What is 'Depletion'
Depletion is an accrual accounting technique used to allocate the cost of extracting natural resources such as timber, minerals and oil from the earth. Unlike depreciation and amortization, which mainly describe the deduction of expenses due to the aging of equipment and property, depletion is the actual physical depletion of natural resources by companies.
!--break--For accounting and financial reporting purposes, depletion 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. When the costs associated to natural resource extraction have been capitalized, the expenses are systematically allocated across different time periods based upon the resources extracted. The costs are held on the balance sheet until expense recognition occurs.
Percentage Depletion Method
One method of calculation depletion expense is the percentage depletion method. The percentage depletion method assigns a fixed percentage to gross revenue to allocate expenses. For example, if $10 million of oil is extracted and the fixed percentage is 15%, $1.5 million of capitalized costs to extract the natural resource are depleted. The percentage depletion method required heavy use of estimates and is, therefore, not a heavily relied upon or accepted method of depletion.
Cost Depletion Method
The second method of calculation depletion is the cost depletion method. Cost depletion is calculated by taking the property's basis, total recoverable units and number of units sold into account. The property’s basis is distributed amongst the total number of recoverable units. As natural resources are extracted, they are counted and taken out from the property’s basis. For example, the capitalized costs of $1 million yields 500,000 barrels of oil. In the first year, if 100,000 barrels of oil are extracted, the depletion expense for the period is $200,000 (100,000 barrels * ($1,000,000 / 500,000 barrels)).
The depletion base is the capitalized costs depleted across multiple accounting periods. There are four types of depletion base costs. First, acquisition costs to buy or lease the property are able to be capitalized. Second, costs related to the exploration and location of expenses may be capitalized. Third, costs necessary to prepare the property for natural resource extraction, such as tunneling or developing wells, may be capitalized. Finally, the costs associated with restoring the property to its original condition upon the completion of depletion are capitalized.
The IRS requires the cost method to be used with timber. It requires the method that yields the highest deduction to be used with mineral property, which it defines as oil and gas wells, mines, and other natural deposits, (including geothermal deposits). 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.