Thus, if you extract 500 barrels of oil and the unit depletion rate is $5.00 per barrel, then you charge $2,500 to depletion expense. During the second year, Pensive Oil extracts 80,000 barrels of oil from the well, which results in a depletion charge of $128,800 (80,000 barrels x $1.61 unit depletion charge). At the end of the second year, there is still a depletion base of $321,200 that must be charged to expense in proportion to the amount of any remaining extractions. Depletion can only be used for natural resources, while depreciation is allowed for all tangible assets. Unlike depreciation, cost depletion is based on usage and must be calculated every period.

1. The resulting net carrying amount of natural resources still on the books of a business do not necessarily reflect the market value of the underlying natural resources.
2. 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.
3. The expenditures spent following the conclusion of resource extraction are referred to as restoration costs.
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5. Cost depletion is computed by estimating the total quantity of mineral or other resources acquired and assigning a proportionate amount of the total resource cost to the quantity extracted in the period.

As assets are gradually removed from a site, the projected amount of natural resources that may be recovered changes continually. The overall expense of underground digging on leased or acquired property is referred to as exploration. Certain firms use the full-cost strategy to capitalize on all expenditures incurred as a consequence of both successful and failed natural resource research initiatives. When a land purchase or lease is completed what is depletion in accounting as anticipated, the acquisition expenditures are converted to exploration costs. Cost is calculated by determining the entire quantity of a certain resource and then applying a proportionate percentage of the resource's cost against the quantity removed (the period is generally one year). The net carrying amount of natural resources still on a business's books may not always represent the market worth of the underlying natural resources.

Recording Depreciation, Depletion, and Amortization (DD&A)

In other words, it lets firms match expenses to the revenues they helped produce. For example, the exact tax structure is not important; the tax may be a percentage tax or a lump-sum tax. The oil extraction process reduces the amount of oil available in the oil well for future extraction.

The general formula for cost depletion substitutes future investment for the initial investment. In the example above, suppose that at the end of the first year, a new company looking to extract oil from Company ABC’s oil well would need to make an initial investment of $80,000. Units are considered sold in the year the proceeds are taxable under the taxpayer's accounting method. The percentage depletion method requires a lot of estimates and is, therefore, not a heavily relied upon or accepted method of depletion.

How Depletion Works

Mineral property includes oil and gas wells, mines, and other natural resource deposits (including geothermal deposits). For that purpose, property is each separate interest businesses own in each mineral deposit in each separate tract or parcel of land. Businesses can treat two or more separate interests as one property or as separate properties. Cost depletion is typically part of the "DD&A" (depletion, depreciation, and amortization) line of a natural resource company's income statement. Depletion is similar to depreciation, which is used to allocate the cost of tangible assets like factories and equipment over their useful lives. Depletion is used for natural resources, which can include minerals, ore, oil, gas, and timber.

Depletion vs. Depreciation

For example, if the percentage were 22%, depletion expense would be gross income times 22%. However, in some cases, cost depletion must be used over percentage depletion, such as the case with standing timber. According to the IRS Newswire,[2] over 50 percent of oil and gas extraction businesses use cost depletion to figure their depletion deduction.

What Is Depreciation, Depletion, and Amortization (DD&A)?

It allows for automated modifications to the basis for the taxable year in question. The general calculation assumes that a portion of the initial investment is a fixed cost. The qualifications and conditions for the same are provided by the accounting authorities of different countries, along with a thorough justification. It is the amount of money made before non-operating expenditures such as interest, rent, and power are paid. As a consequence, if Company ABC earns $10 million in sales and the percentage is 2%, it may infer that $200,000 of the income is due to its resources.

If the final investment differs from the corporation's intended, the expenses may be written off as a loss. In this scenario, the rate would be determined by various oil industry parameters. Any opinions, analyses, reviews or recommendations expressed here are those of the author's alone, and have not been reviewed, approved or otherwise endorsed by any financial institution. Analysts and investors in the energy sector should be aware of this expense and how it relates to cash flow and capital expenditure. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more.