Depletion

Reviewed by Annapoorna | Updated on Aug 27, 2020

What is Depletion?

Depletion refers to an accrual accounting method used to determine the expense of extracting natural resources from the earth, such as wood, minerals, and oil.

Just like depreciation and amortisation, depletion is a non-cash expense. It incrementally lowers an asset's cost value through scheduled income charges. Where depletion differs, it refers to the gradual degradation of natural resources reserves, as opposed to wearing depreciable assets or ageing intangible lives.

Concept of Depletion Explained

In accounting and financial reporting, depletion is intended to help correctly classify the value of the assets on the balance sheet and document expenditures on the income statement within the correct period.

When the costs associated with the exploitation of natural resources are capitalised, the costs are distributed systematically over various periods, based on the resources extracted. The costs are carried on the face of the balance sheet until the expenses are recognised.

There are two fundamental forms of depletion allowance: the percentage depletion and cost depletion.

In order to determine which costs need to be distributed for the use of natural resources, account must be taken of each specific step of output. The basis of depletion is the capitalised costs which have been reduced over several accounting periods. Four key factors are influencing the foundation of depletion:

  • *Acquisition: *It refers to the costs connected to the purchase or lease of land ownership rights, which the client claims have natural resources.
  • Exploration: Expenses related to digging under the leased or purchased property.
  • *Development: *These are costs needed to prepare the land for the exploitation of natural resources, such as tunnelling or the construction of wells.
  • *Restoration: *Costs associated with returning the property upon completion to its original state.

Forms of Depletion

Percentage Depletion Method One way of estimating the cost of depletion is the way of depletion by percentage. It assigns a fixed amount to the gross income to distribute expenses — revenues minus costs.

For example, if Rs 10,00,000 worth of oil is extracted, and the fixed percentage is 20 per cent, Rs 2,00,000 is lost from capitalised costs to extract the natural resource. The percentage depletion approach needs multiple calculations and is thus not a form of depletion that is highly dependent upon or embraced.

Cost Depletion Method The cost-depletion method is the second approach to measuring depletion. Price depletion is measured, taking into account the base of the land, gross recoverable reserves and number of units sold. The basis of the property is distributed among the total number of units which can be recovered. These are counted and taken out of the base of the property when natural resources are removed.

The capitalised Rs 10,00,000 expense, hypothetically, for example, yields 5,000 barrels of oil. If 1,000 barrels of oil are extracted in the first year, the extraction cost for the year is Rs 2,00,000, i.e 1,000 barrels (*)(Rs 10,00,000/5,000 barrels).