What is the Depletion 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. read more.

Depletion Expense Formula

The formula for calculating the period of depletion expenses is:

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Types of Depletion Expense

The following are types of depletion expenses:

#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 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 DepletionS = Units sold in the current yearR = Reserves in hand at the end of the current yearAB = 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 bonusCapitalized 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:

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 the 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.read more 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.read more.

Depletion vs. Depreciation

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

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.read more, 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.

Conclusion

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

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

  • Journal Entries ExamplesDepreciation Rate CalculationCapex vs OpexExpense Accounting Definition