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• Why are standing timber, oil & gas fields, coal and iron ore mines called wasting assets. • The carrying value of an oil well, gas field , coal mine is reduced by a small amount for each barrel of oil pumped, for each ton of iron ore or coal mined. • Why is value of aluminum ore mine higher if near a cheap source of electricity?
Depletion is an accounting concept which is similar to depreciation but it is mostly used in timber, mining and mineral oil extraction industries to refer to the gradual exhaustion of natural resource deposits such as coal mines, oil fields, etc. Unlike depreciable assets, natural resources do not wear out (i.e. depreciate) with passage of time but they actually lose value when the resource is being extracted. Therefore we differentiate between depletion and depreciation.
The matching principle of accounting requires that amount of asset depleted in a given period must be expensed against the revenue in that period. Therefore, any method used for calculation of depletion expense must strictly obey the relevant accounting.
FormulaAssuming a company sells all of the natural resource extracted within a given period, the formula to calculate depletion expense for the period will be:
Depletion Expense =
Cost − Salvage Value
× Number of Units Extracted
Estimated Number of Units
The cost of a natural resource includes developmental costs. Subtracting estimated salvage value (if any) from the cost gives us the delectable cost which is then divided by estimated number of units to obtain cost per unit of natural resource. Multiplying cost per unit by number of units extracted during the period gives us the depletion expense for the period. This method to calculate depletion expense is similar to the units of production method of depreciation.
However, if a company does not sell all of the resource extracted in a given period, the calculation process needs to be modified so as to record any unsold amount as inventory and not as depletion expense. This is explained using the following example:
ExampleA mining company purchased a coal mine on Jan120X5 for $2,800,000. The estimated capacity of the mine is1,750,000 tons of coal and the estimated salvage value is zero. The company incurred additional $50,000 on development of mine for extraction purposes. They had extracted210,000 tons of coal from the mine up to Jan31,20X5 and sold all but13,000 tons of the coal extracted from the mine, with in Jan20X5. Calculate the depletion expense on the mine for the month ending Jan31,20X5.
Solution
Cost per Ton =
2,800,000 +50,000 −0
1,750,000
Cost per Ton = $1.62857
Total Depletion of Mine = $1.62857 ×210,000 = $342,000
Total Depletion of Mine = $342,000
So the mine will be stated at $2,558,000 (=2,800+50−342) in balance sheet on Jan31,20X5 but not all of the amount $342,000 will be recorded as depletion expense because the company had13,000 ton of coal unsold at the end of the month. Here, the depletion expense will be calculated using the following formula:
Depletion Expense = Total Depletion of Mine − Depletion Related to Unsold Extract
Depletion Expense = $342,000 − $1.62857 ×14,000
Depletion Expense = $342,000 − $22,800
Depletion Expense = $319,200
The following journal entry records the depletion expense and inventory on Jan31,20X5:
Coal Inventory
22,800
Depletion Expense
319,200
Coal Mine Assets
342,000
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