Which Assets Can Be Depleted
Instead of, or in addition to, owning tangible assets, a company may purchase or own rights to certain natural resources. Depletion is the way companies allocate the cost of natural resources to financial periods. As with depreciation, depletion gives the owner of the resources a way to account for the reduction in the natural resource reserves (after all, natural resources don’t last forever!).
So what’s the lowdown on the type of assets you classify as natural resources? Well, natural resources have two major characteristics:
There is a complete consumption of the asset.
Replacement of the asset takes place only by an act of nature.
Examples of natural or wasting resources are timber, coal, oil, precious metals such as gold and silver, and gemstones such as diamonds, rubies, and emeralds — oh my!
How to figure your base for depletion
To correctly figure the annual expense for the use of natural resources, you have to correctly allocate costs to the natural resource’s depletion base.
Four factors affect depletion base: acquisition costs, exploration costs, development costs, and restoration costs.
Acquisition costs: The cost to purchase or lease the property rights to the land, which a company believes has natural resources. For example, cattle ranches in Wyoming may lease drilling rights to oil companies.
Acquisition costs are held in an asset account. If the purchase pans out, they convert to exploration costs. If the investment is a bust (no diamonds, dang it!), the company writes off the costs as a loss.
Exploration costs: The costs to dig around in the leased or owned property to find the natural resources — sometimes successfully, sometimes not. Typically, companies expense these costs as incurred.
Development costs: The costs necessary to exploit the natural resources after exploration, such as drilling machinery and equipment. These costs are capitalized as part of the depletion base.
If equipment used to develop the natural resources is multipurpose and used on other nondepletion projects, it may not be included in the depletion base and is depreciated instead.
Restoration costs: The costs a company incurs to restore the land to its original state as or after all natural resources are exploited. These costs reduce the net amount the company expects to receive from the sale and, therefore, increase the depletion base.
After you work through the costs and have a depletion base, you still have to come up with an estimate for salvage value and the total amount of recoverable units you feel the natural resources will provide. Coming up with these types of estimates isn’t a function of accounting. Engineers, geologists, and other experts in the various fields provide this information.
To get the unit depletion rate, you figure up all the costs, deduct salvage value, and divide that amount by the total estimated units available for the natural resource.
To bring this concept home, consider a complete example. The figure shows the oil drilling costs Wyoming Land Company expects to incur with its latest well (Oil Well #509).
Say that the experts Wyoming Land Company hired estimate that this well will provide 5,250,000 barrels of crude oil. The depletion rate per barrel is $0.519 ($2,725,000 / 5,250,000 barrels).
Now you have to compute the depletion charge for each period, basing your figure on the actual number of barrels produced. For example, if in the first period production was 500,000 barrels, depletion charged to the period would be $259,500 (500,000 x $0.519).
The journal entry to record this extravaganza is to debit inventory and credit another asset account, Oil Well #509, for the $259,500. As barrels are sold, inventory reduces and the cost moves to the income statement account cost of goods sold.
If there are future additional costs or changes in the estimated units to be extracted, the depletion base and depletion rate are changed prospectively, which means they apply to current and future periods only.