What is depletion expense?
Depletion Expense can be defined as the cost associated with usage of natural resources, including oil, natural gas, and coal. This cost is mostly incurred once these natural resources have been extracted.
It includes purchase price, or the cost of the resource, cost of rights, or anything else required to prepare areas that are responsible for extraction of these resources.
The reason these expenses are separately categorized lies on the fact that there is a significant amount of resources that surface from the ground.
There is always ambiguity pertaining to these resources in terms of quantity and the cost associated with these resources.
This is primarily because until and unless resources have adequately been extracted from the ground, there is no way to ascertain the actual expenses and the overhead cost incurred on the project.
Therefore, depletion expenses are categorized as such so that they are allocated in advance and subsequently spread across the timeline of the extraction project.
The concept of depletion is similar to the depreciation expense because this cost is spread across the number of units that are produced (or extracted) over the course of time.
Depletion Expense Formula
The formula for calculating depletion expense is as follows:
Depletion Expense = (Cost – Salvage Value) / Estimated Number of Units x Number of units extracted
In the formula above, it can be seen that costs include all the developmental costs that are associated with the extraction process.
Salvage Value also needs to be adjusted in order to calculate the actual costs that have gone into the extraction process.
The net amount is then divided by the estimated number of units extracted during the given period. This generates the depletion expense incurred on a per-unit basis.
What is the difference between Depletion and Depreciation?
Depreciation and depletion can be summarized as follows:
- Depletion is an actual reduction in the natural resources of the company. It basically accounts for the amount of consumption. On the other hand, depreciation is the deduction of the asset value occurring due to wear and tear of the asset.
- Depletion expense is imposed on non-renewable resources. Depreciation, on the other hand, is charged on tangible assets.
- Examples of assets where depletion is charged include coal, oil, and natural gas. Examples of assets where depreciation is charged includes plant and machinery, building and vehicles.
Accounting Treatment of Depletion Expenses
Depletion Expenses cannot be accurately predetermined unless they are actually incurred. This means that unless the natural resources have been correctly extracted from the mine itself, the actual cost of the help cannot be estimated. However, in order to combat this issue, there is a need to precisely assess the value of depletion expense on a per unit basis.
Hence, it is essential to properly segregate the expenses and record the relevant depletion expenses in the accounts.
Therefore, depletion expenses relevant to the amount extracted (or sold) are recorded in the financial statements as relevant expenses. The remainder expenses, which are not yet mined, are recorded separately.
Journal Entries of Depletion Expenses
The correct accounting treatment of depletion expenses is depicted in the following journal entry:
|Dr. Depletion Expense
|Cr Accumulated Depletion
Depletion Expense is debited since it is an income statement item representing the exhaustion of natural resources. In contrast, Accumulated Depletion is a balance sheet item and lies typically on the credit side of the journal entry.
Example of Depletion Expense
The concept of depletion expense is illustrated in the following example:
Henry Mining Co. is a mining company that purchased a coal mine on 1st January 2018 for $2,500,000. The estimated capacity of the coal mine was calculated at 1,000,000 tons.
The mine is estimated to have a salvage value of $100,000 .The Company has extracted 95,000 tons of coal at the end of the year. What is the journal entry if Henry Mining Co. has sold all 95,000 tons of coal in the first year?
In the illustration mentioned above, the depletion cost can be calculated using the formula:
(Cost – Salvage Value) / Estimated Number of Units x Number of units extracted
Depletion Expense= ($2,500,000 – $100,000) / (1,000,000) = $2.4 per ton
Since the company has sold all 95,000 tons, the total depletion expense is calculated as follows:
Total Depletion Expense = $2.4 x 95,000 = $228,000
In order to record the transactions mentioned above, the following journal entry is made:
|Dr. Depletion Expense
|Cr. Accumulated Depletion
Types of Cost Depletion
Cost depletion can be broadly categorized into the following categories:
- Cost Depletion
The cost depletion method focuses on gradual reduction across the estimated life of the asset. The actual corresponding amount of cost depletion can be computed by calculating the relevant quantity of a specific resource and accordingly allocates a proportionate amount of the cost of help against the actual amount extracted.
For example, let’s assume that a company discovered a large coal mine to produce around 2000 tons of coal. To achieve this, the company has invested $100,000 in mining coal.
During the first year of operations, the organization extracted around 200 tons of coal. Therefore, the depletion expense is going to be recorded as follows:
($100,000 * 200/2000) = $10,000
- Percentage Depletion
This cost depletion method involves allocating a certain percentage specified for each mineral using the gross income for the property paid during the tax year to calculate the depletion cost using the percentage depletion method.
The calculation of the depletion expense formula is as follows:
Depletion Expense = Number of units consumed x depletion value per unit
For instance, let’s assume that a company purchases an oil field for $2,000,000. They estimate the oil field to have 1,000,000 gallons of oil reserves on the property.
This implies that the total cost per gallon comes down to $2 per gallon. In the first year of operation, the company extracts around 100,000 gallons of oil. Therefore, the depletion cost can be calculated as follows:
Depletion Expense = 100,000 * $2 = $200,000