Cost depletion is a method of allocating the cost of extracting natural resources, such as minerals, oil, gas, or timber, over the total estimated recoverable units of the resource. It is an accounting technique used primarily by companies involved in resource extraction industries to determine the depletion expense for a given accounting period.
Cost depletion is calculated by dividing the total cost of the resource (including acquisition, exploration, and development expenses) by the estimated total recoverable units (e.g., barrels of oil, tons of coal, or board feet of timber). The resulting cost per unit is then multiplied by the number of units extracted during the accounting period to determine the depletion expense for that period.
The depletion expense is recorded as a reduction in the carrying value of the resource on the balance sheet and is also deducted as an expense on the income statement. This helps to spread the cost of the resource over its useful life, ensuring that the company’s financial statements accurately reflect the economic reality of the resource’s depletion.
It is important to note that cost depletion is different from percentage depletion, another method used to allocate the cost of natural resources. While cost depletion is based on the actual cost of the resource and the estimated recoverable units, percentage depletion is calculated as a fixed percentage of the resource’s gross income, regardless of the resource’s actual cost or remaining units. Percentage depletion is generally more favorable for tax purposes but may not be available for all types of resources or companies.
Example of Cost Depletion
Let’s consider a fictional oil extraction company, “PetroExtraction Corp.” The company acquires an oil field for $10 million, spends $5 million on exploration and development, and estimates that the field contains 5 million barrels of recoverable oil.
Total cost = $10 million (acquisition) + $5 million (exploration and development) = $15 million
Next, we’ll divide the total cost by the estimated total recoverable units (barrels of oil) to find the cost per unit:
Cost per unit = $15 million / 5 million barrels = $3 per barrel
Now, let’s assume that PetroExtraction Corp. extracts 500,000 barrels of oil during the accounting period (e.g., a year). We can calculate the depletion expense for this period by multiplying the cost per unit by the number of barrels extracted:
Depletion expense = $3 per barrel × 500,000 barrels = $1.5 million
In this example, PetroExtraction Corp. would record a depletion expense of $1.5 million for the accounting period, reducing the carrying value of the oil field on the balance sheet by the same amount. This depletion expense would also be deducted on the income statement, spreading the cost of the resource over its useful life and reflecting the economic reality of the oil field’s depletion.