Calculate Depletion Expense Formula Example

Unlike other depreciation methods that focus on the deterioration of physical assets, the depletion method recognizes the reduction in the quantity or reserves of the natural resource being extracted. It aims to match the expenses of resource extraction with the revenue generated from the sale of the resource. Depreciation is calculated taking the cost of the asset, the expected useful life of the asset, residual value of the asset and percentage where necessary. On the balance sheet, we classify natural resources as a separate group among noncurrent assets under headings such as “Timber stands” and “Oil reserves”. In extraction and mining industry, entities have fixed assets mines, quarries and wells to extract natural resources like coal, oil, timber, metal, salt etc. Unlike property, plant and equipment that are used during the period, these assets get consumed as a result of extraction.

The Standout Features of Accounting Software Every Business Needs

Hence, these methods help the company to record the asset / resource’s value as it reduces due to the usage, and hence, help to understand its value at a given time. Depletion expense is commonly used by miners, loggers, oil and gas drillers, and other companies engaged in natural resource extraction. Enterprises with an economic interest in mineral property or standing timber may recognize depletion expenses against those assets as they are used. The account has a credit balance and will be reported on the balance sheet as a contra asset. Your company may purchase long-lived assets such as property, plant and equipment that you depreciate over their useful lives.

Percentage depletion, on the other hand, allows a fixed percentage of the gross income from the resource to be deducted as a depletion expense. This method is particularly beneficial for industries like oil and gas, where the which method should be used to calculate depletion for a natural resource company? percentage can be substantial. For example, the Internal Revenue Service (IRS) allows a 15% depletion rate for oil and gas wells. If a company generates $5 million in revenue from these wells, it can claim $750,000 as a depletion expense.

What is Depletion and How is Depletion Rate Calculated?

Explore how different depletion methods affect financial statements and tax obligations, enhancing your understanding of resource management. The cost of a company’s development is the expense of preparing the property for natural resource exploration. Company ABC operates a mining operation that extracts shale oil from an oil well using heavy machinery (capital) and qualified engineers (labor) (land). Natural resources cannot be depreciated over time because they do not have a useful life like fixed assets. The Michigan Mining Company has acquired a coal mine for a cost of $4,500,000.

A major controversy relates to the accounting for exploration costs in the oil and gas industry. Conceptually, the question is whether unsuccessful ventures are a cost to those that are successful. MacLeod may also depreciate on a units-of-production basis the tangible equipment used in extracting the gold. This approach is appropriate if it can directly assign the estimated lives of the equipment to one given resource deposit. Normally, companies compute depletion (often referred to as cost depletion) on a units-of-production method (an activity approach). As soon as a company has the right to use the property, it often incurs exploration costs needed to find the resource.

This is why it is suitable to use in the calculation of depletion expense as the available natural resource will be reduced by the number of extracted units in each period. No, the depletion method is primarily used for tangible natural resources such as minerals, oil, gas, and timber. Intangible natural resources, such as patents or copyrights, are typically amortized using other depreciation methods. Thus, statement users can see the percentage of the resource that has been removed.

• It lowers the amount of oil the corporation will be able to sell in the future.
• In this case, with the result of the calculation, the depletion expense in 2020 is $228,000.
• This transparency is crucial for investors, creditors, and analysts who need to understand the long-term sustainability of the company’s resource base.
• You should be familiar with the definition of an asset in a company and how to account for them on the balance sheet.
• Recall that the accounting profession uses the term depletion to allocate the cost of natural resources.

Example of How to Use Cost Depletion

The resulting net carrying amount of natural resources still on the books of a business does 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. 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 percentage depletion method requires a lot of estimates and is, therefore, not a heavily relied upon or accepted method of depletion.

• Once the cost of natural resource is established, depreciable value or “depletable” value is determined by deducting any residual value from depletion base.
• The percentage is predetermined by tax authorities and varies depending on the type of resource.
• Depreciation is the gradual reduction of a tangible asset’s recorded value over that asset’s useful life.
• Depletion aids in determining the true worth of assets on the balance sheet and recording costs on the income statement for a given period.
• Depletion, like depreciation and amortization, allows businesses to charge various costs to expense over time.
• Depletion expense is commonly used by miners, loggers, oil and gas drillers, and other companies engaged in natural resource extraction.

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. For example, on January 1, 2020, the company ABC has invested $2,000,000 in a coal mine that is estimated to contain 1,000,000 tons of coal. The mine is expected to be able to sell for $100,000 at the end of its useful life and the company ABC has extracted and sold 120,000 tons of coal in 2020. The accumulated depletion account is. reported on the balance sheet as a deduction from the cost of the mineral deposit. The process of transferring the cost of metal ores and other minerals removed from the earth to an expense account is called.

By crediting the Accumulated Depletion account instead of the asset account, we continue to report the original cost of the entire natural resource on the financial statements. This method involves applying a fixed percentage to the gross income generated from the resource. The percentage is predetermined by tax authorities and varies depending on the type of resource. To calculate the depletion expense, the company multiplies the gross income from the resource by the applicable percentage. This method can be advantageous as it allows for a consistent deduction, regardless of the actual extraction costs. However, it is essential to note that percentage depletion is subject to limitations, such as the net income limitation, which restricts the deduction to a percentage of the taxable income from the property.

Charlene Rhinehart is a CPA , CFE, chair of an Illinois CPA Society committee, and has a degree in accounting and finance from DePaul University. While AI has evolved dramatically in recent months, the impact of technology on the accounting profession is nothing new. Cost depletion is more often used by companies and typically provides the most accurate calculations.

Tax Collected at Sources (TCS)

They do so because they have new information or more sophisticated production processes available. In the income statement, the depletion cost is part of the cost of goods sold. Tangible equipment costs include all the transportation and other heavy equipment needed to extract the resource and prepare it for the market. There are three steps involved in computation of depreciation under depletion method. Depreciation is the gradual reduction of a tangible asset’s recorded value over that asset’s useful life.

Depletion charge for year 3:

A complete discussion of the accounting for restoration costs and related liabilities (sometimes referred to as asset retirement obligations). Like other long-lived assets, companies deduct from the depletion base any salvage value to be received on the property. On the other hand, intangible development costs are such items as drilling costs, tunnels, shafts, and wells. These costs have no tangible characteristics but are needed for the production of natural resource. Depletion is the process of lowering the cost value of a natural resource asset in predetermined increments. Depletion as a strategy aids businesses in precisely determining the value of assets on the balance sheet and properly documenting expenses on the income statement.

The costs of extracting natural resources remain on the company’s budget sheets until the entire cost has been acknowledged. This means the unit depletion charge will increase to $1.61 ($450,000 remaining depletion base / 280,000 barrels). 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). This means that the unit depletion charge will increase to $1.61 ($450,000 remaining depletion base / 280,000 barrels).

Depreciation is a critical accounting concept that allows businesses to allocate the cost of their assets over their useful life. While most people are familiar with common depreciation methods such as straight-line and accelerated methods, there’s another approach called the depletion method, which is specifically used for natural resources. In this blog post, we’ll delve into the depletion method of depreciation, exploring its definition, calculation, and significance for businesses involved in industries like mining, oil extraction, and timber. The actual depletion expense for a given period is calculated by multiplying the per-unit depletion rate by the number of units extracted during that period. This method ensures that the expense is proportionate to the resource’s usage, providing a more accurate financial picture. For example, if a company extracts 50,000 tons of ore in a year and the per-unit depletion rate is $10, the depletion expense would be $500,000.

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. Cost depletion is one of the two accounting methods used to allocate the costs of extracting natural resources. Depletion is the process of adjusting the value of a natural resource asset so that it accounts for the removal of the natural resources during the asset’s life. Accumulated depletion is the amount of depletion expense that has built up over time in relation to the use of a natural resource. You should be familiar with the definition of an asset in a company and how to account for them on the balance sheet.