For related information, read about how to account for depletion and other non-cash charges. Charlene Rhinehart is an expert in accounting, banking, investing, real estate, and personal finance.
Instead of using a contra‐asset account to record accumulated depletion, companies may also decrease the balance of natural resources directly. Therefore, depletion expense of $5,000,000 might be recorded by debiting depletion expense for $5,000,000 and crediting the gold mine for $5,000,000. The company can calculate the depletion expense with the formula of using the total cost to deduct the salvage value and dividing the result with the total estimated units in the resource to get the cost per unit. Then, it can multiply the cost per unit with the units extracted and sold to get the depletion expense in the period.
Types Of Depletion Expense
Depletion expenses are non-cash in nature and may be used in sync with depreciation and amortization, but the bifurcations are required for accurate accounting purposes and the nature of the asset in use. The write-off journal entry will credit the asset’s account balance and debit the balance in the accumulated depletion account. The asset’s book value is the amount debited to an expense or loss account reported on the income statement. Like depreciation and amortization, depletion is a non-cash expense that lowers the cost value of an asset incrementally through scheduled charges to income. Where depletion differs is that it refers to the gradual exhaustion of natural resource reserves, as opposed to the wearing out of depreciable assets or aging life of intangibles.
- Businesses can treat two or more separate interests as one property or as separate properties.
- It is typically part of the DD&A, a line of a natural resource company’s income statement.
- Similar to depreciation, depletion reflects the use and reduction of value of an asset over the course of time.
- Depletion expense allows a business to account for the reduction in value of natural reserves.
- One method of calculating depletion expense is thepercentage depletionmethod.
The asset’s balance is reduced by the impairment amount to reflect the asset’s new economic value and the account remains on the balance sheet. Unlike depreciable assets, natural resources do not wear out (i.e. depreciate) with passage of time but they actually loose value when the resource is being extracted. Cost depletion is calculated by taking the property’s basis, total recoverable reserves and number of units sold into account. The property’s basis is distributed among the total number of recoverable units. As natural resources are extracted, they are counted and taken out from the property’s basis. One method of calculating depletion expense is thepercentage depletionmethod. It assigns a fixed percentage to gross revenue — sales minus costs — to allocate expenses.
Understanding The Difference Between Amortization And Depreciation
These costs are reported on the balance sheet and assigned to the asset in question, such as “timber stands” or “oil reserves. 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.
You can learn more about the standards we follow in producing accurate, unbiased content in oureditorial policy. The Internal Revenue Service requires the cost method to be used with timber. Daniel Liberto is a journalist with over 10 years of experience working with publications such as the Financial Times, The Independent, and Investors Chronicle. He received his masters in journalism from the London College of Communication. Daniel is an expert in corporate finance and equity investing as well as podcast and video production.
For example, if $10 million of oil is extracted and the fixed percentage is 15%, $1.5 million of capitalized costs to extract the natural resource are depleted. Examples of natural resources include minerals, oil, natural gas wells and timber. As these resources are removed from the ground or harvested, they are converted into inventory. For this reason, natural resources are usually listed separately from other tangible assets on a company’s balance sheet. In accounting terminology, it refers to recognition of the reduced or zero value of an asset no longer in use. Assets that are natural resources, which are used throughout the course of business, are subject to periodic depletion.
The Recovery Of Natural Reserves
The estimated capacity of the mine is 1,750,000 tons of coal and the estimated salvage value is zero. The company incurred additional $50,000 on development of mine for extraction purposes. They had extracted 210,000 tons of coal from the mine up to Jan 31, 20X5 and sold all but 13,000 tons of the coal extracted from the mine, with in Jan 20X5. Calculate the depletion expense on the mine for the month ending Jan 31, 20X5. The cost of natural resources includes all costs necessary to acquire the resource and prepare it for extraction. If the property must be restored after the natural resources are removed, the restoration costs are also considered to be part of the cost.
The company can make the depletion expense journal entry by debiting the depletion expense account and crediting the accumulated depletion account. The financial accounting term depletion refers to the allocation of cost to an accounting period as units of a natural resource are mined, cut, pumped or otherwise harvested or consumed. One way to record depletion expense of $5,000,000 is to debit depletion expense for $5,000,000 and credit accumulated depletionmine for $5,000,000. Under the units-of-production method, the depreciation expense per unit produced is calculated by dividing the historical value of the asset minus the residual value by its useful life in terms of units . The method records a higher expense amount when production is high to match the equipment’s higher usage. The matching principle of accounting requires that amount of asset depleted in a given period must be expensed against the revenue in that period.
What Is The Depletion Expense?
In this case, it needs to record the unsold portion as the inventory and the depletion expense will be recorded in the period it is sold. The above journal entry is made for the accounting period where the company has extracted and sold all portion of natural resource (e.g. coal) that they have extracted. Natural reserve costs are reported on the balance sheet and assigned to the asset in question, such as “timber stands” or “oil reserves.
When can you take cost depletion?
If you have an economic interest in mineral property (which includes royalty income), you can take a deduction for depletion. You have an economic interest if both of the following apply: You have acquired by investment any interest in mineral deposits.
It involves accounting methods and practices determined at the corporate level. Gross IncomeThe difference between revenue and cost of goods sold is gross income, which is a profit margin made by a corporation from its operating activities. It is the amount of money an entity makes before paying non-operating expenses like interest, rent, and electricity. Every year after this, BJ will record a depletion expense until the full $1 million of cost is allocated to the asset. 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. 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.
Extracted And Sold
It is important to note that the depletion expense should be recorded in the period that the extracted natural resource (e.g. coal) is sold. The unsold part of the extracted natural resource should be recorded as inventory. While the depreciation expense represents the deterioration of the plant assets, the depletion expense represents the exhaustion of a natural resource. This is why the way that the company determines the depletion expense is similar to that of the depreciation expense.
- Natural reserve costs are reported on the balance sheet and assigned to the asset in question, such as “timber stands” or “oil reserves.
- Natural resources like oil, natural gas, and coal are drilled or mined from the ground.
- Therefore, depletion expense of $5,000,000 might be recorded by debiting depletion expense for $5,000,000 and crediting the gold mine for $5,000,000.
- The write-off journal entry will credit the asset’s account balance and debit the balance in the accumulated depletion account.
- Tangible AssetsAny physical assets owned by a firm that can be quantified with reasonable ease and are used to carry out its business activities are defined as tangible assets.
For example, on January 1, 2020, the company ABC has invested $2,000,000 in a coal mine that is estimated to contain 1,000,000 tons of coal. The mine is expected to be able to sell for $100,000 at the end of its useful life and the company ABC has extracted and sold 120,000 tons of coal in 2020. For example, the company ABC purchases a coal mine that costs $10 million which is estimated to contain 5,000,000 tons of coal.
The Difference Between Cost Depletion And Percentage Depletion
The per‐unit cost times the actual number of units extracted and sold in one year equals the amount of depletion expense recorded for the asset during that year. The write-off journal entry moves the asset’s book value to the income statement, where it is reported as an expense or loss and reduces the accounting period’s income.
To calculate, multiply a certain percentage, specified for each mineral, by your gross income from the property during the tax year. For this purpose, the term “property” means each separate interest business owned in each mineral deposit in each separate tract or parcel of land.
On the balance sheet, natural resources are part of non-current assets and classified as separate groups, such as oil reserves. For e.g., cane crushing equipment in a sugar firm would be eligible for depreciation from the point of time of it in use since there would be continuous wear and tear of the machine. However, in an oil company, the resources will have a depletion amount being calculated during its usage. Hence, these methods are helpful to help the company for recording the asset’s value as it reduces due to the usage and highlighting the value at a given point of time. The depletion base is the total cost of a natural resource and includes acquisition, exploration, development, and restoration costs.
Does depletion reduce shareholder basis?
Ordinary income, separately stated income, tax-exempt income and excess depletion all increase a shareholder’s basis. … Ordinary loss, separately stated loss, nondeductible expenses, non-dividend distributions, and depletion for oil and gas all decrease basis.
Depletion is anaccrual accountingtechnique used to allocate the cost of extracting natural resources such as timber, minerals, and oil from the earth. This depletion expense formula is the units-of-activity method where the depletion represents the exhaustion of a natural resource. Likewise, this formula functions by using the actual units extracted to reflect the depletion or the exhaustion of a natural resource in each period. The units-of-activity method is the measurement that uses the units of activity during the year to apply the cost per unit in order to determine the annual expense. This is why it is suitable to use in the calculation of depletion expense as the available natural resource will be reduced by the number of extracted units in each period. Sometimes, the company has not sold all the natural resource in the year it is extracted.
What Is Depletion Expense?
Non-cash charges are expenses unaccompanied by a cash outflow that can be found in a company’s income statement. See how the declining balance method is used in our financial modeling course. For example, Company A purchases a building for $50,000,000, to be used over 25 years, with no residual value. The annual depreciation expense is $2,000,000, which is found by dividing $50,000,000 by 25. GAAP GAAP are standardized guidelines for accounting and financial reporting.