What Is Depletion in Accounting and How Is It Calculated?

As discussed above, depletion and depreciation are similar concepts but used under different circumstances. For example, Atlantic Richfield Co., at one time, reported net producing property of $2.6 billion. The major accounting problem is to distinguish between dividends that are a return of capital and those that are not.

Depletion accounting influences investment decisions, as it affects the valuation of resource assets. A well-executed depletion strategy can enhance a company’s reputation, fostering trust among investors and other stakeholders who rely on accurate financial information. After the costs of extracting the natural resource have been capitalized, the expenses are which method should be used to calculate depletion for a natural resource company? spread out over several time periods.

Depletion expense formula

This can be particularly advantageous for companies in the oil and gas industry, where the depletion rate can be as high as 15%. The ability to claim a depletion expense that exceeds the cost basis of the resource can lead to significant tax savings, enhancing the company’s cash flow and financial flexibility. Depletion accounting significantly influences a company’s financial statements, reshaping how assets, expenses, and profitability are perceived. Through the systematic allocation of depletion expenses, companies can adjust their asset valuations on the balance sheet. This adjustment ensures that the carrying value of natural resource assets reflects a more accurate financial picture, considering the gradual consumption of these resources over time.

Depletion vs. Depreciation

In that case, it may gradually distribute to stockholders its capital investments by paying liquidating dividends, which are dividends greater than the amount of accumulated net income. For example, Assume Mike Coal Company invests $20 million in a coal mine with a capacity of 2 million tons and no salvage value. Charlene Rhinehart is a CPA , CFE, chair of an Illinois CPA Society committee, and has a degree in accounting and finance from DePaul University.

The Formula for Cost Depletion Is:

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. As a result, a company in the extractive industries, like ExxonMobil, frequently adopts a conservative policy in accounting for the expenditures related to finding and extracting natural resources. Recall that the accounting profession uses the term depletion to allocate the cost of natural resources. On the balance sheet, depletion reduces the book value of natural resource assets. As resources are extracted, their carrying value decreases, affecting asset records and financial ratios such as return on assets (ROA) and asset turnover.

How to Record the depletion in an Accounting Book?

The corporation then divides the costs of natural resources over multiple time periods. 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). On the income statement, it is recorded as an expense, reducing net income and reflecting resource extraction costs. The chosen depletion method, whether cost or percentage, influences the magnitude of the expense, impacting profitability metrics like operating income.

In accounting, depletion is a method of estimating the entire amount of money needed to extract any form of a natural resource from the ground. 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. A company often owns a property from which it intends to extract natural resources as its only major asset. 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.

• 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.
• Cost depletion allocates the costs of extracting natural resources and those costs are recorded as operating expenses to lower pre-tax income.
• For cost depletion, the process begins with establishing the total recoverable units, which requires geological surveys and engineering reports to estimate the quantity of the resource.
• To illustrate, at year-end, Callahan Mining had a retained earnings balance of $1,650,000, accumulated depletion on mineral properties of $2,100.000, and paid-in capital in excess of par of $5,435,493.
• However, it is subject to limitations and specific eligibility criteria set by tax authorities.

• This initial step is crucial as it forms the basis for calculating the per-unit cost.
• Once the total recoverable units are known, the next step is to determine the cost basis, which includes acquisition costs, exploration expenses, and development expenditures.
• Depletion, by contrast, is tied exclusively to natural resources diminishing through extraction.
• If 100,000 tons are extracted in a year, the depletion expense for that year would be $1 million.

Since the percentage depletion method relies heavily on projections, it is not widely used or recognized as a method of depletion. Depletion, depreciation, and amortization are methods of allocating asset costs over time, but they apply to different asset types. While all three aim to systematically reduce asset value, their application depends on the nature of the asset. Most countries’ tax regulations allow firms to deduct depletion from their formal tax payments. The depletion deduction is based on the notion that accounting earnings are higher than real profits in certain businesses. The amount not sold remains in inventory and is reported in the current assets section of the balance sheet.

Depletion: Learn Natural Resource Accounting Full Guide

For example, an oil company that reports high revenues without accounting for depletion would present an inflated view of its financial health, potentially misleading stakeholders. In accounting, the company usually uses the units-of-activity method to calculate the depletion expense. This is due to the actual extracted resources usually fairly represents the exhaustion in each period of a natural resource that the company has invested in. Various accounting standards, such as the GAAP (Generally Accepted Accounting Principles), have been kept in place to guide the firms in accounting for both depreciation and depletion expenses. Both these methods are utilized for calculating the periodic value of the respective asset/resource. Depending on the firm and its resources or assets underuse, these methods gradually reduce the value of the respective resource or asset.

Example 3  – Change in estimates:

Incorporating depletion accounting requires understanding the resource lifecycle and its financial implications. Companies must assess the lifespan of their resource deposits and align their financial strategies accordingly. This involves calculating depletion expenses and forecasting future extraction activities and their potential impact on financial performance. On the income statement, the depletion expense is typically included in the cost of goods sold (COGS) or as a separate line item under operating expenses. This inclusion helps in matching the expense with the revenue generated from the resource, adhering to the matching principle in accounting. By doing so, companies ensure that their financial performance is not overstated, providing a more accurate representation of profitability.