Definition: Depletion is the systematic allocation of costs associated with extracting natural resources from a reserve. Typical these natural resources utilized by businesses include minerals, precious metals, wood, and oil.
What Does Depletion Mean?
What is the definition of depletion? Like depreciating an asset or amortizing an intangible, depletion allocates the cost associated with using an asset, in this case the reduction of a natural resource or reserve. As the resources are used up, the company records an expense called depletion.
An entity’s ability to accurately calculate depletion expense is derived from various estimates, and is founded on the basic accounting principle of matching revenues and expenses in a given period. The depletion expense formula requires three main estimates:
- Total amount of resources in the reserve
- Total amount extracted in a period
- Total cost of the reserve
This equation is typically broken down into units for simplicity’s sake. Thus, the formula would look like this:
Cost of Entire Reserve / Estimate of Total Reserve Units Available = Expense per Resource Unit Extracted
This calculation relies heavily on estimates since we have no idea how many resource units are actually in a reserve. For instance, we can’t measure how many barrels of oil are underground. We simply have to estimate.
Let’s take a look at an example.
Let’s say a lumber company purchases land to forest and sell timber to consumers. The timber company bought the land for $1,000,000 (cost of resource), and they estimate the land is capable of producing 1,000,000 individual trees (resource units) over the entire useful life of the reserve. Going back to our unit formula, the purchase cost of the land divided by the estimated number of resource units available calculates the cost per unit extracted ($1,000,000 cost / 1,000,000 units = $1.00 per unit).
Now, we use the $1.00 expense per unit as the basis of our total expense calculation. Let’s assume that the lumber company cuts down 8,500 trees this year. It would record depletion expense of $8,500 (8,500 trees x $1 per unit) for the year.
In this way, the company is allocating and recording the cost associated with depleting the forest or using their asset since now their natural reserve is .85% less valuable.
Examples in The News
“It just seems to me that if we are going to not have percentage depletion for oil, maybe we should not have it for gold and silver.” – Forbes
Define Depletion Expense: Depletion means the costs incurred by a business for the reduction of natural resources used to generate profit.