Have you ever come across the term depletion? If not, don’t worry - lots of people haven’t. So, what does depleted mean? Well, when we refer to the Cambridge Dictionary’s depleted definition, it states ‘to reduce something in size or amount, especially supplies of energy’. In accounting, depletion is an expensing strategy used to allocate the cost of extracting natural resources from the earth - namely, timber, minerals and oil.
Like fellow accounting concepts, depreciation and amortisation, it enables companies to gradually charge various costs to expense over an extended period. While depletion allocates the cost of extracting natural resources, depreciation spreads the cost of a tangible asset over that asset's estimated economic useful life and amortisation spreads the cost of an intangible asset over its useful life. Both depreciation and amortisation are common to most industries, but depletion is usually solely used by energy and natural resource companies.
Depletion: how does it work?
As a technique, depletion helps firms to accurately identify the value of the assets on the balance sheet and document expenses in the appropriate time period on the income statement. When the costs involved with extracting the natural resource have been capitalised, the expenses are allocated across different time periods
So, how do you calculate what expenses need to be spread out for the use of natural resources? Simple. Each different phase of production must be taken into account. The depletion base is the capitalised costs depleted across multiple accounting periods, and it is affected by acquisition, exploration, development and restoration costs.
Acquisition costs: Expenses incurred by acquiring a new client or purchasing an asset. For example, purchasing or leasing the property rights to a piece of land that is thought to have natural resources.
Exploration costs: Expenses involved in searching for the natural resource, including researching appropriate places to drill and drilling into the land itself.
Development costs: Expenses incurred by preparing the land for natural resource extraction.
Restoration costs: Expenses involved in restoring the land to its original condition after the natural resource extraction is complete.
Two methods are used to calculate depletion: percentage depletion and cost depletion.
1. The percentage depletion method
The percentage depletion method is calculated by multiplying a set, or fixed, percentage, specified for each resource, by the gross income from the property during the tax year. Property refers to each separate interest business owned in each resource deposit in each separate tract of land.
For example, if £10 million of oil is extracted and the fixed percentage is 10%, £1 million of capitalised costs are depleted.
2. The cost depletion method
The second depletion method, cost depletion, allows the value of the depleted natural resource to be spread out over the resource’s lifetime. It is much easier to calculate, taking the adjusted property value, total recoverable reserves and number of units sold into account.
The formula for cost depletion is:
Cost depletion = adjusted property value / total reserves x units extracted in a given period
If we break it down, that’s:
CD = APV / TR x U
The formula for calculating the adjusted property value is:
Adjusted property value = investment cost of a property or asset + development or exploration costs - salvage value
In mathematical terms, that’s:
APV = IC + DC - SV
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