Depletion: Definition, How It Works, and Methods

Depletion is an accrual accounting technique that allocates the capitalized cost of extracting natural resources—such as timber, minerals, oil, and gas—over the periods in which those resources are produced and sold. Like depreciation and amortization, depletion is a non-cash expense that reduces the carrying value of an asset and matches extraction costs to the revenue they generate.

How depletion works

When costs of acquiring, exploring, developing, or restoring a resource property are capitalized, those costs form a depletion base on the balance sheet. Depletion expense is recorded on the income statement over time as resources are removed from the property, helping present a more accurate measure of periodic profit and the remaining asset value.

Factors that affect the depletion base

The depletion base is made up of capitalized costs related to the property. Key components include:
* Acquisition: Purchase or lease costs for property rights.
* Exploration: Costs of locating and evaluating resource deposits.
* Development: Expenses to prepare the site for extraction (e.g., wells, tunnels).
* Restoration: Costs to reclaim or restore the land after operations end.

Methods of calculating depletion

There are two primary methods:

Percentage depletion

Percentage depletion applies a fixed statutory percentage to gross income from the resource (gross revenue less certain costs) to determine the allowable deduction. Example: if $10 million of oil is produced and the applicable percentage is 15%, the depletion deduction would be $1.5 million.

Pros and cons:
* Simple to apply.
* Relies on gross income rather than actual units extracted, so it can diverge from the economic depletion of the resource.
* Not permissible for all resources and is subject to various limits under tax law.

Cost depletion

Cost depletion allocates the capitalized basis of the property over the estimated total recoverable units. Each period’s expense equals the number of units extracted multiplied by the per-unit cost basis.

Formula:
Per-unit cost = Property basis / Total recoverable units
Depletion expense = Units extracted × Per-unit cost

Example: If capitalized costs (basis) are $1,000,000 and total recoverable reserves are 500,000 barrels, the per-barrel cost is $2. If 100,000 barrels are extracted in year one, depletion expense = 100,000 × $2 = $200,000.

Cost depletion ties deductions to actual extraction and is commonly used in practice and for tax reporting.

Tax and reporting considerations

Tax rules vary by resource and jurisdiction. For example:
* The IRS requires the cost depletion method for timber.
* For mineral properties (including oil and gas wells, mines, and other natural deposits), rules governing depletion often permit more than one method and impose limitations; in practice, taxpayers must follow applicable statutory restrictions and limits (including gross income and taxable income limits for percentage depletion).

For specific tax guidance and detailed rules, consult IRS Publication 535 and relevant tax authorities.

Key takeaways

• Depletion allocates the capitalized costs of extracting natural resources across the periods when the resources are produced and sold.
• It is a non-cash expense analogous to depreciation and amortization but specifically for exhaustible natural resources.
• The depletion base includes acquisition, exploration, development, and restoration costs.
• Two main methods are percentage depletion (based on gross income) and cost depletion (based on units extracted); tax rules determine which method is allowed or preferable for a given resource.