Compute Depletion

Learning Outcomes

  • Compute depletion for a given cost, residual value, and estimated output

The calculation of depletion involves these steps:

A crane digging out dirt.

  • Compute a depletion base.
  • Compute a unit depletion rate.
  • Charge depletion based on units of usage.

The resulting net carrying amount of natural resources still on the books of a business does not necessarily reflect the market value of the underlying natural resources. Rather, the amount simply 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:

[latex]\dfrac{\text{depletion base}-\text{salvage value}}{\text{total units to be recovered}}[/latex]

The depletion charge is then created 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 assets are gradually extracted from a property. As you revise your estimates of the remaining amount of extractable natural resource, incorporate these estimates into the unit depletion rate for the remaining amount to be extracted.

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

A ship transporting oil.

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

Pensive’s geologists estimate the proven oil reserves 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 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.

You have learned about calculating depletion for a natural resource, but how do you journalize it? That will be the subject in the next section.

practice question