Cost Depletion: Meaning, Formula, Example

Percentage depletion is a capital cost recovery method that is allowed for nearly all natural resources except timber. The rules of oil and gas accounting require that the costs incurred to find, develop, and obtain minerals and oil- and gas-producing properties must be capitalized. There are a number of methods that accountants can use to depreciate capital assets. They include straight-line, declining balance, double-declining balance, sum-of-the-years’ digits, and unit of production. We’ve highlighted some of the basic principles of each method below, along with examples to show how they’re calculated. In accounting, amortization refers to a method used to reduce the cost value of a intangible assets through increments scheduled throughout the life of the asset.

It refers to the costs of purchasing or leasing land ownership rights that the customer asserts include natural resources. The overall expense of subterranean digging on leased or purchased land is known as exploration. Natural resource depletion is equivalent to the depreciation of fixed assets.

  • Restoration aims to restore the land to its pre-exploration condition by concealing exposed holes or tunnels.
  • The value of various types of asset decreases over the years for various reasons.
  • Cost depletion is an accounting method by which costs of natural resources are allocated to depletion over the period that make up the life of the asset.
  • On the other hand, the resources in an oil firm will have a depletion amount computed during their use.
  • Based on these assumptions, the depreciable amount is $4,000 ($5,000 cost – $1,000 salvage value).

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. The concept is used in accounting to charge the costs of natural resource extraction to expense as those resources are being used. Depletion can be considered a variable cost, since it is closely linked to the rate at which resources are consumed. This varies from the fixed cost treatment that is accorded to depreciation and amortization, since these types of expensing mechanisms do not vary with activity levels. Overall, depletion is a useful calculation in accounting for a business that sells natural resources.

Cost depletion is computed by estimating the total quantity of mineral or other resources acquired and assigning a proportionate amount of the total resource cost to the quantity extracted in the period. For example, assume Big Texas Oil, Co. had discovered a large reserve of oil and estimates that the oil well will produce 200,000 barrels of oil. If the company invests $100,000 to extract the oil and extracts 10,000 barrels the first year, the depletion deduction is $5,000 ($100,000 X 10,000/200,000). Depreciation, depletion, and amortization (D&A) refers to the set of techniques used to gradually charge certain costs to expense over an extended period of time. The planned, gradual reduction in the recorded value of a tangible asset over its useful life is referred to as depreciation. The use of depreciation is intended to spread expense recognition for fixed assets over the period of time when a business expects to earn revenue from those assets.

Recoverable Reserves

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. Rather, the amount simply reflects an ongoing reduction in the amount of the original recorded cost of the natural resources. Percentage depletion refers to when the market value of depletion is assumed to be some constant or varying proportion of a company’s revenue. Therefore, if Company ABC generates $10 million in revenue, and the percentage depletion is 2%, then it can assume that $200,000 of that revenue is a result of resource depletion. For example, the exact tax structure is not important; the tax may be a percentage tax or a lump-sum tax. The oil extraction process reduces the amount of oil available in the oil well for future extraction.

In its footnotes, the energy giant revealed that the slight DD&A expense increase was due to higher production levels for certain oil and gas producing fields. Company ABC runs a mining operation that uses heavy machinery (capital) and skilled engineers (labor) to extract shale oil from an oil well (land). The company is required by law to pay a certain amount of its profits as tax. Salvage value can be based on past history of similar assets, a professional appraisal, or a percentage estimate of the value of the asset at the end of its useful life. The IRS publishes depreciation schedules indicating the number of years over which assets can be depreciated for tax purposes, depending on the type of asset. In accounting, accumulated amortization refers to the sum allocated to an asset from when it started being used to the period it was quantified.

The Difference Between Cost Depletion and Percentage Depletion

The complete expenses or costs connected with leasing or acquiring land, including ownership rights, are referred to as acquisition. The acquisition cost is determined by the size of the land and the expected worth of the natural resources contained within it. Energy companies that sell natural resources can claim to account for the gradual depletion of energy.

However, for oil and gas wells, mines, other natural deposits (including geothermal deposits), and mineral property, companies generally use the method that gives them the larger deduction. 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. The calculation of depletion expense is to multiply the number of consumed units of the natural resources by the cost per unit.

On the other hand, a larger company might set a $10,000 threshold, under which all purchases are expensed immediately. In order to secure the tax deduction, a company must follow the IRS rules while depreciating their assets. The IRS has fixed rules on how and when a company can claim such deductions. Just upload your form 16, claim your deductions and get your acknowledgment number online. You can efile income tax return on your income from salary, house property, capital gains, business & profession and income from other sources.

Examples of Depreciable Property

Also, it varies from wear and tears in that it relates to the progressive depletion of natural resource reserves, as opposed to the wear and tear of depreciable assets or the aging life of intangibles. Depletion in accounting is the process of allocating the cost of recoverable units of a natural resource. This expense is in a systematic and rational manner as those units are extracted or consumed. This means that the unit depletion charge will increase to $1.61 ($450,000 remaining depletion base / 280,000 barrels). Percentage depletion assigns a set percentage of depletion to the gross income derived from extracting these nonrenewable resources. The deduction is intended as an incentive for drillers and investors to develop domestic mineral and energy production.

Factors that influence the Depletion Base

Now, we use the $1.00 expense per unit as the basis of our total expense calculation. It would record depletion expense of $8,500 (8,500 trees x $1 per unit) for the year. This calculation relies heavily on estimates since we have no idea how many resource units are actually in a reserve. Thomson Reuters can provide the software and expert guidance on depletion and other cost recovery issues (like amortization) to help you better manage your clients’ depletion expenses.

For example, if a company had $100,000 in total depreciation over the asset’s expected life, and the annual depreciation was $15,000, the rate would be 15% per year. The Internal Revenue Service (IRS) rule requires that you use the cost method when dealing with timber. You are also supposed to use a method that produces the highest deduction when dealing with mineral property. Accumulate amortization in both accounting and tax might have the same sum of have different sums. This is based on certain factors such as when depreciations are yet to be deducted from tax expense. The useful life of the patent for accounting purposes is deemed to be 5 years.

The net carrying amount of natural resources still on a business’s books may not always represent the market worth of the underlying natural resources. Rather, the sum simply represents a continuing decline in the original reported cost of the natural resources. Depreciation and amortization are non-cash expenses progressively reducing an asset’s cost value through regular charges to income. Cost depletion is more widely accepted since it’s easier to calculate and works less with estimations. This depletion method spreads out the natural resource’s depletion across the full lifespan of the resource. The percentage depletion method depends on estimations of factors that impact the percentage.