Thomson Reuters can provide the software and expert guidance on depletion and other cost recovery issues (like amortization) to help you better manage your clients’ depletion expenses. However, the total sum of the deduction cannot exceed 50% (100% for the oil and gas industry) of the client’s taxable income. 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. Thus, every year Zebra Crude will record depletion expenses until the complete $2.1mm of cost is allocated to the asset. This aspect involves a certain percentage multiplied specified for each mineral by the gross income for the property during the tax year.
Percentage Depletion Method
Explore how depletion accounting methods affect financial statements and tax obligations, offering insights into resource management strategies. Periodic depletion will lower the value of these natural resources as they are exploited in the course of business. Depletion expense is a way for a company to account for the loss in value of natural resources. Depletion, like depreciation, is a term that describes how an asset is used and its value decreases over time.
The Internal Revenue Service (IRS) requires the cost method to be used with timber. It requires the method that yields the highest deduction to be used with mineral property, which it defines as oil and gas wells, mines, and other natural deposits, including geothermal deposits. Normally, companies compute depletion (often referred to as cost depletion) on a units-of-production method (an activity approach). As soon as a company has the right to use the property, it often incurs exploration costs needed to find the resource.
Formula
Depletion is similar to depreciation, which is used to allocate the cost of tangible assets like factories and equipment over their useful lives. Depletion is used for natural resources, which can include minerals, ore, oil, gas, and timber. In particular, a company that extracts resources will use depletion to account for the use of these assets. Companies should maintain detailed records of the quantity of resources extracted during each financial period.
Reporting Requirements
- Maximize your asset management with our expert guide on the acquisition and disposition of property, plant, and equipment.
- However, its reliance on comprehensive data means it may not always be the most advantageous method for companies with fluctuating extraction rates or uncertain reserves.
- This can be particularly advantageous for companies in the oil and gas industry, where the depletion rate can be as high as 15%.
- However, in an oil company, the resources will have a depletion amount calculated during usage.
- These changes provide stakeholders with insights into operational efficiency and asset management.
The percentage is predetermined by tax authorities and varies depending on the type of resource. To calculate the depletion expense, the company multiplies the gross income from the resource by the applicable percentage. This method can be advantageous as it allows for a consistent deduction, regardless of the actual extraction costs. Determining the depletion expense involves a nuanced understanding of both the resource’s value and the method chosen for allocation. For cost depletion, the process begins with establishing the total recoverable units, which requires geological surveys and engineering reports to estimate the quantity of the resource.
- Generally, natural resource acquisition costs are recorded in an Undeveloped Property account.
- Explore how different depletion methods affect financial statements and tax obligations, enhancing your understanding of resource management.
- Scientifically, the quantum of resources below the earth’s surface is not possible before their extraction.
- Subsequently, the expenses are allocated over the period until they are consumed.
This method is primarily relevant for U.S. tax purposes, with the percentage varying by resource type. For example, oil and gas typically qualify for a 15% deduction, while certain minerals may be eligible for up to 22%. Unlike cost depletion, percentage depletion can exceed total capitalized costs, providing a favorable tax position.
The units-of-activity method is the measurement that uses the units of activity during the year to apply the cost per unit in order to determine the annual expense. This is why it is suitable to use in the calculation of depletion expense as the available natural resource will be reduced by the number of extracted units in each period. However, for oil and gas wells, mines, other natural deposits (including geothermal deposits), and mineral property, companies generally use the method that gives them the larger deduction. A mining company buys mineral rights for $20,000,000 and spends an additional $4,000,000 to develop the land. Given this, the depletion rate would be $24,000,000 divided by 600,000, or $40 per ton.
How to Record the depletion in an Accounting Book?
The depletion rate per unit of a natural resource or asset depends upon which method should be used to calculate depletion for a natural resource company? the total number of units expected to be extracted. This is calculated by dividing the depletion base less salvage value (if any) by the number of units expected to be extracted. Such assets are also referred as wasting assets because their value deteriorates with the increasing extraction of resources. For example in case of a coal mine, more the coal is extracted more will be the depletion of the mine etc. 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.
Calculation Approaches
It is a fundamental accounting concept that aids businesses in presenting a more accurate financial picture, especially in industries heavily reliant on depletable assets. The tax implications of depletion accounting are crucial for companies in industries like mining and oil extraction, where resource management is integral to operations. Tax regulations often provide specific guidelines on how depletion methods can be applied, which can significantly influence a company’s tax liability.
On the other hand, Percentage Depletion offers a deduction based on a fixed percentage of gross income derived from resource extraction. This method can result in tax deductions that exceed the actual cost of resource development, providing potential tax benefits. However, these benefits are subject to limitations and ceilings imposed by tax authorities, which vary depending on the resource type and jurisdiction. This method is attractive to companies seeking to maximize tax efficiency, particularly when comprehensive reserve data is unavailable or difficult to maintain.
Depletion Method
However, it is subject to limitations, such as a “50% of taxable income” cap, which restricts the deduction to half of taxable income from the property. This method benefits companies with low-cost reserves or fluctuating extraction costs by offering a consistent deduction based on revenue. Depletion, by contrast, is tied exclusively to natural resources diminishing through extraction. Unlike depreciation, which is often time-based, depletion depends on the volume of resource extraction, making it more dynamic. For instance, if a company extracts 10% of its estimated oil reserves in a year, it records depletion for that proportion.
For example, oil and gas reserves require companies to estimate total resource quantities and extraction rates through geological and engineering studies. Mining companies assess mineral reserves to establish a depletion base, which includes acquisition and exploration costs. Even timber, despite being regenerative, qualifies for depletion due to systematic harvesting. Assets eligible for depletion are those that diminish through extraction or use, primarily including natural resources like oil, gas, minerals, and timber.
