What is Depletion and How is Depletion Rate Calculated?

The cost attributed to natural resources when they are extracted is known as depletion expense. Depletion, like depreciation and amortization, allows businesses to charge various costs to expense over time. 

 

Natural resource depletion is equivalent to the depreciation of fixed assets. Natural resources cannot be depreciated over time because they do not have a useful life like fixed assets. Instead, as they are utilized or sold, they are depleted.

 

Depreciation spreads the cost of a tangible asset over its anticipated economic usable life, while amortization spreads the cost of an intangible asset over its useful life, whereas depletion allocates the cost of extracting natural resources. 

 

Although other sectors utilize depreciation and amortization, energy and natural resource corporations are the only ones who use depletion.

 

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What is Depletion?

 

In accounting, depletion is a method of estimating the entire amount of money needed to extract any form of a natural resource from the ground. This accounting cost recovery system ensures that a natural resource firm's operator or owner accounts for the whole worth of the items the company mines while adhering to the regulations of the region. 

 

Depletion is the process of lowering the cost value of a natural resource asset in predetermined increments. Depletion as a strategy aids businesses in precisely determining the value of assets on the balance sheet and properly documenting expenses on the income statement. 

 

After the costs of extracting the natural resource have been capitalized, the expenses are spread out over several time periods.

 

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Depletion in Accounting

 

Most countries' tax regulations allow firms to deduct depletion from their formal tax payments. The depletion deduction is based on the notion that accounting earnings are higher than real profits in certain businesses.

 

Depletion aids in determining the true worth of assets on the balance sheet and recording costs on the income statement for a given period. To begin, a firm capitalizes on the costs of natural resource extraction, which means they record an expense without fully paying for it. 

 

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.

 

Consider the following example:

 

Company ABC operates a mining operation that extracts shale oil from an oil well using heavy machinery (capital) and qualified engineers (labor) (land). All of the oil that the company extracts is sold on the worldwide oil market. The corporation is legally obligated to pay a portion of its income in taxes.

 

The specific tax structure, for example, is unimportant; the tax could be a percentage tax or a lump-sum tax. The oil extraction procedure reduces the amount of oil in the oil well that can be extracted in the future. 

 

It lowers the amount of oil the corporation will be able to sell in the future. Because the taxable earnings do not account for the reduction in future gains, ABC can allege that the profits on which it is paying tax are actually an overestimate of the real profits.

 

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What is the Process of Depletion?

 

Depletion is used in accounting and financial reporting to help precisely determine the worth of assets on the balance sheet and record expenses on the income statement in the appropriate time period.

 

The expenses connected with natural resource extraction are systematically apportioned throughout different time periods based on the resources extracted once the costs associated with natural resource extraction have been capitalized. Costs are kept on the balance sheet until they are recognized as expenses.

 

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How to Calculate the Depletion Rate?

 

Subtract the asset's salvage value from the depletion base and divide by the total number of measurement units you intend to recover to get a unit depletion rate. The unit depletion rate is calculated using the following formula:

 

 (Depletion base - Salvage value) / Total units to be recovered

 

Depletion expenses = ((cost-salvage value)/estimated number of units))* number of units extracted
 

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Different Types of Depletion

 

1. Percentage Depletion Method

 

Depletion by percentage is one method of evaluating the cost of depletion. It distributes expenses—revenues minus costs—by assigning a predetermined amount to gross income. To figure out how much you owe, multiply your gross income from the property during the tax year by a percentage that is defined for each mineral. 

 

The term "property" refers to each unique interest business in each mineral deposit in each separate tract or parcel of land for this purpose. Two or more different interests can be treated as one property or as separate properties by businesses.

 

 

2. Cost Depletion

 

This is a system of accounting in which the expenses of natural resources are allocated to depletion during the asset's life cycle. The second way for determining depletion is the cost-depletion method. The land base, gross recoverable reserves, and the number of units sold are all factors in determining price depletion. 

 

The property's value is divided among the entire number of units that can be retrieved. When natural resources are removed, these are counted and removed from the property's foundation.

 

Cost depletion is calculated by estimating the total quantity of mineral or other resources acquired and allocating a proportionate amount of the overall resource cost to the amount extracted over time.

 

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Factors that influence the Depletion Base

 

The depletion base is influenced by four major factors:

 

1. Exploration

 

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. 

 

The full-cost strategy is when a company capitalizes on all costs associated with both successful and unsuccessful natural resource exploration efforts. Other corporations opt to capitalize only on their successful exploratory activities while deducting the costs of the unsuccessful ones.

 

 

2. Development

 

The cost of a company's development is the expense of preparing the property for natural resource exploration. Construction of wells and tunneling are examples of this type of activity. 

 

 

3. Acquisition

 

When the land purchase or lease is completed as anticipated, the acquisition expenditures are converted to exploration costs. The complete expenses or costs connected with leasing or purchasing land, including ownership rights, are referred to as acquisition. 

 

The cost of acquisition is determined by the size of the property and the expected worth of the land's natural resources. Companies keep track of their purchase expenditures in an asset account. If the overall investment does not come out as predicted, the corporation may be able to write off the costs as a loss.

 

 

4. Restoration

 

The costs incurred after resource extraction are referred to as restoration. Restoration aims to return the land to its pre-exploration state, for example, by concealing exposed holes or tunnels. Another restoration cost is the money spent on returning the land to the owner if a corporation rents the land.

 

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Conclusion

 

Periodic depletion will lower the value of these natural resources as they are exploited in the course of business. Depletion expense is a way for a company to account for the loss in value of natural resources. Depletion, like depreciation, is a term that describes how an asset is used and its value decreases over time. 

 

There are two approaches for calculating depletion: cost and percentage. The most prevalent method employed by oil and gas corporations is cost depletion. When determining the depletion amount for financial reporting and tax reasons, the amount can vary, resulting in a varying effect on the accounting period's income and income tax expense.