OCW041: Depletion of Assets

Depletion Base

The depletion base is the total cost of a natural resource and includes acquisition, exploration, development, and restoration costs.

Learning Objectives

Differentiate between percentage depletion and cost depletion

Key Takeaways

Key Points

  • Two methods are used to calculate depletion: percentage and cost.
  • Percentage depletion is calculated by multiplying a certain percentage, specified for each mineral, by your gross income from the property during the year.
  • Cost depletion is computed by (1) estimating the total quantity of mineral or resources acquired,(2) assigning a proportionate amount of the total resource cost to the quantity extracted in the period (total cost of the property/(the quantity extracted in the period/total estimated production).
  • Industries involved in mining, timber, petroleum, and the extraction or use of natural resources are the types of businesses most affected by depletion.

Key Terms

  • depreciation: The measurement of the decline in value of assets. Not to be confused with impairment, which is the measurement of the unplanned, extraordinary decline in value of assets.
  • adjusted basis: The net cost of an asset after adjusting for various tax-related items.

Definition of Depletion

Depletion is a method of recording the use of natural resources over time. It is the amount of resources used in each accounting period that is expensed for U.S. tax and financial reporting purposes. Depletion is similar to depreciation, in that it is a cost recovery system for accounting and tax reporting. Industries involved in mining, timber, petroleum, and the extraction or use of natural resources are the types of businesses most affected by depletion. The depletion base is the total cost of the natural resource. It can include costs related to the acquisition of the asset, exploration, development and preparation of the asset for use, and performance of restoration work.

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The depletion base for oil reserves includes all the costs incurred to put the asset into use.: Types of costs include acquisition, exploration, development, and restoration costs.

Methods to Calculate Depletion

Percentage Depletion:

To calculate, multiply a certain percentage, specified for each mineral, by your gross income from the property during the tax year. For this purpose, the term “property” means each separate interest business owned in each mineral deposit in each separate tract or parcel of land. Businesses can treat two or more separate interests as one property or as separate properties.

Cost Depletion:

This is an accounting method by which costs of natural resources are allocated to depletion over the period that make up the life of the asset. Cost depletion is computed by (1) estimating the total quantity of mineral or other resources acquired and (2) assigning a proportionate amount of the total resource cost to the quantity extracted in the period.Cost Depletion FormulaAccording to the IRS Newswire, over 50 percent of oil and gas extraction businesses use cost depletion to figure their depletion expense. Mineral property includes oil and gas wells, mines, and other natural deposits (including geothermal deposits). The cost depletion formula for financial reporting purposes is the total investment cost of the property / (the quantity extracted during the period / the property’s total estimated production). When calculating cost depletion for tax purposes, multiply the formula by the property’s adjusted basis or the property’s historical cost subtracted by depletion expense for prior years.

Resource Cost Write-Off

The term write-off describes removing an asset whose value is zero and is no longer in use from the balance sheet.

Learning Objectives

Explain how to write off a natural resource asset

Key Takeaways

Key Points

  • When a natural resource has been depleted to a value of zero, the asset ‘s remaining book value, as calculated by the original historical cost minus the depletion of prior years, is removed from the balance sheet through a write-off journal entry.
  • The write-off journal entry will credit the asset’s account balance and debit the balance in the accumulated depletion account. The asset’s book value is the amount debited to an expense or loss account reported on the income statement.
  • Write-offs should not be confused with impairment. A write-off journal entry removes an asset not in use and its related contra account from the balance sheet. An entry to record impairment merely reduces the asset’s value.

Key Terms

  • impairment: A downward revaluation, a write-down.
  • journal entry: A journal entry, in accounting, is a logging of transactions into accounting journal items. The journal entry can consist of several items, each of which is either a debit or a credit. The total of the debits must equal the total of the credits or the journal entry is said to be “unbalanced. ” Journal entries can record unique items or recurring items, such as depreciation or bond amortization.
  • contra asset account: an account that corresponds to another is affected when a transaction is recorded
  • salvage value: also known as residual value; the remaining value of an asset after it has been fully depreciated.

Definition of Asset Write-offs:

The term write-off describes a reduction in recognized value. In accounting terminology, it refers to recognition of the reduced or zero value of an asset no longer in use. Assets that are natural resources, which are used throughout the course of business, are subject to periodic depletion. When the asset has been depleted to a value of zero or its value has dropped to less than its salvage value, the asset’s remaining book value, as calculated by the original historical cost minus the depletion of prior years, is removed from the balance sheet through a write-off.

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When natural resources have their value reduced to zero they are written off.: An asset write-off removes an asset’s cost off the balance sheet and expenses it on the income statement.

Writing Off Assets with No Value

An asset is written off the balance sheet by recording a journal entry. The write-off journal entry moves the asset’s book value to the income statement, where it is reported as an expense or loss and reduces the accounting period’s income. The journal entry will credit (decrease) the asset’s account balance (equal to its historical cost) and debit (decrease) the balance in the accumulated depletion account. The asset’s book value (historical cost minus accumulated depletion) is the amount debited (increased) to an expense or loss account reported on the income statement for the accounting period. The decrease in the asset and accumulated depletion accounts reduces the balance to zero and removes the account from the balance sheet.

Asset Write-offs Vs. Impairment

Asset write-offs should not be confused with impairment. A write-off journal entry removes an asset not in use and its related contra account (accumulated depletion) from the balance sheet. If the asset has suffered a permanent reduction in value, the amount of the asset impairment is expensed on the income statement as a reduction to the accounting period’s income. The asset’s balance is reduced by the impairment amount to reflect the asset’s new economic value and the account remains on the balance sheet.

Recoverable Reserves

Recoverable reserves are the amount of a natural resource present and their value is used to compute the resource’s depletion expense.

Learning Objectives

Explain how to calculate a natural resources recoverable reserve

Key Takeaways

Key Points

  • On the balance sheet, natural resources are part of non-current assets and classified as separate groups, such as oil reserves.
  • The natural reserves recovered involve several costs related to acquisition, exploration, development, and restoration of the natural resources.
  • Natural reserve costs are reported on the balance sheet and assigned to the asset in question, such as “timber stands” or “oil reserves. ” They are reported at their total cost, less accumulated depletion.
  • Depletion expense allows a business to account for the reduction in value of natural reserves. Similar to depreciation, depletion reflects the use and reduction of value of an asset over the course of time.

Key Terms

  • non-current assets: Also known as fixed assets, a non-current asset is a term used in accounting for assets and property which cannot easily be converted into cash.
  • depreciation: The measurement of the decline in value of assets. Not to be confused with impairment, which is the measurement of the unplanned, extraordinary decline in value of assets.

Accounting for Natural Reserves

Natural reserves supplied by nature, such as ore deposits, mineral deposits, oil reserves, gas deposits, and timber stands, are natural resources or wasting assets. Natural resources represent inventories of raw materials that are consumed (exhausted) through extraction or removal from their natural setting (e.g. removing oil from the ground). On the balance sheet, natural resources are part of non-current assets and classified as separate groups, such as oil reserves.

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Recoverable copper reserves include the amount of the current copper deposits present.: The amount of recoverable reserves are used to compute an asset’s depletion.

The Recovery of Natural Reserves

Businesses that are involved in the recovery of natural resources, such as mining, growing timber, and extracting petroleum will incur costs related to the resource recovery. The natural reserves recovered involve several costs related to acquisition, exploration, development, and restoration of the natural resources. These costs are reported on the balance sheet and assigned to the asset in question, such as “timber stands” or “oil reserves. ” They are reported at their total cost, less accumulated depletion.

The Effect of Depletion

As these natural resources are used throughout the course of business, their value will be reduced by periodic depletion. Depletion expense allows a business to account for the reduction in value of natural reserves. Similar to depreciation, depletion reflects the use and reduction of value of an asset over the course of time. Two methods are available to calculate depletion: the cost and percentage method. Cost depletion is the most commonly used by oil and gas companies. The depletion amount can also vary when calculating it for financial reporting and tax purposes, so it can have a different effect on the accounting period’s income and income tax expense.


Source: Accounting