Question

Describe depletion and, in general, how it differs or not from depreciation.

Answer 1

Depletion is an accurual accounting technique used to allocate the cost of extracting natural resources such as timber, minerals and oil from the earth. When the costs associated with natural resource extraction have been capitalized, the expenses are systematically allocated across different time periods based upon the resources extracted.Depletion for accounting and financial reporting purpose is meant to assist in accurately identifing the value of the assets on the balance sheet and recording expenses in the appropriate time period on the income ststement.

There are two different forms of depletion allowances, Percentage depletion and Cost depletion.

Percentage depletion assigns a fixed percentage to gross revenue - sales minus cost- to allocate expense. For example, if $10 million of oil is extracted and the fixed percentage is 15% , $1.5 million of capitalised costs to extract the natural resourses are depleted.

Cost depletion is calculated by taking the property basis, total recoverable resources and number of units sold into account.

There are four main factors that affect the depletion base:

1. Acquisition: Costs associated with purchasing or leasing the property rights to land that the company belives has natural resources.

2. Exploration: Epenses linked to digging under the land that was leased or bought.

3. Development: The costs necessary to prepare the land for natural resource extraction such as tunneling or developing wells.

4. Restoration: Expenses associated with restoring the land to its original condition after completion.

Depreciation is an accounting method of allocating the cost of a tangiable or physical asset over its useful life. Assets such as machinery and equipments are expensive, instread of realizing the entire cost of the asset in year one, depreciating the asset allows the companies to spreadout that cost ang generate revenue from it.

The difference between depletion and depreciation is :

1. Depreciation is on tangiable assets whereas depletion is on non-renewable resources.

2. Depreciation is the deduction of asset value due to aging whereas depletion is the actual phsical reduction of the company's natural resources.

Both methods (Depletion and Depreciation) are used to calculate Asset/ Resource's periodic value. Depending on the company and its resource/ asset in use, these method reduce the value of the asset/resource which is taken into account. Different accounting standards are in place to guide companies in accounting for both Depletion and Depreciation. These methods help the company to record the asset/resource's value as it reduces due to the usage , and hence, help to understand the value at a given time.