Cost Depletion: Meaning, Formula, Example

Bookkeeping

Cost Depletion: Meaning, Formula, Example

Sep 01 2023 | by Author Pathfinder

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.

Cost depletion

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.

Our Team Will Connect You With a Vetted, Trusted Professional

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.

In some countries, depletion is treated as a deductible expense for tax purposes.
Pensive’s geologists estimate the proven oil reserves accessed by the well are 400,000 barrels, so the unit depletion charge will be $1.50 per barrel of oil extracted ($600,000 depletion base / 400,000 barrels).
The depletion rate per unit of a natural resource or asset depends upon the total number of units expected to be extracted.
Such assets are also referred as wasting assets because their value deteriorates with the increasing extraction of resources.
We follow strict ethical journalism practices, which includes presenting unbiased information and citing reliable, attributed resources.
The property’s basis is distributed among the total number of recoverable units.

Example of How to Use Cost Depletion

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 what is the liability to equity ratio of chester 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.

Why You Can Trust Finance Strategists

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.

AccountingTools

Cost depletion is calculated by estimating the total quantity of a given resource and then dividing the percentage withdrawn by the total quantity. Let’s say an oil company expects to spend $200,000 to withdraw 50,000 barrels of oil every year from a field with estimated reserves of 1 million barrels. The amount of depletion that could be claimed would be $10,000, or $200,000(50,000/1,000,000). At the start of the year 2, a new survey is conducted and it is found that the expected extraction of minerals is only 160,000 tons (i.e.,40,000 tons less then the original estimate). The company decided to workout a new depletion rate on the basis of information provided by revised survey.

The depletion rate per unit of a natural resource or asset depends upon the total number of units expected to be extracted. This is calculated by dividing the depletion base less salvage value (if any) by the number of units expected to be extracted. Since the amount of depreciation may be relatively large, depreciation expense is often a significant factor in determining net income. For this reason, most financial statement users are interested in the amount of, and the methods used to compute, a company’s depreciation expense.

For example in case of a coal mine, more the coal is extracted more will be the depletion of the mine etc. Useful life refers to the time the company owning the asset intends to use it; useful life is not necessarily the same as either economic life or physical life. The economic life of a car may be 7 years and its physical life may be 10 years, but if a company has a policy of trading cars every 3 years, the useful life for depreciation purposes is 3 years. Various firms express useful life in years, months, working hours, or units of production.