In each accounting period, the depletion recognized is an estimate of the cost of the natural resource that was removed from its natural setting during the period. To record depletion, debit a Depletion account and credit an Accumulated Depletion account, which is a contra account to the natural resource asset account. Under these provisions, a producer is allowed to deduct an arbitrary fixed percentage of gross income as a depletion expense without regard to the historical cost of the property. The cost of natural resources extracted by a firm from a property is known as depletion. The Internal Revenue Service (IRS) requires the cost method to be used with timber. It requires the method that yields the highest deduction to be used with mineral property, which it defines as oil and gas wells, mines, and other natural deposits, including geothermal deposits.
Depletion: Definition, 4 Affecting Factors, and Depletion Methods
The tax implications of depletion depend on the country in which the natural resources are located. In some countries, depletion is treated as a deductible expense for tax purposes. In other countries, depletion may be subject to special taxes or royalties. In situations where the consumption of the usefulness of these assets parallels the production of the resource, they may be amortized and depreciated using the units of production approach.
Who can claim depletion expenses?
Book value is the amount of the asset that has not been allocated to expense through depreciation. Cost depletion is calculated by taking the property’s basis, total recoverable reserves and number of units sold into account. The property’s basis is distributed among the total number of recoverable units.
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In this approach, the total cost of the natural resource less salvage value is divided by the number of units estimated to be in the resource deposit to obtain a cost per product unit. When analyzing depreciation, accountants are required to make a supportable estimate of an asset’s useful life and its salvage value. The units of production method is different from the two above methods which method should be used to calculate depletion for a natural resource company? in that while those methods are based on time factors, the units of production is based on usage. However, the total amount of depreciation taken over an asset’s economic life will still be the same. In our example, the total depreciation will be $48,000, even though the sum-of-the-years-digits method could take only two or three years or possibly six or seven years to be allocated.
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When it pertains to standing timber, cost depletion is the required method. However, for oil and gas wells, mines, other natural deposits (including geothermal deposits), and mineral property, companies generally use the method that gives them the larger deduction. The units-of-activity method is the measurement that uses the units of activity during the year to apply the cost per unit in order to determine the annual expense. This is why it is suitable to use in the calculation of depletion expense as the available natural resource will be reduced by the number of extracted units in each period. Thus, depletion is a function of the number of units extracted -during the period.
Is depletion an operating expense?
Companies engaged in mining or extracting identify their depletion expense methods and comment on period expenses in the management discussion and analysis (MD&A) sections of their quarterly and annual filings. The percentage depletion method requires a lot of estimates and is, therefore, not a heavily relied upon or accepted method of depletion. For example, on January 1, 2020, the company ABC has invested $2,000,000 in a coal mine that is estimated to contain 1,000,000 tons of coal. The mine is expected to be able to sell for $100,000 at the end of its useful life and the company ABC has extracted and sold 120,000 tons of coal in 2020.
Other methods include the units-of-production method and the percent-of-revenue method. The estimated amount of a natural resource that can be recovered will change constantly as assets are gradually extracted from a property. As you revise your estimates of the remaining amount of extractable natural resource, incorporate these estimates into the unit depletion rate for the remaining amount to be extracted.
- In the determination of capitalized costs, we do not consider just the initial cost of the asset; instead, we determine all of the costs necessary to place the asset into service.
- Where depletion differs is that it refers to the gradual exhaustion of natural resource reserves, as opposed to the wearing out of depreciable assets or aging life of intangibles.
- The depletion rate per unit of a natural resource or asset depends upon the total number of units expected to be extracted.
- As soon as a company has the right to use the property, it often incurs exploration costs needed to find the resource.
- 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.
For example, in the current example both straight-line and double-declining-balance depreciation will provide a total depreciation expense of $48,000 over its five-year depreciable life. The expense recognition principle that requires that the cost of the asset be allocated over the asset’s useful life is the process of depreciation. For example, if we buy a delivery truck to use for the next five years, we would allocate the cost and record depreciation expense across the entire five-year period. After the purchase, we incurred $300,000 in additional costs to explore and develop the site.
Accumulated depreciation is a contra account, meaning it is attached to another account and is used to offset the main account balance that records the total depreciation expense for a fixed asset over its life. In this case, the asset account stays recorded at the historical value but is offset on the balance sheet by accumulated depreciation. Accumulated depreciation is subtracted from the historical cost of the asset on the balance sheet to show the asset at book value.
For example, a company like ExxonMobil makes sizable expenditures to find natural resources, and for every successful discovery, there are many failures. Assume in the earlier Kenzie example that after five years and $48,000 in accumulated depreciation, the company estimated that it could use the asset for two more years, at which point the salvage value would be $0. The company would be able to take an additional $10,000 in depreciation over the extended two-year period, or $5,000 a year, using the straight-line method. At the start of the year 2, a new survey is conducted and it is found that the expected extraction of minerals is only 160,000 tons (i.e.,40,000 tons less then the original estimate). The company decided to workout a new depletion rate on the basis of information provided by revised survey.
He also estimates that he will make 20,000 clothing items in year one and 30,000 clothing items in year two. Determine Liam’s depreciation costs for his first two years of business under straight-line, units-of-production, and double-declining-balance methods. Depletion is an accounting technique that allows investors to write down the value of a natural resource as it’s extracted or harvested. Enshrined into the tax code in 1926, depletion is most commonly used in the oil and gas, mining, and timber industries. If a company uses all three of the above expensing methods, they will be recorded in its financial statement as depreciation, depletion, and amortization (DD&A).