What is Depletion?


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Depletion is an accounting and tax concept used to allocate the cost of extracting natural resources such as timber, minerals, and oil from the earth. Like depreciation and amortization, depletion is a method of cost allocation that assigns the original cost of the resource to the periods during which the resources are consumed or removed.

There are two methods for calculating depletion: cost depletion and percentage depletion.

  • Cost Depletion: This is calculated by estimating the total quantity of mineral or other resources in the ground and then assigning a proportionate amount of the total resource cost to each unit based on the quantity removed in a particular period.
  • Percentage Depletion: This is calculated as a percentage of the gross income from the property. This method is often used for oil or gas wells and can sometimes result in larger tax deductions than cost depletion. However, it’s subject to certain qualifications and limitations.

For example, if a company invests $1 million to extract a mineral and estimates that the total yield from the property will be 500,000 tons, the depletion expense per ton extracted would be $2 ($1 million / 500,000 tons). So, if the company extracts 50,000 tons in a particular year, the depletion expense would be $100,000 ($2 per ton * 50,000 tons).

The purpose of depletion is to accurately reflect the true cost of the natural resource as it is used up over time. It’s a way to match the expense of obtaining the resource to the periods of time when the resource is actually used, and thus the revenue is earned. This helps in reporting accurate financial performance.

Example of Depletion

Let’s consider an example of a mining company.

Suppose a mining company spends $15 million to acquire a mine, and geological surveys estimate that the mine contains 2.5 million tons of the mineral deposit. The company then begins mining operations and extracts 250,000 tons of the mineral in the first year.

The depletion rate is calculated based on the total cost and the total estimated quantity of the mineral. In this case, it would be $15 million / 2.5 million tons = $6 per ton.

In the first year, the company extracts 250,000 tons, so the depletion expense for the first year would be 250,000 tons * $6/ton = $1.5 million.

This $1.5 million represents the cost of the natural resource that the company has used in the first year, and it would be reported as an expense on the company’s income statement, reducing the company’s taxable income.

This process would continue each year based on the quantity of the mineral extracted, accurately reflecting the cost of the consumed resource over time.

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