What is Depletion?
Let me explain depletion to you directly: it's an accrual accounting technique I use to allocate the cost of extracting natural resources like timber, minerals, and oil from the earth.
Similar to depreciation and amortization, depletion is a non-cash expense that reduces the cost value of an asset step by step through scheduled charges to income. What sets depletion apart is that it deals with the gradual exhaustion of natural resource reserves, unlike the wearing out of depreciable assets or the aging of intangibles.
How Depletion Works
Depletion in accounting and financial reporting helps you accurately identify the value of assets on the balance sheet and record expenses in the right time period on the income statement.
Once you've capitalized the costs tied to natural resource extraction, you systematically allocate those expenses across different periods based on the amount of resources extracted. These costs stay on the balance sheet until it's time to recognize them as expenses.
Key Takeaways
Here's what you need to remember: depletion is an accrual accounting method for allocating the cost of extracting natural resources such as timber, minerals, and oil from the earth. When costs for natural resource extraction are capitalized, expenses get allocated systematically over periods based on extracted resources. There are two basic forms of depletion allowance: percentage depletion and cost depletion.
Recording Depletion
To figure out what expenses to spread out for using natural resources, you have to consider each phase of production. The depletion base consists of the capitalized costs depleted over multiple accounting periods. Four main factors affect this base: acquisition costs for purchasing or leasing property rights to land with believed natural resources; exploration expenses for digging under that land; development costs to prepare the land for extraction, like tunneling or building wells; and restoration expenses to return the land to its original condition after extraction.
Percentage Depletion Method
One way to calculate depletion expense is the percentage depletion method. It assigns a fixed percentage to gross revenue—sales minus costs—to allocate expenses. For instance, if you extract $10 million of oil and the fixed percentage is 15%, then $1.5 million of capitalized costs get depleted.
This method relies on many estimates, so it's not heavily used or accepted for depletion calculations.
Cost Depletion Method
The other method is cost depletion, which you calculate by considering the property's basis, total recoverable reserves, and units sold. The basis gets distributed among the total recoverable units, and as resources are extracted, they're subtracted from the basis.
Take this example: capitalized costs of $1 million yield 500,000 barrels of oil. In the first year, extracting 100,000 barrels means a depletion expense of $200,000 (100,000 barrels times $1,000,000 divided by 500,000 barrels).
Reporting Requirements
The IRS requires you to use the cost method for timber. For mineral property—which includes oil and gas wells, mines, other natural deposits, and geothermal deposits—it demands the method that gives the highest deduction.
Since percentage depletion focuses on gross income and taxable income limits rather than the amount extracted, it's not acceptable for reporting on certain natural resources.
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