Depletion is the exhaustion that results from the physical removal of a part of a natural resource. Many companies rely on capital assets such as buildings, vehicles, equipment, and machinery as part of their operations. In accordance with accounting rules, companies must depreciate these assets over their useful lives. As a result, companies must recognize accumulated depreciation, the sum of depreciation expense recognized over the life of an asset. Accumulated depreciation is reported on the balance sheet as a contra asset that reduces the net book value of the capital asset section. Assets are categorized as fixed when they are utilized in the business over a long period of time to generate long term benefits and revenues for the entity.
Sometimes, the company has not sold all the natural resource in the year it is extracted. In this case, it needs to record the unsold portion as the inventory and the depletion expense will be recorded in the period it is sold. Let’s assume that at the beginning of the current year a company’s asset account Equipment reported a cost of $70,000. From the time the equipment was put into service until the beginning of the year the related Accumulated Depreciation account shows a credit balance of $45,000. During the current year the company debits Depreciation Expense for $10,000 and credits Accumulated Depreciation for $10,000. Therefore, at the end of the current year the credit balance in Accumulated Depreciation is $55,000.
There may be instances, where the acquisition of the resource requires a restoration cost at the end of its useful life. For example, in case of extraction of timber from a forest, the entity might be required to restore the forest’s plantation which may involve an additional cost. In such cases the formula for depletion would be modified to include this restoration cost. For example, the company ABC purchases a coal mine that costs $10 million which is estimated to contain 5,000,000 tons of coal. Chevron Corp. (CVX) reported $19.4 billion in DD&A expense in 2018, more or less in line with the $19.3 billion it recorded in the prior year.
- In general, accumulated depreciation is calculated by taking the depreciable base of an asset and dividing it by a suitable divisor such as years of use or units of production.
- A liability is a future financial obligation (i.e. debt) that the company has to pay.
- The percentage can simply be calculated as twice of 100% divided by the number of years of useful life.
- It is important to note that accumulated depreciation cannot be more than the asset’s historical cost even if the asset is still in use after its estimated useful life.
For example, let’s say an asset has been used for 5 years and has an accumulated depreciation of $100,000 in total. Like depreciation and amortization, depletion is a non-cash expense that lowers the cost value of an asset incrementally through scheduled charges to income. Where depletion differs is that it refers to the gradual exhaustion of natural resource reserves, as opposed to the wearing out of depreciable assets or aging life of intangibles. The accounting entry for depletion is similar to that of depreciation, with a charge to profit and loss account and accumulation in accumulated depletion account.
Because the life of the mine (10 years or 1,000,000 tons) is shorter than the life of the building (20 years), the building should be depreciated over the life of the mine. The basis of the depreciation charge is tons of ore rather than years because the mine’s life could be longer or shorter than 10 years, depending on how rapidly the ore is removed. The equipment is going to provide the company with value for the next 10 years, so the company expenses the cost of the equipment over the next 10 years. The philosophy behind accelerated depreciation is assets that are newer, such as a new company vehicle, are often used more than older assets because they are in better condition and more efficient.
A commonly practiced strategy for depreciating an asset is to recognize a half year of depreciation in the year an asset is acquired and a half year of depreciation in the last year of an asset’s useful life. This strategy is employed to fairly allocate depreciation expense and accumulated depreciation in years when an asset may only be used for part of a year. Under the double-declining balance (also called accelerated depreciation), a company calculates what its depreciation would be under the straight-line method. Then, the company doubles the depreciation rate, keeps this rate the same across all years the asset is depreciated and continues to accumulate depreciation until the salvage value is reached. The percentage can simply be calculated as twice of 100% divided by the number of years of useful life.
Depreciation, Depletion, and Amortization (DD&A): Examples
Depreciation, depletion, and amortization (DD&A) is an accounting technique that enables companies to gradually expense various different resources of economic value over time in order to match costs to revenues. After two years, the company realizes the remaining useful life is not three years but instead six years. Under GAAP, the company does not need to retroactively adjust financial statements for changes in estimates. Instead, the company will change the amount of accumulated depreciation recognized each year. In this example, the accumulated depletion of $200,000 represents the portion of the timberland’s original cost that has been used up during the first year of operation. As the company continues to extract timber, the accumulated depletion will increase, reducing the value of the timberland asset on the balance sheet.
Depletion expense journal entry
Divided over 20 years, the company would recognize $20,000 of accumulated depreciation every year. Watch this short video to quickly understand the main concepts covered in this guide, including what accumulated depreciation is and how depreciation expenses are calculated. It is important to note that accumulated depreciation cannot be more than the asset’s historical cost even if the asset is still in use after its estimated useful life. The dollar amount represents the cumulative total amount of depreciation, depletion, and amortization (DD&A) from the time the assets were acquired.
Percentage Depletion:
Similar to depreciation, the journal entry for depletion includes the depletion expense on the income statement and the accumulated depletion on the balance sheet. Depletion expense is commonly used by miners, loggers, oil and gas drillers, and other companies engaged in natural resource extraction. Enterprises with an economic interest in mineral property or standing timber may recognize depletion expenses against those assets as they are used.
8: Natural Resources and Depletion
For example, if a large piece of machinery or property requires a large cash outlay, it can be expensed over its usable life, rather than in the individual period during which the cash outlay occurred. This accounting technique is designed to provide a more accurate depiction of the profitability of the business. Accrual accounting permits companies to recognize capital expenses in periods that reflect the use of the related capital asset. It requires the method that yields the highest deduction to be used with mineral property, which it defines as oil and gas wells, mines, and other natural deposits, including geothermal deposits.
Accumulated amortization and accumulated depletion work in the same way as accumulated depreciation; they are all contra-asset accounts. For tangible assets such as property or plant and equipment, it is referred to as depreciation. If a company uses all three of the above expensing methods, they will be recorded in its financial statement as depreciation, depletion, and amortization (DD&A). A single line providing the dollar amount of charges for the accounting period appears on the income statement. There are balance sheet and income statement entries that must be recorded when getting rid of equipment by scrapping it or selling it. It also discusses intangible assets, how to record them, and how to account for their diminishing value.
Since accelerated depreciation is an accounting method used to recognize depreciation, the result of accelerated depreciation is to book accumulated depreciation. Under this method, the amount of accumulated depreciation accumulates faster during the early years of an asset’s life and accumulates slower the accumulated depletion account is later. This change is reflected as a change in accounting estimate, not a change in accounting principle. For example, say a company was depreciating a $10,000 asset over its five-year useful life with no salvage value. Using the straight-line method, an accumulated depreciation of $2,000 is recognized.
This is why the way that the company determines the depletion expense is similar to that of the depreciation expense. Companies depreciate plant assets erected on extractive industry property the same as other depreciable assets. If such assets will be abandoned when the natural resource is exhausted, they depreciate these assets over the shorter of the (a) physical life of the asset or (b) life of the natural resource. In many cases, firms compute periodic depreciation charges using the units-of-production method. Using this method matches the life of the plant asset with the life of the natural resource. This method is recommended where the physical life of the plant asset equals or exceeds the resource’s life but its useful life is limited to the life of the natural resource.
Under the declining balance method, depreciation is recorded as a percentage of the asset’s current book value. Because the same percentage is used every year while the current book value decreases, the amount of depreciation decreases each year. Even though accumulated depreciation will still increase, the amount of accumulated depreciation will decrease each year.
This is done by adding up the digits of the useful years and then depreciating based on that number of years. Depletion thus occurs due to the exhaustion of supply of the specific natural resource. https://personal-accounting.org/ For example, Company A buys a company vehicle in Year 1 with a five-year useful life. Regardless of the month, the company will recognize six months’ worth of depreciation in Year 1.