What is exhaustion?
Depletion is an accrual accounting technique used to spread the cost of extracting natural resources such as wood, minerals and petroleum from the ground.
Like depreciation and amortization, depletion is a non-cash expense which progressively reduces the cost value of an asset by means of charges programmed into the result. Where depletion differs is that it refers to the gradual depletion of natural resource reserves, as opposed to the depletion of depreciable assets or the aging of the duration of intangible assets.
How exhaustion works
Depletion for accounting and financial reporting purposes is intended to help accurately identify the value of assets on the balance sheet and record expenses in the appropriate period of the income statement.
When the costs associated with the extraction of natural resources have been capitalized, the expenses are systematically distributed over different periods according to the resources extracted. The costs are kept on the balance sheet until the charges are recognized.
Key points to remember
- Depletion is an accrual method used to allocate the cost of extracting natural resources such as wood, minerals and petroleum from the ground.
- When the costs associated with the extraction of natural resources have been capitalized, the expenses are systematically distributed over different periods according to the resources extracted.
- There are two basic forms of burnout allowance: percentage burnout and cost burnout.
Recording of exhaustion
To calculate the costs to be allocated for the use of natural resources, each production phase must be taken into account. The depletion basis corresponds to the capitalized costs exhausted over several accounting periods. There are four main factors that affect the basis of exhaustion:
- Acquisition: Costs associated with the purchase or rental of property rights on land which, according to the company, has natural resources.
- Exploration: Expenses related to digging under the land rented or purchased.
- Development: the the costs necessary to prepare the ground for the extraction of natural resources, such as digging tunnels or developing wells.
- Restoration: Expenses associated with restoring the land to its original condition after completion.
Percentage depletion method
One method of calculating depletion expenses is the percentage depletion method. It allocates a fixed percentage to gross revenues – sales minus costs – to allocate expenses. For example, if $ 10 million of oil is extracted and the fixed percentage is 15%, $ 1.5 million of capitalized costs to extract the natural resource are exhausted.
The percentage depletion method requires many estimates and is therefore not a widely used or accepted exhaustion method.
Cost depletion method
The second method of calculating depletion is the cost depletion method. Cost depletion is calculated taking into account the base of the property, the total recoverable reserves and the number of units sold. The base of the property is distributed among the total number of recoverable units. As natural resources are extracted, they are counted and removed from the base of the property.
For example, the capitalized costs of $ 1 million bring in 500,000 barrels of oil. The first year, if 100,000 barrels of oil are extracted, the depletion expense for the period is $ 200,000 (100,000 barrels * ($ 1,000,000 / 500,000 barrels)
The Internal Revenue Service (IRS) requires that the cost method be used with wood. It requires the method that gives the highest deduction to use with mining properties, which it defines as oil and gas wells, mines and other natural deposits, including geothermal deposits.
Since the percentage of depletion examines the gross income and the taxable income limit of the property, as opposed to the amount of natural resource extracted, this is not an acceptable reporting method for some natural resources.