What is Depletion Expense?
Depletion expense is the cost allocated to natural resources (like Oil, Natural Gas, Coal, etc.) when they have been extracted, and it includes the purchase price or the cost of the resource, cost of rights as well as anything that is required for preparing the areas as suitable for extraction of resources. Similar to depreciation and amortization, a depletion expense journal entry is passed as a non-cash expense.
The extraction of a large number of natural resources happens from beneath the ground for various purposes. Scientifically, the quantum of resources below the earth’s surface is not possible before their extraction. This aspect has made accounting authorities conclude that natural resources should be recapitalized at cost initially. Subsequently, the expenses are allocated over the period until they are consumed. The concept is similar to the depreciation of fixed assetsDepreciation Of Fixed AssetsDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. .
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Depletion Expense Explained
Depletion expense is a critical accounting concept that reflects the gradual reduction in the value of natural resources or long-term assets over time. In the context of finance and accounting, understanding depletion expense is essential for accurately representing the true cost of utilizing these finite resources.
Depletion primarily applies to businesses involved in industries such as mining, timber, oil, and natural gas extraction, where they exploit finite resources from the Earth’s crust. When a company acquires the rights to extract these resources, they are initially recorded as assets on the balance sheet. However, these assets are not infinite; they deplete as the resources are extracted and sold.
To calculate depletion expense, a business typically uses one of two methods: cost depletion or units-of-production depletion. Cost Depletion method divides the total cost of the natural resource (including acquisition, exploration, and development expenses) by the estimated total quantity of recoverable units. Under the Units-of-Production Depletion method, the business estimates the total quantity of recoverable units and allocates a portion of the total cost to each unit.
The depletion expense calculator is crucial for accurate financial reporting because it spreads the cost of acquiring and developing these natural resources over the periods they consume. This approach aligns with the matching principle in accounting, ensuring that expenses are recognized in the same period as the associated revenue generated from selling the resources.
Therefore, depletion expense represents the systematic allocation of the cost of natural resources over time as they are extracted and utilized. It is a fundamental accounting concept that aids businesses in presenting a more accurate financial picture, especially in industries heavily reliant on depletable assets.
The formula discussed below shall act as the basis for our understanding of depletion expense journal entries in detail.
How To Calculate?
Below is a step-by-step process that helps us understand how to calculate and how a depletion expense calculator is used.
- Determine the Total Cost: Add up all costs associated with acquiring, exploring, and developing the natural resource, including purchase price, exploration expenses, and development costs.
- Estimate Recoverable Units: Assess the total quantity of recoverable units within the resource deposit. This can be in terms of tons, barrels, board feet, or any relevant unit of measure.
- Choose a Depletion Method: Decide whether to use the ‘cost depletion’ or ‘units-of-production depletion’ method. Cost depletion divides the total cost by the estimated recoverable units. Units-of-production depletion allocates a portion of the total cost to each unit based on actual extraction.
- Calculate Depletion Per Unit: If using cost depletion, divide the total cost by the estimated recoverable units to determine the cost per unit. For units-of-production, this per-unit cost is already established during the allocation.
- Calculate Depletion Expense: Multiply the number of units extracted during a specific period by the per-unit depletion cost. This gives you the depletion expense for that period.
- Repeat for Each Period: Calculate depletion expense for each reporting period, considering the quantity of units extracted and any changes in the cost or estimated recoverable units.
Let us understand the types of depletion expense journal entries passed by businesses through the discussion below.
#1 – Cost Depletion
This method focuses on a gradual reduction over the asset’s estimated life. The amount of cost depletion is computed by arriving at a total quantity of the specific resource and allocating a proportionate amount of the cost of resources against the quantity extracted (the period is generally one year). Suppose ABC firm discovered a large coal mine expected to produce 200 tons of coal. The firm invests $100,000 in mining the coal. They successfully extracted 20 tonnes of coal in the first year. Thus, the depletion expense shall be:
($100,000 * 20/ 200) = $10,000
Cost depletion for tax purposes might be completely different for accounting purposes:
CD = S/(R+S) * AB = AB/(R+S) * S
- CD = Cost Depletion
- S = Units sold in the current year
- R = Reserves in hand at the end of the current year
- AB = Adjusted basis of the property at the end of the current year
[Adjusted basis is the basis at the end of the year with adjustments for prior years in cost/%]. It automatically permits adjustments to the basis for the taxable year applicable.
We can analyze the above concept with the help of a simple example:
Assuming Producer ‘P’ has capitalized various costs on Property ‘A’ of $50,000, which originally includes:
- Amount of Lease bonus
- Capitalized exploration costs and certain capitalized carrying costs,
- Lease amount it has been producing for several years.
During this time, P has claimed $15,000 of allowable depletion. In 2012, P’s share of production consisted of 50,000 barrels sold, and the audited engineer’s report further highlighted that 160,000 barrels could be recovered after December 31, 2012.
The calculation of cost depletion for this leaseLeaseLeasing is an arrangement in which the asset's right is transferred to another person without transferring the ownership. In simple terms, it means giving the asset on hire or rent. The person who gives the asset is “Lessor,” the person who takes the asset on rent is “Lessee.” would be calculated with the help of below formula:
Cost depletion = AB/(R+S) × S or S/(R+S) × AB
CD = 50,000 / (50,000 + 160,000) × ($50,000 − $15,000)
= 50,000/200,000 × $35,000
#2 – Percentage Depletion
This aspect involves a certain percentage multiplied specified for each mineral by the gross incomeGross IncomeThe difference between revenue and cost of goods sold is gross income, which is a profit margin made by a corporation from its operating activities. It is the amount of money an entity makes before paying non-operating expenses like interest, rent, and electricity. for the property during the tax year. The conditions and qualifications for the same are specified by the accounting authorities of respective countries with an adequate explanation for the same.
The calculation of the depletion expense formula is:
Let’s consider the following example. Zebra Crude recently purchased an oil field in South America for $2.1 mm. They further estimate 700,000 gallons of oil reserves on the property. It makes the cost allocated to each gallon $3. In the first year, Zebra Crude successfully extracts 150,000 gallons of oil and sells it to refineries and resellers. Therefore,
Depletion Expense = 150,000 * 3 = $450,000 [$0.45mm]
Thus, every year Zebra Crude will record depletion expenses until the complete $2.1mm of cost is allocated to the asset.
The above example can also be extended to display how the journal entries are recorded:
If we extend the above example and state that the year-end oil inventory for Zebra Crude is 20,000 barrels, the amount computed on the same would further be deducted to arrive at the correct amount of expenses. The inventory amount would be 20,000 * $3 (Cost of each gallon) = $60,000. Thus, the journal entry would be:
The matching principle of accountingMatching Principle Of AccountingThe Matching Principle of Accounting provides accounting guidance, stating that all expenses should be recognized in the income statement of the period in which the revenue related to that expense is earned. This means that, regardless of when the actual transaction is made, the expenses that are entered into the debit side of the accounts should have a corresponding credit entry in the same period. requires the amount of asset depleted in a given period to be expensed against the revenue for that period. Thus, any method used to compute depletion expenses must strictly follow the respective accounting policiesAccounting PoliciesAccounting policies refer to the framework or procedure followed by the management for bookkeeping and preparation of the financial statements. It involves accounting methods and practices determined at the corporate level..
Depletion vs. Depreciation
As discussed above, depletion and depreciation are similar concepts but used under different circumstances. Let’s understand their differences through the comparison below.
|It is an actual physical reduction in the natural resources of the company. It accounts for the amount of consumption.
|The asset value deduction is due to the asset’s wear and tear.
|Imposed on Non-renewable resources
|Imposed on Tangible assetsTangible AssetsTangible assets are assets with significant value and are available in physical form. It means any asset that can be touched and felt could be labeled a tangible one with a long-term valuation.
|E.g., Coal, Oil, Natural Gas
|E.g., Plant & Machinery, Building, Vehicles
Various accounting standards, such as the GAAP (Generally Accepted Accounting Principles)GAAP (Generally Accepted Accounting Principles)GAAP (Generally Accepted Accounting Principles) are standardized guidelines for accounting and financial reporting., have been kept in place to guide the firms in accounting for both depreciation and depletion expenses. Both these methods are utilized for calculating the periodic value of the respective asset/resource. Depending on the firm and its resources or assets underuse, these methods gradually reduce the value of the respective resource or asset.
E.g., cane crushing equipment in a sugar firm would be eligible for depreciation from the time of its use since there would be continuous wear and tear on the machine. However, in an oil company, the resources will have a depletion amount calculated during usage. Hence, these methods help the company record the asset’s value as it reduces due to the usage and highlights the value at a given time.
This has been a Guide to what is Depletion Expense. Here we explain its formula, how to calculate, examples, types, and compare it with depreciation. You can learn more about financing from the following articles –