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Depletion (Accounting) Definition
Depletion refers to an accrual accounting technique commonly used in the natural resources extracting industries such as mining, petroleum, timber, among others. What makes depletion similar to depreciation is that they are both cost recovery system for tax reporting and accounting. The depletion deduction enables an individual to account for the product reserves’ reduction.
A Little More on What is Depletion in Accounting
When you use depletion for financial and accounting for reporting purposes, it ensures that value identification on the balance sheet is accurate. It also makes sure that the recording of expenses on the income statement is done within the required time.
After capitalizing natural resource extraction costs, you can easily allocate the expenses across different periods based on the extracted resource. Until that time, when the expense recognition takes place, these costs are usually held on the balance sheet.
Methods of Depletion
There are two methods of depletion used for the purpose of tax. They include cost and percentage.
Percentage Depletion Method
Percentage technique is one of the many methods used to calculate expenses related to depletion. It works by assigning a fixed percentage to gross income to allocate expenses. This method requires heavy use of estimates. For this reason, it is not relied upon.
Cost Depletion Method
Cost depletion is also another method of calculating depletion. It is an accounting technique where you allocate the costs of natural resources to depletion over the period making up the asset’s life. To calculate cost depletion, you take the property basis, units’ total recoverable, and account’s number of units sold. As you extract natural resources, they are counted and removed from the basis of the property.
Depletion base refers to capitalized costs that are depleted across a number of accounting periods. We have four types of depletion base costs:
- Acquisition costs to lease or purchase the property
- Location and exploration of expenses
- Costs for preparing the property for the extraction of natural resources
- Costs to do with the restoration of property to its condition
The Internal Revenue Service (IRS) rule requires that you use the cost method when dealing with timber. You are also supposed to use a method that produces the highest deduction when dealing with mineral property.