Depletion method

Depletion Method Overview

Depletion is a periodic charge to expense for the use of natural resources. Thus, it is used in situations where a company has recorded an asset for such items as oil reserves, coal deposits, or gravel pits. The calculation of depletion involves these steps:

  1. Compute a depletion base
  2. Compute a unit depletion rate
  3. Charge depletion based on units of usage

The resulting net carrying amount of natural resources still on the books of a business do not necessarily reflect the market value of the underlying natural resources. Rather, the amount simplify reflects an ongoing reduction in the amount of the original recorded cost of the natural resources.

The depletion base is the asset that is to be depleted. It is comprised of the following four types of costs:

  • Acquisition costs. The cost to either buy or lease property.
  • Exploration costs. The cost to locate assets that may then be depleted. In most cases, these costs are charged to expense as incurred.
  • Development costs. The cost to prepare the property for asset extraction, which includes the cost of such items as tunnels and wells.
  • Restoration costs. The cost to restore property to its original condition after depletion activities have been concluded.

    To compute a unit depletion rate, subtract the salvage value of the asset from the depletion base and divide it by the total number of measurement units that you expect to recover. The formula for the unit depletion rate is:

    (Depletion base - Salvage value) ÷ Total units to be recovered 

    You then create the depletion charge based on actual units of usage. Thus, if you extract 500 barrels of oil and the unit depletion rate is $5.00 per barrel, then you charge $2,500 to depletion expense.

    The estimated amount of a natural resource that can be recovered will change constantly as you gradually extract assets from a property. As you revise your estimates of the remaining amount of extractable natural resource, you should incorporate these estimates into the unit depletion rate for the remaining amount to be extracted. This is not a retrospective calculation.

    Depletion Method Example

    Pensive Corporation’s subsidiary Pensive Oil drills a well with the intention of extracting oil from a known reservoir. It incurs the following costs related to the acquisition of property and development of the site:

    Land purchase $280,000
    Road construction 23,000
    Drill pad construction 48,000
    Drilling fees 192,000
    Total $543,000

    In addition, Pensive Oil estimates that it will incur a site restoration cost of $57,000 once extraction is complete, so the total depletion base of the property is $600,000.

    Pensive’s geologists estimate that the proven oil reserves that are accessed by the well are 400,000 barrels, so the unit depletion charge will be $1.50 per barrel of oil extracted ($600,000 depletion base / 400,000 barrels).

    In the first year, Pensive Oil extracts 100,000 barrels of oil from the well, which results in a depletion charge of $150,000 (100,000 barrels x $1.50 unit depletion charge).

    At the beginning of the second year of operations, Pensive’s geologists issue a revised estimate of the remaining amount of proven reserves, with the new estimate of 280,000 barrels being 20,000 barrels lower than the original estimate (less extractions already completed). This means that the unit depletion charge will increase to $1.61 ($450,000 remaining depletion base / 280,000 barrels).

    During the second year, Pensive Oil extracts 80,000 barrels of oil from the well, which results in a depletion charge of $128,800 (80,000 barrels x $1.61 unit depletion charge).

    At the end of the second year, there is still a depletion base of $321,200 that must be charged to expense in proportion to the amount of any remaining extractions.