Depletion is cost allocation of natural resources that depends on its usage. It is the process of transferring the cost of searching for and extracting natural resources (items such as petroleum (oil and / or gas), minerals, or timber) to expenses for a period of its estimated useful life. Natural resources have limited useful life which is not depends on certain related groups or types of properties rather how big the project is and how fast an entity will use them up. Different wells have different amounts of natural resources in them. For example, the estimated finite life of an oil well will usually be by the time the company pumps all the liquid out. In addition, technology used, experience, and organization of the firm will play significant role in extracting the natural resources as well.
Depletion computation is similar to depreciation and amortization ones, but relates to wasting (exhausting) of natural resources instead of reduction in cost of tangible and intangible finite assets. Natural resources are different from other fixed tangible (touched) assets because those extracting companies consume (exhaust) those resources to the point when there won’t have any physical substance eventually. Those long-term assets should be accordingly properly accounted to prorate the incurred expenses over the quantity of their extraction.
Depletion calculation methods
There are two depletion methods:
- cost depletion (common)
- percentage depletion (used for tax purposes)
To calculate the depletion cost per unit (the depletion rate) an entity uses the following formula:
Depletion cost per unit = (Initial cost* – Residual value**) / Total estimated units available
* Initial cost involves summing the purchased price, exploration costs, development cost, and restoration costs (but not always).
** Residual value is the value of the depleted asset at the end of its useful life after the natural recourses were partially or in full extracted from the earth. For example, the land can be sold afterwards for other uses, such as agricultural, residential or commercial.
For example, to illustrate the depletion calculation, let’s assume that a company acquired a mineral mine for $1,000,000. Their best estimate that they will extract approximately 800,000 tons. The land after removal of the minerals will cost about $100,000. The firm must spend approximately $700,000 on the developing cost. During the first year of production 300,000 tons were extracted from the earth. They are not obligated to restore the property at the end of the mineral mine useful life.
The first step in solving the problem is to find the total initial cost before beginning to extract minerals from the mine. An entity should account carefully for the expenses related to searching and developing which will define the initial cost of the project.
$1,000,000 + $700,000 = $1,700,000
Computation of the depletion cost per unit (the depletion rate)
Depletion cost per unit = ($1,700,000* - $100,000**) / 800,000 tons = $2 per ton
Calculation of depletion for the 1st year of the mineral mine use
Depletion for year 1 = unit depletion x units extracted
= $2 per ton x 300,000 tons = $600,000
What is accounting entries should be made?
Dr. Inventory (as natural resources become goods for sale)
Cr. Accumulated Depletion (reduction of the carrying (book) value of the natural resources)