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Definition of Depletion Expenses

Depletion can be defined as a decline, fall, or reduction in the value of any asset being commonly used in the case of natural resources (Oil, gas, iron ore, etc.) due to the use, consumption, extraction, or exploitation of that asset which is written off as expense during an accounting period and reduced from the value of that asset. In this topic, we are going to learn about Depletion Expenses.

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Explanation

Various types of natural resources, like oil, natural gas, coal, etc., are drilled out/ extracted out of the mineral-rich land. It is impossible to calculate the total value of resources beneath the ground until they are extracted completely. GAAP usually makes it a mandatory requirement for companies engaged in mining to capitalize on the acquisition cost of the extracted resources. Depletion expense uses an accrual accounting system to allocate the cost of extracting natural resources. It is a non-cash expense like depreciation and amortization, which reduces the value of an asset incrementally via scheduled charges on income. Depletion expenses are charged against revenue generated as a natural resource utilization/ extraction cost. Charging these expenses as cost helps determine actual profits and identify the company’s financial position on the balance sheet date. When the cost of extraction of natural resources has been capitalized, these expenses are allocated across the leasing period/ utilization period based upon their extraction.

The formula for Depletion Expenses

Calculate the average price per unit.

To calculate the unit price, one should consider the total cost of natural resource acquisition reduced by the salvage value.

The value derived will be divided by the total estimated number of product units.

Next, multiply the cost per unit derived in (3) by the total number of units extracted or consumed during a particular period.

The formula is as follows –

Depletion Expenses = ( (cost – Salvage Value) / Estimated Number of Units )* Total Number of Units Extracted During an Accounting Period

How to Calculate Depletion Expenses?

Depletion expenses can be calculated using the following steps –

Step #1

Calculation of Depletion Base / Cost – Depletion base is the cost that must be capitalized and depleted across multiple accounting periods. It is the cost incurred to purchase or lease the asset, deployment cost, exploration cost, or any other type of cost incurred to restore the asset to its original condition once the depletion of the asset is completed. There are four factors that affect the depletion base –

Acquisition: All associated costs incurred to buy or lease land a company knows is full of resources.

Exploration: It includes all the expenses associated with going inside the land, like digging and mining the land which was bought or leased.

Development: It is the cost necessary to prepare the land for extraction, like digging wells or tunnels.

Restoration: These are all expenses incurred to restore the land to its original condition.

Step #2

Calculation of Depletion Rate Per Unit – The depletion rate per unit of an asset or any natural resource depends on the total number of units that will be extracted. To calculate the rate per unit, one needs to consider the total cost less salvage value and then divide it by the total number of estimated units.

Depletion rate = (Depletion Cost – Salvage Value) / Estimated Number of Units

Step #3

Calculation of Depletion Expense – Finally, the units extracted for a period are multiplied depletion rate per unit to calculate the depletion expense for that period.

Depletion Expense = Depletion Rate Per Unit x Total Number of Units Extracted.

Examples of Depletion Expenses

Following are the examples are given below:

Example #1

Coal Inc. acquired a coal mine on 01 April 2023 for $30,00,000. The acquired mine has an estimated capacity of 20,00,000 tons of coal; the salvage value at the end is zero. There was an additional cost incurred of $60,000 for developing a mine to extract coal. Coal Inc. extracted 2,50,000 tons of coal from the mine till 31 March 2023. The company wants to know the depletion expenses for the period.

Solution:

Depletion Expenses = { (cost – Salvage Value) / Estimated Number of Units } * Total Number of Units Extracted

Depletion Rate = (Depletion Cost – Salvage Value) / Estimated Number of Units

Depletion Cost = $30,00,000 + $60,000 = $30,60,000

Salvage Value = 0

Estimated number of units = 20,00,000 tons

Depletion Rate = 30,60,000 / 20,00,000

Depletion Rate = $1.53

Depletion Expense is calculated as

Depletion Expense = Depletion Rate Per Unit * Total Number of Units Extracted.

Depletion Expense for the financial year 2023-20 = $1.53 * 2,50,000 tons

Depletion Expense for the financial year 2023-20 = $3,82,500

Example #2

Red Ore Inc. occupied an iron ore site on a 5-year lease. Based on the given info, determine the yearly depletion cost for all 5 years.

Cost of acquisition – $11,00,000

Estimated total extraction units – 1,00,000 Tons

Salvage Value – $1,00,000

Year

Actual Extraction

2023 10,000

2023 20,000

2023 25,000

2023 30,000

2023 15,000

Solution:

Depletion Rate = {(11,00,000 – 1,00,000)/1,00,000}

= 10 per unit of iron ore extracted

Therefore, the annual depletion charge will be as follows: –

Year

Actual Extraction

Depletion Charge (Actual Extraction * 10)

2023 10,000 1,00,000

2023 20,000 2,00,000

2023 25,000 2,50,000

2023 30,000 3,00,000

2023 15,000 1,50,000

How to Record Depletion Expense Journal Entry

If a company does not use Accumulated Depletion A/c –

Date

Particulars

L/f

Debit

Credit

— Depletion Expense A/c Dr.

xxx

To Natural Resource (Capitalised Asset) A/c

xxx

(Being Depletion expense charged against the asset)

—- P&L A/c Dr.

Xxx

To Depletion Expense A/c

(Depletion expense charged in P&L A/c)

If a company does use Accumulated Depletion A/c

Date

Particulars

L/f

Debit

Credit

— Depletion Expense A/c Dr.

xxx

To Accumulated Depletion A/c

xxx

(Being Depletion expense charged against the asset)

—- P&L A/c Dr.

Xxx

To Depletion Expense A/c

(Depletion expense charged in P&L A/c)

Under this method, the Balance sheet will depict natural resources at the total historical cost of acquisition reduced by accumulated depletion A/c and net figure in the outer column.

Advantages

Charging off depletion expenses helps management and other stakeholders to determine actual profits earned during an accounting period.

Charging depletion cost as an expense simultaneously reduces the asset’s book value from the balance sheet. This book value reduction reflects the business’s financial position on the balance sheet date.

The depletion expense method is generally used for periodic reduction in the asset cost. Therefore the carrying amount of the asset and real market value may differ, thereby failing to depict actual business worth.

This method is extremely subjective, especially since the estimated value of units to be extracted is difficult to calculate.

Conclusion

Depletion expenses can be described as an expense charged off in books of account against consumption or extraction of any mineral or other natural resource occupied or leased from the government or any other person. The concept of depletion is similar to that of depreciation and amortization. This term is commonly used in the case of any natural resource rather than in the case of fixed tangible or intangible assets.