period. 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.
- Cost depletion is one of two accounting methods used to allocate the costs of extracting natural resources, such as timber, minerals, and oil, and to record those costs as operating expenses to reduce pretax income.
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- Cost depletion is typically part of the “DD&A” (depletion, depreciation, and amortization) line of a natural resource company’s income statement.
- Therefore, the output-oriented units of production approach is widely used to allocate the cost to the materials and the time periods in which they are used.
Example of the Depletion Method
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. The estimated amount of a natural resource that can be recovered will change constantly as assets are gradually extracted from a property. As sales volume english meaning 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. Thus, if you extract 500 barrels of oil and the unit depletion rate is $5.00 per barrel, then you charge $2,500 to depletion expense.
Financial Accounting
But unless you’re an independent producer or royalty owner, the IRS says you usually can’t use the percentage depletion method for oil and gas wells. 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. The depletion base comprises of cost incurred to acquire or lease the asset, exploration cost, development cost and any cost incurred to restore the property to its original condition after the assets or resources have been fully depleted.
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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. 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. Depletion method of depreciation is mostly used by the companies that have assets that are natural resources like oil, gas, coal, mines, quarries or other wasting assets. Depletion is the process by which natural resources lose their benefits as the resources are removed. It follows the same process used in the units of production method of depreciation.
Then, multiply this figure by the number of units of goods or services produced during the accounting period to find the period’s depreciation expense. The percentage depletion method gives a fixed percentage of the gross income obtained from a natural resource. If a company has $5 million in gross income from a resource and wants to use a 15% depletion rate over a given period, its depletion deduction would amount to $750,000 million. Cost depletion is calculated by taking the property’s basis, total recoverable reserves and number of units sold into account.
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More than one person (or company) can have an economic interest in a mineral deposit or timber land. The IRS defines an economic interest as having any interest in mineral deposits or standing timber and a legal right to income from mineral extraction or timber harvesting. Cost depletion (which is required under GAAP) should not be confused with percentage depletion deductions allowed by the income tax laws. Founded in 1993, The Motley Fool is a financial services company dedicated to making the world smarter, happier, and richer.
At the point where book value is equal to the salvage value, no more depreciation is taken. The tax implications of depletion depend on the country in which the natural resources are located. In some countries, depletion is treated as a deductible expense for tax purposes. In addition, Pensive Oil estimates it will incur a site restoration cost of $57,000 once extraction is complete, making the total depletion base of the property $600,000. 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 Motley Fool reaches millions of people every month through our premium investing solutions, free guidance and market analysis on Fool.com, top-rated podcasts, and non-profit The Motley Fool Foundation. There are three steps involved in computation of depreciation under depletion method. For information pertaining to the registration status of 11 Financial, please contact the state securities regulators for those states in which 11 Financial maintains a registration filing. 11 Financial may only transact business in those states in which it is registered, or qualifies for an exemption or exclusion from registration requirements.