Explanation :
Natural resources like oil, natural gas, and coal are drilled or mined from the ground. It’s impossible to accurately know how much resources are below the earth’s surface before they are extracted. That is why GAAP requires that natural resources be capitalized at cost initially. The purchase price or cost of the resources, mineral rights, and anything needed to prep the area for extraction is then allocated over the period of time they are consumed. The depletion equation is somewhat different than a typical depreciation formula because you have to figure out an average price per unit first. To calculate the depletion per unit you take the total cost less salvage value and divide it by the total number of estimated units. The expense is calculated by multiplying the depletion per unit by the number of units consumed or sold during the current period.
Example:
Let’s take a look at an example. Big John Oil recently purchased an oil field in central Texas for $1 million. BJ estimates that there are 500,000 gallons of oil in the reserve on this property. Thus, the cost allocated to each gallon is two dollars. Over the course of the first year, BJ successfully drills and extracts 100,000 gallons of oil and sells it to his resellers and refineries. BJ would record $200,000 of depletion in the first year. Every year after this, BJ will record a depletion expense until the full $1 million of cost is allocated to the asset.In a nutshell :
- Depletion is an accrual accounting method used to allocate the cost of extracting natural resources such as timber, minerals, and oil from the earth.
- When the costs associated with natural resource extraction have been capitalized, the expenses are systematically allocated across different time periods based upon the resources extracted.
- There are two basic forms of depletion allowance: percentage depletion and cost depletion.
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