Depletion Method of Depreciation

The Depletion method of depreciation is a cost allocation method that works for depleting natural resources. The accounting working for depletion works similarly as in depreciation of tangible assets or amortization with intangible assets. As the natural resources or assets “deplete” with extraction over time, the term is used as a depletion method of depreciation.

What is Depletion of Depreciation?

Depletion refers to the cost recovery in accounting terms for natural resources owned by a company. Companies working in mining, coal, timber, and metal industries use the depletion method of depreciation.

When do We Use the Depletion Method?

As with the depreciation of tangible assets, the purpose of the depletion method is also to recover the economic cost of natural resources. The difference remains with the nature of assets being the natural resources rather than built or manufactured assets.

Natural resources need capital investments for extraction. The estimated values of underlying natural resources then become the basis of cost allocations. As the resources deplete with extraction, the depletion charge accumulates on the balance sheet of the company.

Companies working in natural resource industries use resource depletion methods. The cost spreading involves an educated guess on the total economic value of the natural resource. The extraction rate on a daily or monthly basis can then be used as a basis for the calculation of depletion charge. As natural resources or commodities like precious metals (Gold and Silver) may change prices, the depletion charge or costs also reflects the changes in the accounting books. The accrual accounting method of depletion is used to allocate costs for natural resources over the estimated total value of the resources.

How to Calculate the Depletion Expense?

There are two main components required to calculate the depletion expense for natural resources.

  1. The natural resource base cost
  2. The depletion rate of the natural resource
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We then can calculate the depletion expense by simply multiplying these two figures. Any Salvage value of natural resources and project is subtracted from total base costs.

The Natural Resource Base Costs

Natural resource extraction requires several types of costs that incur before and during the extraction process. Companies in natural resource extraction have to spend cyclic costs from licensing and exploration rights to the shut-down costs.

  • Licensing and Leasing Costs: These costs relate to company licensing and land or sea leasing rights. Natural extraction of resources requires specific bidding rights costs and leasing costs from the governments.
  • Exploration and Extraction Costs:   These are projects that incur during the exploration and then extraction of natural resources. Several exploration costs may not yield revenue as many exploration projects end up without positive results. The extraction costs relate to the mining and refining of resources before selling into the market.
  • Project Shut-down and Rehabilitation Costs:     These costs are the environmental rehabilitation costs that incur after the project is completed. Shut-down costs for the project including safety and hazard assessments make a significant portion of the total project costs.

The Depletion Rate

The depletion rate can be calculated as a percentage term of total costs or per unit basis. In a percentage method, the calculation is based on the units extracted in the current period and expressed in terms of the percentage of the total estimated resources. In the dollar-value method or cost method, the depletion rate is simply the current period extracted unit cost in unit terms.

The Depletion Expense Formula

The depletion expense for the period can be calculated as:

Depletion Expense = Depletion Rate × the number of units extracted in current period

Or,

Depletion Expense = [(Depletion Base Costs – Salvage Value)/Total Estimated Reserves or Units] × Units Extracted

Working Example

Let’s assume a company Argus Co. secures natural gas exploration rights. The cost estimates for the site and natural reserves information with no project salvage value are given. The company estimated a total of 2 million cubic feet gas and current period exploration remained at 300,000 cubic feet.

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Cost FactorIn $ million
Land Acquisition and exploration rights2.5
Site preparation and plant1.8
Other project costs1.0
Total Project costs5.3

The Depletion rate = 5,300,000 / 2,000,000 = $ 2.65           

The Depletion Expense = current units extracted × the depletion rate

Hence, the Depletion Expense =     300,000 × 2.65 = $ 795,000.

Depletion Journal Entry

The accounting treatment of natural resources and its depletion charge is the same as normal tangible and intangible assets.

Journal entry at the date of successfully obtaining the exploration right:

AccountDebit
$m
Credit
$m
Natural gas exploration rights5.3 
Cash 5.3

Assume that all the costs were paid by cash.

Depletion Journal entry at the end of each reporting period to recognize depletion charge:

AccountDebit
$m
Credit
$m
Depletion expense0.795 
Accumulated depletion expense 0.795

Effect of Changes in Estimation

Continuing on our example, let’s assume the project has a residual value of $ 1.0 million. The estimated natural gas reserves reduced to 1.8 million cubic feet. The depletion rate, charge and hence the depletion costs will change.

The Depletion rate = (5,300,000 – 1,000,000)/ 1,800,000 = $ 2.39

Thus, we can calculate the depletion charge as follow:

The Depletion Expense= current units extracted × the depletion rate

Hence, the Depletion Expense = 300,000 × 2.39 = $ 717,000.

Changes in the Exploration Units Extracted

With a changing extracted volume of units, the depletion charge is calculated on the depletion rate for each exploration period. The cumulative depletion account is adjusted with each period accordingly.

Suppose the extracted units in our example remained 250,000 and 280,000 cubic feet for the next two periods respectively.

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The Depletion Expense 2nd period = $ 2.39 × 250,000 = $ 597,500

The Depletion Expense 3rd period = $ 2.39 × 280,000 = $ 669,200

Advantages of Depletion Method

Depletion method like depreciation and amortization offers some accounting benefits in cost recovering for the natural resources. Although, it remains a non-cash item on the financial statement but offers certain cost allocation advantages.

  • We can use the depletion method with both cost and percentage basis for calculating the depletion charge. It offers wider flexibility with varying natural resource prices
  • The method is simple to allocate costs for natural resources with the companies working in mines, timber, fishing, or oil sector etc.

Disadvantages of Depletion Method

The depletion method being an accounting entry has some limitations too.

  • The Depletion method can only be used for natural resources like oil, gas, metals, etc.
  • The cost allocation is based purely on estimation that may be different from the market values
  • Like depreciation of tangible assets, the cash flows need to be adjusted in cash flow financial statements
  • The depletion charge and rate depend solely on units extraction that can easily be manipulated to adjust the accounting costs and reducing tax obligations

Conclusion

The depletion method provides a useful cost allocation method where the depreciation method or amortization method cannot be used. Any salvage or residual values, and changes in unit prices can be adjusted. However, the cash flow statements need to be adjusted. The accuracy of cost estimates and unit extraction remains highly speculative and subjective.

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