The salvage value of the property tends to be more significant for natural resource-producing property and should be included in computing the lifetime depletion to be recorded. As a side note, there often is a difference in useful lives for assets when following GAAP versus the guidelines for depreciation under federal tax law, as enforced by the Internal Revenue Service (IRS). This difference is not unexpected when you consider that tax law is typically determined by the United States Congress, and there often is an economic reason for tax policy.
3 Explain and Apply Depreciation Methods to Allocate Capitalized Costs
Percentage depletion is based on a percentage of the gross income generated from the sale of the resource, and is typically used when the value of the resource is high relative to the cost of acquiring and developing it. When analyzing depreciation, accountants are required to make a supportable estimate of an asset’s useful life and its salvage value. The units of production method is different from the two above methods in that while those methods are based on time factors, the units of production is based on usage. However, the total amount of depreciation taken over an asset’s economic life will still be the same. In our example, the total depreciation will be $48,000, even though the sum-of-the-years-digits method could take only two or three years or possibly six or seven years to be allocated.
What is the Depletion Method?
Let’s say an oil company expects to spend $200,000 to withdraw 50,000 barrels of oil every year from a field with estimated reserves of 1 million barrels. The amount of depletion that could be claimed would be $10,000, or $200,000(50,000/1,000,000). Cost depletion is based on the actual cost of acquiring and developing the resource, and is typically used when the cost of acquiring and developing the resource is high relative to the value of the resource itself.
Example of How to Use Cost Depletion
This is particularly important for companies that rely on natural resources as a significant source of income. By recognizing the expense of extracting the resource over time, companies can ensure that their financial statements accurately reflect the true cost of doing business. Depreciation is an accounting technique that allows businesses to spread the cost of a fixed asset over its useful life. This helps companies to recognize the expense of an asset over time and aligns the cost of using the asset with the revenue generated from it. There are different methods of depreciation, and one of the most popular ones is the depletion method.
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It follows the same process used in the units of production method of depreciation. Depletion method of depreciation is mostly used by the companies that have assets that are natural resources like oil, gas, coal, mines, quarries or other wasting assets. During the second year, Pensive Oil extracts 80,000 barrels of oil from the well, which results in a depletion charge of $128,800 (80,000 barrels x $1.61 unit depletion charge). At the end of the second year, there is still a depletion base of $321,200 that must be charged to expense in proportion to the amount of any remaining extractions.
Such assets are also referred as wasting assets because their value deteriorates with the increasing extraction of resources. For example in case of a coal mine, more the coal is extracted more will be the depletion of the mine etc. Depletion is an accounting technique that allows investors to write down the value of a natural resource as it’s extracted or harvested. Enshrined into the tax code in 1926, depletion is most commonly used in the oil and gas, mining, and timber industries. The depletion method affects both the income statement and the balance sheet, as it impacts the calculation of expenses and the valuation of assets. One of the main disadvantages is that it can be difficult to determine the estimated amount of the resource that can be extracted.
Depletion is the reduction in the amount of a natural resource, such as minerals or timber. From an accounting perspective, it is a charge against the recorded asset value of a natural resource. This charge is made in each reporting period, in an amount that reflects the level of asset usage during the period.
- This is the ability, under IFRS, to adjust the value of those assets to their fair value as of the balance sheet date.
- This is calculated by dividing the depletion base less salvage value (if any) by the number of units expected to be extracted.
- At the end of five years, the asset will have a book value of $10,000, which is calculated by subtracting the accumulated depreciation of $48,000 (5 × $9,600) from the cost of $58,000.
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Assets deteriorate in value over time and this is reflected in the balance sheet. 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. At the start of the year 2, tax implications of supporting adult children a new survey is conducted and it is found that the expected extraction of minerals is only 160,000 tons (i.e.,40,000 tons less then the original estimate). The company decided to workout a new depletion rate on the basis of information provided by revised survey. Finally, the units extracted during the period are multiplied by the depletion rate per unit to compute the depletion or depreciation charge for the period.
It is important to note, however, that not all long-term assets are depreciated. For example, land is not depreciated because depreciation is the allocating of the expense of an asset over its useful life. It is assumed that land has an unlimited useful life; therefore, it is not depreciated, and it remains on the books at historical cost. As a general rule, investors have to use the method that provides the largest deduction. But unless you’re an independent producer or royalty owner, the IRS says you usually can’t use the percentage depletion method for oil and gas wells. Depletion is an accounting method that allows individuals or companies to reflect the declining value of a natural resource over time.