Many companies use what's known as depreciation for tax and accounting purposes. Depreciation is a method of allocating the cost of an asset over the course of its useful life. Companies that purchase physical equipment can use deprecation to write down the expenses they incur in acquiring assets. But for companies whose inventory and assets are based on natural resources, things work a bit differently.
While natural resources, like coal and oil, don't wear out over time like equipment and machinery, they do lose value by virtue of being removed, and that's where depletion comes in. Depletion is an accounting concept used in specific industries such as mining, petroleum, and timber. Depletion is the process of allocating costs to account for the reduction of a product's reserves. There are two primary types of depletion: cost depletion and percentage depletion.
Purpose of depletion
When natural resources are extracted, they're converted into a company's inventory of sorts and recorded on its balance sheet. As those resources are consumed, their value as an asset is reduced. Depletion allows a company with such resources to assign a cost to the amount of resources consumed in a given period.
Cost depletion is tied to a company's investment-related costs in a given property or area of land. It's calculated by taking the total quantity of a natural resource available to a company and assigning a proportionate amount of that total to the amount consumed over a given accounting period.
For example, let's say a company discovers that an oil well will produce 400,000 barrels of oil, spends $200,000 to extract that oil, and removes 50,000 barrels over the course of a year. The depletion deduction it can claim for that period is $25,000 ($200,000 x 50,000/400,000).
Percentage depletion is calculated by assigning a fixed percentage to the gross income earned by extracting natural resources. This percentage can vary based on the specific resource consumed.
The goal of percentage depletion is to help a company recover its investment costs of obtaining the property that supplies the natural resources from which it makes money. If a company's gross income is $5 million and the fixed percentage of the resource consumed is 15% for a given period, its depletion deduction under this method is $750,000.
Percentage depletion is often heavily based on estimates, and is not considered an acceptable reporting option for certain types of resources. The IRS requires that depletion deductions for timber, for example, follow the cost method. Under the percentage depletion method, it's possible for a company's total deductions to exceed its initial capital investment.
Because the rules of depletion are quite complex, most companies rely heavily on accounting professionals to implement it for tax and reporting purposes.
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