Depletion Method of Depreciation

In extraction and mining industry, entities have fixed assets mines, quarries and wells to extract natural resources like coal, oil, timber, metal, salt etc. Unlike property, plant and equipment that are used during the period, these assets get consumed as a result of extraction. For such assets, depreciation is calculated using depletion method.

Depletion is allocation of cost of natural resource to the period based on the rate of consumption of natural resource. In order to determine periodic charge we need following pieces of information:

  1. Cost of natural resource also called depletion base
  2. Determination of depletion rate for which we need following two items:
    1. Expected total reserve available for extraction that expressed in particular unit of measurement e.g. tonnage, cubic feet etc.
    2. Quantity of resource extracted in the period

Cost of natural resource is determined like other fixed assets of the entity. General principle is that all such costs that are specifically incurred to bring the assets into its intended use are included as cost of the asset. In case of natural resource cost includes:

  1. Purchase cost of the asset: this is the price paid to acquire the land or property where extraction will be done.
  2. Exploration and drilling costs: this includes the cost on efforts applied to locate the position of natural resource and analysing potential point of extraction. These costs are incurred well before actual extraction starts. Its up to the entity if it want to add only such costs that were incurred on successfully “hitting” the resource in which case failed attempts will be treated as loss or use “total approach” in which case all the costs incurred  are treated as cost of the asset.
  3. Extraction and development cost: this includes all such efforts, assets both tangible or intangible that were necessary to extract the resource and includes machinery, temporary sight constructions, licences, legal fee etc.
  4. Restoration and rehabilitation costs: once the extraction work is concluded, entities are often duty bound to restore the location back to its natural state instead of leaving the spill and destruction behind. This cost is also added as cost of natural resource or in other words depletion base.

Once the cost of natural resource is established, depreciable value or “depletable” value is determined by deducting any residual value from depletion base.

Depletion rate is much like unit of production method of depreciation. A surveyor or expert is hired to estimate the total quantity of resource in particular units and at end of every period the units extracted are divided by the total units available. For example if total estimated coal in mine is 5,000 tonnes and in current period 100 tonnes have been extracted then depletion rate is simply 0.02 or 2% (100/5000)

Depletion rate can also be expressed in dollar value instead of percentage. For that depreciable value is divided by total quantity of resource. For example, depreciable value of quarry is $50,000 and total quantity of coal is estimated to be 500,000 then depletion rate is 10 cents per ton extracted.

The complete formula to calculate depreciation using depletion method is:

Depletion for current period = Units consumed this period x Cost – residual value
Total units of natural resource

Example: Depletion method of Depreciation

Uchali Corporation extracts methane gas. It is expected that Soon Skesar valley is rich in methane reserves and feasibility shows its of high quality.

A piece of land is already decided and it will cost $1 million. The survey and identification of drilling point is outsourced to a local company for a price of $250,000. Site preparation will cost 100,000 and entity is under an obligation to restore the place to its natural state once extraction concludes. It is estimated that plantation will cost 200,000 twenty years from now. (Ignore the time value effect)

With no salvage value, resource is estimated to hold 10 million cubic feet of gas. In current period, Uchali extracted 200,000 mcf of gas.

Calculate depletion charge for the period

First lets calculate the cost:

Land 1,000
Survey fee 250
Site preparation 100
Plantation 200
Total cost 1,550

As there is no scrap value therefore, depreciable value is 1.55 million. In this period, 200,000 mcf is extracted out of 10 million. Therefore depletion charge can be calculated as follows:

Depletion for the period = 200,000 x 1,550,000

Depletion for the period = $31,000

Example 2: Depletion method of depreciation – Change in estimate

Considering the same example as above. Suppose, the next year latest survey report tells that recoverable gas is lesser than previous estimate. It is found to be only 8 million. In second year, entity extracted 500,000 mcf of gas.

If estimates change, then their adjustment is made prospectively by adjusting the depletion rate and not retrospectively just like methods of depreciation in which change of estimate is dealt prospectively.

The net book value for second year is 1,519,000 (1,550,000 – 31,000). With 8 million now in total and 500,000 mcf of gas extracted in second year, the depletion charge will be calculated as following:

Depletion for 2nd year = 500,000 x 1,519,000

Depletion for 2nd year = $94,938