In financial accounting, depletion is used to capture the decline in a natural resource such as petroleum, timber, and minerals. Natural resources subject to depletion can be identified by one of two features:
- The asset can be completely consumed
- The asset can only be replaced by nature
Depletion = Cost Basis for Resource x (Units Extracted or Harvested / Total Units)
In order to calculate depletion, the company must first determine the depletion base, or cost of the natural resource. These costs generally fall into three categories:
- Cost to acquire the resource
- Cost to develop the resource
- Costs associated with exploration of the resource
There is considerable controversy surrounding the depletion base for oil and gas reserves, due to the difficulty in estimating recoverable reserves.
Timber Company owns 50,000 acres of harvestable trees, which were purchased for $10,000,000. The company clears 5,000 acres in year one. The depletion deduction would be:
= $10,000,000 x (5,000 / 50,000) = $10,000,000 x 0.10, or $1,000,000
This example uses the cost depletion method of accounting, which is used by most companies. Alternatively, a percentage depletion method can be used.