What is depletion (short definition)
– Depletion is an accounting method for allocating the capitalized cost of extracting natural resources (for example, oil, gas, minerals, timber) over the periods when the resources are removed and sold. It is a non-cash expense, like depreciation (for tangible fixed assets) and amortization (for intangible assets), that matches resource-extraction costs to the revenue those resources generate.
How depletion works (conceptual)
– When a company incurs costs to acquire or prepare a natural-resource property, those costs are recorded as an asset on the balance sheet (they are capitalized). As units of the resource are extracted and sold, a portion of that capitalized cost is recognized as an expense. The intent is to reflect the declining value of the resource asset and to match expense recognition to production and revenue.
Key components and terms
– Depletion base: the total capitalized cost to be allocated (purchase price, development costs, restoration costs, etc.).
– Recoverable units (total reserves): the estimated total quantity of resource expected to be extracted (e.g., barrels, tons, board feet).
– Units extracted: the actual amount removed during the accounting period.
– Accumulated depletion (contra-asset): the balance-sheet account that aggregates depletion charges over time.
Two primary methods to compute depletion
1) Cost depletion (unit-of-production)
– Principle: allocate the capitalized basis over estimated recoverable units; expense equals units extracted × cost per unit.
– Formula:
– Cost per unit = Depletion base / Total recoverable units
– Depletion expense = Units extracted × Cost per unit
– Practical note: as reserves estimates change, cost per unit is recalculated prospectively.
2) Percentage depletion
– Principle: apply a fixed statutory percentage to gross income from the property to compute the deduction.
– Formula:
– Depletion expense = Gross income from property × Percentage rate
– Practical note: this method is percentage-based and does not directly use the cost basis or the estimated recoverable units. Tax rules limit or disallow percentage depletion for certain properties.
Recording depletion in the accounts (journal entry)
– Typical entry:
– Debit: Depletion expense (income statement)
– Credit: Accumulated depletion (contra-asset on balance sheet)
– Alternative presentation: reduce the resource asset directly (less common). The accumulated depletion approach mirrors depreciation accounting and preserves the original capitalized cost for disclosure.
Reporting requirements and practical points
– Reserve estimates: Depletion depends on estimated recoverable units; companies should review and update estimates regularly.
– Disclosures: financial statements commonly disclose the depletion method used, major assumptions about reserves, and the depletion expense for the reporting period.
– Tax-specific rules: tax authorities may prescribe or limit the method allowed for particular resources (see checklist below).
Checklist — what to verify when calculating depletion
– Has the cost to be depleted been properly capitalized (purchase, development, restoration)?
– What is the most recent estimate of total recoverable units (reserves)?
– How many units were extracted and sold in the current period?
– Which depletion method is appropriate or required (cost method, percentage method, or a tax-mandated rule)?
– Are there tax limitations or special rules affecting the allowable deduction?
– Have reserve revisions or asset impairment events been considered and applied prospectively?
– Are disclosures in the notes sufficient (method, key assumptions, and amount charged)?
Worked numeric examples
A) Cost depletion (unit-of-production)
– Given:
– Capitalized costs (depletion base) = $1,000,000
– Total recoverable barrels = 500,000 barrels
– Barrels extracted this year = 100,000 barrels
– Calculation:
– Cost per barrel = $1,000,000 / 500,000 = $2.00 per barrel
– Depletion expense = 100,000 × $2.00 = $200,
= continued =
Depletion expense = 100,000 × $2.00 = $200,000.
– Post-entry balances and checks:
– Accumulated depletion (contra-asset) increases by $200,000.
– Carrying amount of capitalized resource costs = $1,000,000 − $200,000 = $800,000.
– Remaining recoverable barrels = 500,000 − 100,000 = 400,000.
– New unit cost (if reserves unchanged) = $800,000 / 400,000 = $2.00 per barrel (recompute if reserves change).
B) Percentage depletion (tax-style) — illustrative example
– Given (hypothetical tax rule for illustration; actual statutory rates vary by mineral and jurisdiction):
– Gross income from property this year = $600,000
– Statutory percentage rate = 10% (example only)
– Calculation:
– Percentage depletion = 10% × $600,000 = $60,000
– Note: percentage depletion is computed on gross income, not on capitalized cost. It may be limited by statute (e.g., overall taxable-income limits, or limits per taxpayer or property). Always consult current tax law.
– Journal entry (for a taxpayer who is also presenting GAAP financials, record tax deduction effect separately):
– Tax return: report $60,000 deduction under percentage depletion.
– If a company elects percentage depletion for tax but uses cost depletion for GAAP, the tax-only deduction creates a deferred tax effect (see checklist below).
C) Journal entries — examples
–