The depletion method is an accounting technique used to allocate the cost of natural resources over the period of their extraction or consumption. Natural resources, also referred to as wasting assets, include items like oil, natural gas, coal, timber, and mineral deposits.
The two most common depletion methods are:
- Cost Depletion Method: This involves determining a fixed rate of depletion for each unit of natural resource extracted. This rate is derived from the total quantity of the resource available and the original cost of the resource. As the resource is extracted or used, the depletion expense is recognized based on the quantity used during a particular period.
- Percentage Depletion Method: This involves multiplying a fixed percentage by the gross income received from the extraction of the natural resource. This method is typically used in the oil and gas industry. However, it’s subject to specific regulatory rules and may result in larger tax deductions than the cost depletion method.
The depletion method is an essential tool for businesses involved in extracting natural resources because it allows them to accurately report the value of their assets and the cost of their goods or services. This method is similar to depreciation for fixed assets and amortization for intangible assets, but it’s specifically for natural resources.
Example of the Depletion Method
Let’s illustrate the depletion method with an example of a mining company:
Suppose ABC Mining Corp. buys a gold mine for $20 million. Based on various geological surveys and studies, it estimates that the mine contains 200,000 ounces of extractable gold.
- Cost Depletion Method: The depletion cost per ounce would be the total cost divided by the total estimated extractable quantity. So, in this case, the depletion cost per ounce would be $20 million / 200,000 ounces = $100 per ounce.If ABC Mining Corp. extracts 10,000 ounces in the first year, the depletion expense for the first year would be 10,000 ounces * $100/ounce = $1 million. This $1 million would be recognized as an expense on the income statement, reducing ABC Mining Corp.’s taxable income for the year.
- Percentage Depletion Method: Suppose, according to regulations, the company can use a 15% rate for percentage depletion. If the company’s gross income from the gold mine is $3 million in the first year, the depletion expense would be 15% * $3 million = $450,000.
The appropriate method depends on the industry, specific regulations, and the company’s strategy for reporting expenses and income. It’s worth noting that in real-life scenarios, depletion calculations can become significantly more complex due to factors like residual value, improvements, or restoration costs.