What it means
A mining or oil company buys or leases the right to a deposit, spends money exploring and developing it, and then extracts the resource over years or decades until it is exhausted. The money spent to acquire and develop the deposit is an asset, because it will generate revenue over the deposit's life, but it is an asset that is literally used up: every tonne of ore or barrel of oil removed leaves less in the ground.
Depletion charges the cost of the asset to expense in proportion to the resource removed, so that each unit sold carries its share of the cost of finding and developing it, and the asset's book value falls as the deposit is consumed. The usual method is cost depletion, a units-of-production approach.
The depletable base is the capitalised cost of the property (acquisition, exploration that has been capitalised, and development such as shafts, roads and wells) plus any restoration obligation recognised, less any residual value the land will have when extraction ends. The base is divided by the estimated recoverable units in the deposit to give a depletion rate per unit, and the period's charge is the rate multiplied by the units extracted.
Because the charge is driven by extraction, depletion goes into the cost of the extracted inventory and reaches the income statement, as cost of sales, when the units are sold. The estimate of recoverable units is the critical input and it changes.
Reserves are re-estimated regularly as drilling reveals more about the deposit, as extraction shows how much can actually be recovered, and as prices and costs change what is economic to extract: a rise in the commodity price can make lower-grade material worth mining and increase reserves, and a fall can do the opposite. When the estimate changes, the depletion rate is recalculated prospectively: the remaining unamortised cost is divided by the revised remaining reserves, and the new rate applies from that point.
A downward revision raises the rate and the charge; an upward revision lowers them. A large downward revision may also indicate that the property is impaired, which is tested separately.
Some tax systems allow percentage depletion as an alternative for tax purposes, under which the deduction is a fixed percentage of the gross income from the property, regardless of cost, subject to limits. Percentage depletion can exceed the property's cost over its life, which is why it is a tax incentive rather than an accounting method; financial statements use cost depletion.
The distinction matters for deferred tax, since the tax and accounting charges differ. Depletion interacts with the other costs of extraction.
The capitalised costs to which depletion applies are distinguished from operating costs (labour, energy, consumables) that are expensed as incurred, and from plant and equipment (crushers, rigs, trucks) that are depreciated, sometimes on a units-of-production basis over the same reserves so that the pattern matches. Exploration costs may be expensed or capitalised depending on the accounting policy and whether the exploration is successful, a choice that significantly affects the depletable base.
Restoration and decommissioning obligations are recognised as liabilities at present value with a matching addition to the asset, and are depleted with it. Readers of extractive companies' accounts should look for the depletion charge per unit, the reserve estimates and their revisions, and the policy for exploration costs, since together they determine how much of the period's revenue is reported as profit.
In practice
Real-world examples.
Example
An oil producer with capitalised field costs of $60,000,000 and proved reserves of 10,000,000 barrels charges depletion of $6 a barrel, and each barrel sold at $70 with $20 of lifting cost contributes $44 before overheads.
Example
A quarry operator depletes its $4,000,000 of capitalised costs over 8,000,000 tonnes of stone at $0.50 a tonne, and depreciates its crushing plant on the same tonnage basis.
Example
A timber company depletes the cost of a forest over the board feet harvested, and adds the cost of replanting to the base for the next rotation.
Think of it
“Depletion is depreciation for natural resources-writing off the cost as you extract minerals, oil, or timber.
Formula
Calculation
Depletable base = Acquisition cost + Capitalised exploration and development costs + Restoration obligation recognised minus Residual value
Depletion rate per unit = Depletable base / Estimated recoverable units
Depletion charge for the period = Depletion rate per unit x Units extracted
Revised rate after a reserve change = Remaining unamortised base / Revised remaining recoverable units
Percentage depletion (tax, where permitted) = Statutory percentage x Gross income from the property, subject to limits
Worked example. A company acquires a mineral deposit for $12,000,000, spends $3,000,000 developing it, recognises a restoration obligation of $1,000,000 at present value, and expects the land to be worth $500,000 when mining ends. Recoverable reserves are estimated at 5,000,000 tonnes.
- Depletable base = $12,000,000 + $3,000,000 + $1,000,000 minus $500,000 = $15,500,000
- Depletion rate = $15,500,000 / 5,000,000 = $3.10 per tonne
- Year 1 extraction 600,000 tonnes: depletion = 600,000 x $3.10 = $1,860,000, charged to the cost of the ore mined; of this, the depletion on tonnes sold reaches cost of sales and the rest sits in inventory
- Remaining base after year 1 = $15,500,000 minus $1,860,000 = $13,640,000; remaining reserves 4,400,000 tonnes
Reserve revision. At the start of year 2, further drilling reduces the remaining recoverable reserves from 4,400,000 to 4,000,000 tonnes.
- Revised rate = $13,640,000 / 4,000,000 = $3.41 per tonne
- Year 2 extraction 700,000 tonnes: depletion = 700,000 x $3.41 = $2,387,000
- The revision raised the charge per tonne by 10%; if the ore sells for $12 a tonne with operating costs of $6, the margin per tonne after depletion falls from $2.90 to $2.59
Percentage depletion for tax. If the tax rules allow 15% of gross income and the year's gross income from the property is $9,000,000, the tax deduction is $1,350,000 (subject to a limit of 50% of the property's taxable income), against cost depletion of $1,860,000 in the accounts; the difference creates a deferred tax effect.Case study
Seen in the real world.
A small oil producer had capitalised $60,000,000 of acquisition and development costs on a field with estimated proved reserves of 10,000,000 barrels, giving a depletion rate of $6 a barrel. With oil at $45 and lifting costs of $20 a barrel, each barrel contributed $19 after depletion, and the company's lenders had extended a reserve-based facility on the strength of the reserves. Over two years the company produced 2,000,000 barrels, charged $12,000,000 of depletion, and carried the remaining $48,000,000 against 8,000,000 barrels of remaining reserves.
The third year's drilling results were poor: two development wells found the reservoir thinner than modelled, and the independent reserves engineer revised the remaining recoverable reserves down by 30%, to 5,600,000 barrels. The depletion rate was recalculated prospectively: $48,000,000 / 5,600,000 = $8.57 a barrel, up from $6.00, and the margin per barrel fell from $19.00 to $16.43 before any change in price or cost.
The reserve revision also triggered an impairment review: the value of the field's remaining production, discounted, was below its $48,000,000 book value, and the company wrote off $12,000,000, reducing the carrying amount to $36,000,000 and the depletion rate on the reduced base to $6.43 a barrel. The lenders, whose facility was sized on reserves, reduced the borrowing base, and the company had to repay $9,000,000 within six months.
The finance director's report to the board separated the three effects, which had arrived together and were easily confused. The depletion rate had risen because the same cost now had to be recovered from fewer barrels, a change in the pattern of expense. The impairment was a change in the value of the asset, recognised at once.
And the borrowing base reduction was a cash consequence of the lenders' reliance on the same reserve estimate. All three flowed from a single geological fact, and the board's lesson was that in an extractive business the reserve estimate is the number on which everything else rests, and that its uncertainty should be reflected in the leverage the company carries.
Watch out
Common mistakes.
- Charging depletion to the income statement as extracted, rather than to inventory and then to cost of sales when sold, which misstates profit when production and sales differ.
- Leaving the depletion rate unchanged after a reserve revision, or applying the revised rate retrospectively; the change is applied prospectively to the remaining unamortised cost.
- Confusing percentage depletion, a tax incentive that can exceed cost, with cost depletion, the accounting method that recovers cost and no more.
Questions
People also ask.
What is the difference between depletion, depreciation and amortisation?
All three spread the cost of a long-lived asset over its use. Depreciation applies to tangible assets such as plant, amortisation to intangible assets such as licences, and depletion to natural resources that are physically consumed. Depletion is almost always calculated on units extracted rather than on time.
Why does depletion change from year to year?
Because the charge depends on the estimate of recoverable reserves, which is revised as extraction proceeds, as drilling reveals more, and as prices change what is economic to extract. Each revision changes the rate per unit for future periods.
Does depletion affect cash?
No. It allocates cost already spent. But it affects reported profit, tax (where cost or percentage depletion is deductible), and lenders' and investors' view of the business, and the reserve estimates behind it drive the cash the company can borrow.
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