As the estimated output has changed as a result of new survey conducted at the start of year 2, we must compute a new depletion rate to be used for year 2 and year 3. There are three steps involved in computation of depreciation under depletion method. In 2012, P’s share of production consisted of 50,000 barrels sold, and the audited engineer’s report further highlighted that 160,000 barrels could be recovered after December 31, 2012.
Recording Depletion
As soon as a company has the right to use the property, it often incurs exploration costs needed to find the resource. When exploration costs are substantial, some companies capitalize on the depletion base. As a result, a company in the extractive industries, like ExxonMobil, frequently adopts a conservative policy in accounting for the expenditures related to finding and extracting natural resources.
Exploration Costs
Cost depletion is calculated by estimating the total quantity of a given resource and then dividing the percentage withdrawn by the total quantity. Let’s say an oil company expects to spend $200,000 to withdraw 50,000 barrels of oil every year from a field with estimated reserves of 1 million barrels. The amount of depletion that could be claimed would be $10,000, or $200,000(50,000/1,000,000). Depreciation, depletion, and amortization (DD&A) is an accounting technique that enables companies to gradually expense various different resources of economic value over time in order to match costs to revenues. Depletion is the exhaustion that results from the physical removal of a part of a natural resource.
Partial-Year Depreciation
Hence, these methods help the company record the asset’s value as it reduces due to the usage and highlights the value at a given time. Thomson Reuters® UltraTax CS delivers streamlined, consistent data entry for up to twelve oil and gas cost centers and 9,999 wells in 1040, 1041, 1065, and 1120 returns. Furthermore, UltraTax CS calculates and limits percentage depletion, tax preferences for percentage depletion and intangible drilling costs, which method should be used to calculate depletion for a natural resource company? and tracks for depletion on a detailed, well-by-well basis. A mining company buys mineral rights for $20,000,000 and spends an additional $4,000,000 to develop the land. Given this, the depletion rate would be $24,000,000 divided by 600,000, or $40 per ton. During the second year, Pensive Oil extracts 80,000 barrels of oil from the well, which results in a depletion charge of $128,800 (80,000 barrels x $1.61 unit depletion charge).
- Accumulated depreciation is subtracted from the historical cost of the asset on the balance sheet to show the asset at book value.
- Under US GAAP, almost all long-lived assets are carried on the balance sheet at their depreciated historical cost, regardless of how the actual fair value of the asset changes.
- The tax implications of depletion depend on the country in which the natural resources are located.
- Pensive’s geologists estimate that the proven oil reserves that are accessed by the well are 400,000 barrels, so the unit depletion charge will be $1.50 per barrel of oil extracted ($600,000 depletion base / 400,000 barrels).
- For example, if the percentage were 22%, depletion expense would be gross income times 22%.
Recall that the accounting profession uses the term depletion to allocate the cost of natural resources. For example, if we want to increase investment in real estate, shortening the economic lives of real estate for taxation calculations can have a positive increasing effect on new construction. If we want to slow down new production, extending the economic life can have the desired slowing effect.
The salvage value of the property tends to be more significant for natural resource-producing property and should be included in computing the lifetime depletion to be recorded. Therefore, the output-oriented units of production approach is widely used to allocate the cost to the materials and the time periods in which they are used. Depletion, on the other hand, is the actual use and exhaustion of natural resource reserves. In the first year, Pensive Oil extracts 100,000 barrels of oil from the well, which results in a depletion charge of $150,000 (100,000 barrels x $1.50 unit depletion charge). In addition, Pensive Oil estimates that it will incur a site restoration cost of $57,000 once extraction is complete, so the total depletion base of the property is $600,000.
Depending on the firm and its resources or assets underuse, these methods gradually reduce the value of the respective resource or asset. Depletion primarily applies to businesses involved in industries such as mining, timber, oil, and natural gas extraction, where they exploit finite resources from the Earth’s crust. When a company acquires the rights to extract these resources, they are initially recorded as assets on the balance sheet. However, these assets are not infinite; they deplete as the resources are extracted and sold. Thus, if you extract 500 barrels of oil and the unit depletion rate is $5.00 per barrel, then you charge $2,500 to depletion expense.
If asset depreciation is arbitrarily determined, the recorded “gains or losses on the disposition of depreciable property assets seen in financial statements”8 are not true best estimates. Due to operational changes, the depreciation expense needs to be periodically reevaluated and adjusted. The double-declining-balance depreciation method is the most complex of the three methods because it accounts for both time and usage and takes more expense in the first few years of the asset’s life. Double-declining considers time by determining the percentage of depreciation expense that would exist under straight-line depreciation. Next, because assets are typically more efficient and “used” more heavily early in their life span, the double-declining method takes usage into account by doubling the straight-line percentage.