an accounting method helpful in allocating the costs of producing or extracting natural resources (e.g. oil or natural gas) on a single period.
Cost Depletion Details
To calculate cost depletion, first, you need to determine the total amount of resource investment, which refers to the cost of purchasing the property or asset (e.g. oil mine) plus all of the necessary exploration and development costs. Afterwards, subtract the figure with the property’s salvage value—the leftover value after you have depleted the resource. Once you have the total amount of resource investment’s value, divide it by the total amount of the resource reserve, then multiply it by the amount of resource extracted in one accounting period. in simplified terms, the formula would look like this:
- Cost Depletion = total amount of resource investment / resource reserve amount * units extracted in a period
Accountants calculate cost depletion for taxing purposes. By adding the value of cost depletion as a part of operating expenses—expenses incurred from normal operations—companies can reduce the value of pre-tax earnings on the income statements. Fewer earnings before taxes (EBT) means that the company pays less income tax.
In terms of accounting, depletion has a lot of similarities to depreciation and amortization. Depletion, deprecation, and amortization calculate the gradual decrease of an asset’s value over its useful life. The difference is that depreciation is used for almost all tangible assets (e.g. cars and computers), not just natural resources, whereas amortization is for intangible assets (e.g. patents and copyrights). Apart from reducing taxable income, these accounts are also helpful for better matching costs to revenues and providing more accurate data to analysts and investors.
Example of Cost Depletion
A mining corporation has a natural resource asset with an initial value of $1 billion. The cost necessary to develop and extract the resource is $30 million. The asset’s salvage value is $150 million. Furthermore, we also know that the estimated number of extractable resource units is 400 million, whereas the company extracts around 5 million units of resource in one fiscal period. Can you calculate the cost depletion?
Using the formula earlier, we can simply input the numbers into the appropriate places:
Cost Depletion = ($1 billion + $30 million - $150 million) / 400 million X 5 million = $11 million
Cost Depletion vs. Percentage Depletion
Similar to cost depletion, percentage depletion also allows companies that extract natural resources to cut down total earnings in their financial statements. However, both work differently. Accountants calculate percentage depletion by multiplying a certain percentage of depletion, determined by a tax administrator like the IRS, to the gross income from extracting resources.
For instance, the U.S. government allows corporations dealing with non-renewable resources of oil and gas to get approximately 15% of their gross income tax-free, assuming these companies meet the right conditions. In that case, as long as the property incurs net income (meaning it doesn’t provide loss for the company), oil and gas companies can have 15% of their gross income to be tax-deductible.
The depletion rates are different from one resource to another. For example, IRS set the percentage depletion of marble, potash, and granite to be 14% of gross income. On the other hand, sulfur and uranium incur a larger percentage at 23%.