Nearly all fixed assets have a useful life, after which they no longer contribute to the operations of a company or they stop generating revenue. During this useful life, they are depreciated, which reduces their cost to what they are supposed to be worth at the end of their useful lives (which is known as salvage value). Land, however, has no definitive useful life, so there is no way to depreciate it. Instead, in the absence of natural resources that are to be extracted (see below), land is considered to have an unlimited life span. Further, due to the scarcity of land, its value tends to increase over time, as opposed to the decline in value of most other types of fixed assets.
When an entity purchases land that has a building on it, the cost must be allocated between the land and the building; the result will be depreciation of the building, but not the land. A good way to derive this allocation is to use a property tax assessment or appraisal.
The one exception to the rule not to depreciate land is when some aspect of the land is actually used up, such as when a mine is emptied of its ore reserves. In this case you depreciate the natural resources in the land using the depletion method.
Depletion is the annual charge for the use of natural resources. In order to compute depletion, it is first necessary to establish a depletion base, which is the amount of the depletable asset.
The depletion base includes the following elements:
- Acquisition costs—The cost to obtain the property rights through purchase or lease, royalty payments to the property owner.
- Exploration costs—Typically, these costs are expenses as incurred; however in certain circumstances in the oil and gas industry, they may be capitalized.
- Development costs—Intangible development costs such as drilling costs, tunnels, shafts, and wells.
- Restoration costs—The costs of restoring the property to its natural state after extraction of the natural resources has been completed.
The amount of the depletion base, less its estimated salvage value, is charged to depletion expense each period using a depletion rate per unit extracted, or unit depletion rate that is computed using the following formula:
|×||Depletion base||×||Units extracted|
|Total expected recoverable units|
The unit depletion rate is revised frequently due to the uncertainties surrounding the recovery of natural resources. The revision is made prospectively; the remaining undepleted cost is allocated over the remaining expected recoverable units.