Depletion in Accounting: How It Works, Methods, and IRS Requirements

Depletion is a vital accounting technique used to allocate the cost of extracting natural resources, including timber, minerals, and oil, from the earth. Much like depreciation and amortization, depletion represents a non-cash expense that gradually reduces the cost value of an asset through scheduled charges to income. However, it stands apart by addressing the gradual exhaustion of natural resource reserves instead of the wear and tear of depreciable assets or the aging life of intangibles.

Depletion plays a pivotal role in ensuring accurate asset valuation on the balance sheet and appropriate expense recognition on the income statement for accounting and financial reporting purposes.

When the costs associated with natural resource extraction have been capitalized, these expenses are systematically allocated across different time periods based on the resources extracted. These costs remain on the balance sheet until they are recognized as expenses on the income statement.

To calculate the expenses that need to be spread out over the use of natural resources, one must consider each phase of production. The depletion base, representing the capitalized costs, is spread across multiple accounting periods. Several factors affect the depletion base:

Acquisition: This includes the costs associated with purchasing or leasing land with natural resources.
Exploration: Expenses related to excavation under the acquired land.
Development: Costs incurred to prepare the land for natural resource extraction, such as tunneling or well development.
Restoration: Expenses connected to restoring the land to its original state after extraction is complete.

One method for calculating depletion expense is the percentage depletion method. It assigns a fixed percentage to gross revenue (sales minus costs) to allocate expenses. For instance, if $10 million worth of oil is extracted and the fixed percentage is 15%, $1.5 million of capitalized costs for resource extraction are depleted.

It’s important to note that the percentage depletion method relies heavily on estimates and is not widely accepted.

The second method for calculating depletion is the cost depletion method. It considers the property’s basis, total recoverable reserves, and the number of units sold. The property’s basis is divided among the total recoverable units, and as natural resources are extracted, they are deducted from the property’s basis.

For example, if the capitalized costs are $1 million and yield 500,000 barrels of oil, and in the first year, 100,000 barrels are extracted, the depletion expense for that period is $200,000 (100,000 barrels * ($1,000,000 / 500,000 barrels)).

The Internal Revenue Service (IRS) mandates the use of the cost method for timber. However, for mineral property, including oil and gas wells, mines, and other natural deposits, the method yielding the highest deduction must be used, according to IRS guidelines.

The choice between percentage and cost depletion methods depends on factors like gross income, taxable income limits, and the type of natural resource being extracted. Percentage depletion, which focuses on property gross income, is not an acceptable reporting method for certain natural resources.

Natural resources subject to depletion primarily include timber, minerals, and oil.

Depletion in accounting aims to accurately allocate the costs associated with extracting natural resources and report these expenses over time.

The cost depletion method considers the property’s basis, total recoverable reserves, and units sold, while the percentage depletion method assigns a fixed percentage to gross revenue.

Yes, the IRS has specific reporting requirements for different types of natural resources. For instance, timber must use the cost method, while mineral properties follow guidelines based on the method yielding the highest deduction.