Depletion Expense

What is the Depletion Expense?

Depletion expense is the cost allocated on 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 aras as suitable for extraction of resources.

The extraction of a large number of natural resources happens from beneath the ground for a variety of purposes. Scientifically, it’s not possible the quantum of resources below the earth’s surface 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 assets.

Depletion Expense Formula

The formula for calculating the period of depletion expenses is:

Depletion Expense Formula
Depletion Expense

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For eg:
Source: Depletion Expense (wallstreetmojo.com)

Types of Depletion Expense

The following are types of depletion expense:

#1 – Cost Depletion

This method focuses on a gradual reduction over the estimated life of the asset. The amount of cost depletion is computed by arriving at a total quantity of the specific resource and accordingly allocating a proportionate amount of the cost of resources against the quantity extracted (the period is generally one year). Let’s say ABC firm discovered a large coal mine expected to produce 200 tonnes of coal. The firm invests $100,000 for mining the coal. They are successful in extracting 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

Whereby,

  • 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.”read more 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

= $8,750

#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.read more 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.

Example

The calculation of the depletion expense formula is:

Depletion Expense Formula

Let’s consider the following example. Zebra Crude recently made a purchase of an oil field in South America for $2.1 mm. They further estimate 700,000 gallons of oil reserves on the property. This makes the cost allocated to each gallon at $3. In the first year, Zebra Crude successfully extracts 150,000 gallons of oil and sells it to the refineries and resellers. Therefore,

Depletion Expense = 150,000 * 3 = $450,000 [$0.45mm]

Thus, every year Zebra Crude will record depletion expense 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:

Journal Entries

Further, if we extend the above example and state that the year-end inventory of oil 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:

Journal Entries 1-1

The matching principle of accounting requires the amount of asset depleted in a given period to be expensed against the revenue for that period. Thus, any method used for the computation of depletion expense 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.read more.

Depletion vs. Depreciation

As discussed above, depletion and depreciation are similar concepts but used under different circumstances. Let’s analyze the differences:

DepletionDepreciation
This is an actual physical reduction in the natural resources of the company. It’s accounting for the amount of consumption.This is the deduction of the asset value due to wear and tear of the asset.
Imposed on Non-renewable resourcesImposed on Tangible assetsTangible AssetsAny physical assets owned by a firm that can be quantified with reasonable ease and are used to carry out its business activities are defined as tangible assets. For example, a company's land, as well as any structures erected on it, furniture, machinery, and equipment.read more
E.g., Coal, Oil, Natural GasE.g., Plant & Machinery, Building, Vehicles

Both these methods are utilized for calculating the periodic value of the respective asset/resource. Depending on the firm and its resources or asset underuse, these methods gradually reduce the value of the respective resource or asset. Various accounting standards, such as the GAAP (Generally Accepted Accounting Principles)GAAP (Generally Accepted Accounting Principles)Generally accepted accounting principles (GAAP) are the minimum standards and uniform guidelines for the accounting and reporting. These standards prohibit firms from engaging in unethical business activities and enable for a more accurate comparison of financial reports to investors.read more, have been kept in place for guiding the firms in accounting for both depreciation and depletion expenses.

For e.g., cane crushing equipment in a sugar firm would be eligible for depreciation from the point of time of it in use since there would be continuous wear and tear of the machine. However, in an oil company, the resources will have a depletion amount being calculated during its usage. Hence, these methods are helpful to help the company for recording the asset’s value as it reduces due to the usage and highlighting the value at a given point of time.

Conclusion

As discussed above, depletion expense is a reduction in the value of natural assets over a period of time. Depletion expenses are non-cash in nature and may be used in sync with depreciation and amortization, but the bifurcations are required for accurate accounting purposes and the nature of the asset in use.

Recommended Articles

This has been a Guide to what is Depletion Expense. Here we discuss depletion expense formula for calculating the period of depletion along with some examples and their Journal Entries. You can learn more about financing from the following articles –

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