The financial accounting term depletion refers to the allocation of cost to an accounting period as units of a natural resource are mined, cut, pumped or otherwise harvested or consumed.
Depletion per Unit = (Original Cost – Residual Value) / Total Number of Units
Depletion Expense = Depletion per Unit x Units Consumed
Examples of natural resources include minerals, oil, natural gas wells and timber. As these resources are removed from the ground or harvested, they are converted into inventory. For this reason, natural resources are usually listed separately from other tangible assets on a company’s balance sheet.
Natural resources are recorded on the company’s balance sheet at cost. Oftentimes this cost will include not only the purchase price of the asset, but also exploration and development costs if they are reasonably expected to provide future benefits.
As those resources are consumed, the asset account must be reduced. Depletion is the process that allows a company to assign a cost to the number of units consumed in any accounting period. As the above calculation demonstrates, this allocation is accomplished by assigning a unit cost to the natural resource. Each accounting period, depletion expense is calculated by assigning a pro-rata share of the total cost of the asset to that time period.
Company A paid $100,000,000 to obtain rights to natural gas reserves held within the Marcellus Shale region. Exploration and development costs were $10,000,000, and it has been determined these reserves held 1 billion cubic feet of extractable gas. The rights to these natural gas reserves are expected to have a residual value of $1,000,000.
In the current accounting period 50,000,000 cubic feet of natural gas was extracted from the ground. The depletion per unit for Company A would be:
= ($100,000,000 + $10,000,000 – $1,000,000) / 1,000,000,000 = $109,000,000 / 1,000,000,000, or $0.109 unit
The depletion expense for Company A would be:
= $0.109 per unit x 50,000,000 units, or $5,450,000