One method of calculating depletion expense is the percentage depletion method. It assigns a fixed percentage to gross revenue—sales minus costs—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. This calculation results in a depletion expense per unit that is charged against the revenue generated from the natural resource. The estimated amount of a natural resource that can be recovered will change constantly as assets are gradually extracted from a property.

depletion accounting definition

The usefulness of resources to a firm is generally directly proportional to the amount extracted (or otherwise removed). Reserves generally include proven developed reserves and “probable” or “prospective” reserves if there is reasonable evidence to have believed that such quantities existed at that time. Our writing and editorial staff are a team of experts holding advanced financial designations and have written for most major financial media publications. Our work has been directly cited by organizations including Entrepreneur, Business Insider, Investopedia, Forbes, CNBC, and many others.

Company

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. 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). According to the IRS Newswire,[2] over 50 percent of oil and gas extraction businesses use cost depletion to figure their depletion deduction. Mineral property includes oil and gas wells, mines, and other natural resource deposits (including geothermal deposits).

What does depletion mean in sales?

Depletion refers to the number of cases that are sold to retailers by a distributor. Oftentimes, as long as producers have made the initial sale to the distributor, they count it as a win. In their minds, they have made money and it is now up to the distributors and retailers to get the product sold.

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. The Internal Revenue Service (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. The cost of natural resources extracted by a firm from a property is known as depletion. Depletion is the process by which natural resources lose their benefits as the resources are removed.

Reserves

Pensive’s geologists estimate that the proven oil reserves that are 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). 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. This means that the unit depletion charge will increase to $1.61 ($450,000 remaining depletion base / 280,000 barrels). There are a number of different methods that can be used to account for depletion. The most common method is the straight-line Depreciation method, which allocates the depletion expense evenly over the estimated economic life of the natural resource. Other methods include the units-of-production method and the percent-of-revenue method.

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. 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.

Recoverable Reserves

As you revise your estimates of the remaining amount of extractable natural resource, incorporate these estimates into the unit depletion rate for the remaining amount to be extracted. 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. During the second year, Pensive Oil extracts 80,000 barrels of oil from the well, which results in a depletion charge of $128,800 (80,000 barrels x $1.61 unit depletion charge). At the end of the second year, there is still a depletion base of $321,200 that must be charged to expense in proportion to the amount of any remaining extractions.

  • In situations where the consumption of the usefulness of these assets parallels the production of the resource, they may be amortized and depreciated using the units of production approach.
  • Therefore, the output-oriented units of production approach is widely used to allocate the cost to the materials and the time periods in which they are used.
  • The usefulness of resources to a firm is generally directly proportional to the amount extracted (or otherwise removed).
  • Our mission is to empower readers with the most factual and reliable financial information possible to help them make informed decisions for their individual needs.
  • Conceptually, depletion is similar to the depreciation of property, plant and equipment.

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. ABC can, therefore, claim that the profits on which it is paying tax are actually an overestimate of the real profits since the taxed profits do not account for the reduction in future profits. In 2009, X’s share of production sold was 40,000 barrels and an engineer’s report indicated that 160,000 barrels could be recovered after December 31, 2009. The objective of depletion is to match the cost of the natural resources that were sold with the revenues from the natural resources that were sold. Percentage depletion refers to when the market value of depletion is assumed to be some constant or varying proportion of a company’s revenue.

Adjusted basis is the basis at end of year adjusted for prior years depletion in cost or percentage. Depletion is the reduction in the quantity of a factor of production as a result of the production process. The conversion of existing goods into new goods is known as a production process. We follow strict https://accounting-services.net/depletion-definition/ ethical journalism practices, which includes presenting unbiased information and citing reliable, attributed resources. While the numerator (units produced in the period) is usually reliably measurable, the denominator (units available from the property) is often impossible to measure precisely.