Depletion is an accounting method that allows individuals or companies to reflect the declining value of a natural resource over time. It's most commonly used to write down the value of mineral and timber properties or rights.

An oil rig at sunset.
Image source: Getty Images.

Definition

What are depletions?

Depletion is an accounting technique that allows investors to write down the value of a natural resource as it's extracted or harvested. Enshrined into the tax code in 1926, depletion is most commonly used in the oil and gas, mining, and timber industries.

The Internal Revenue Service defines depletion as "the using up of natural resources extracted from a mineral property by mining, drilling, quarrying stone, or cutting timber." In some ways, it's not unlike depreciation or amortization; depletion is simply the recognition that the value of a natural asset has dwindled over time.

More than one person (or company) can have an economic interest in a mineral deposit or timber land. The IRS defines an economic interest as having any interest in mineral deposits or standing timber and a legal right to income from mineral extraction or timber harvesting.

Types of depletion

The IRS allows for two types of accounting when it comes to depletion: cost depletion and percentage depletion.

Cost depletion

Cost depletion is calculated by estimating the total quantity of a given resource and then dividing the percentage withdrawn by the total quantity. Let's say an oil company expects to spend $200,000 to withdraw 50,000 barrels of oil every year from a field with estimated reserves of 1 million barrels. The amount of depletion that could be claimed would be $10,000, or $200,000(50,000/1,000,000).

Percentage depletion

The percentage depletion method gives a fixed percentage of the gross income obtained from a natural resource. It aims to help a company recoup its investment costs in a natural resource. If a company has $5 million in gross income from a resource and wants to use a 15% depletion rate over a given period, its depletion deduction would amount to $750,000 million.

An important point: Depletion rates are generally set by the type of resource. For example:

  • U.S. deposits of gold, silver, copper, oil shale, and geothermal deposits are set at 15%.
  • Asbestos is 10%.
  • Materials such as gravel, sand shale, clay, and lava rock depletion rates are set at 5%.

As a general rule, investors have to use the method that provides the largest deduction. But unless you're an independent producer or royalty owner, the IRS says you usually can't use the percentage depletion method for oil and gas wells.

The annual deduction for percentage depletion is limited to the smaller of:

  • 100% of taxable income from the property, figured without the deduction for depletion.
  • 65% of taxable income from all sources, figured without the depletion allowance.

Related investing topics

3 Most Important Financial Statements

When researching companies, the financial statement is a great place to start.

How to Read a Cash Flow Statement

This little-understood financial statement can contain important investor information.

Profit and Loss Statement

Making sense of a P&L statement can help guide your investments. We show you how.

What Is a Good Return on Investment?

You invest to get a return. So what makes a good ROI?

The bottom line on depletion

From an accounting standpoint, depletion ensures that the value of assets listed on a balance sheet and expenses on an income statement are recorded accurately and in a timely fashion. But as with most corporate accounting issues, it’s essential to get advice from a trained professional, preferably someone who deals with depletion issues on a regular basis.

The Motley Fool has a disclosure policy.