Notes

Depletion is the adjustment of value, typically of natural resource assets, due to their diminishing supply. Follow the steps in computing depletion, and learn how this is applied through an example.
Natural Resource Assets
You should be familiar with the definition of an asset in a company and how to account for them on the balance sheet. However, you may not know how an asset such as land with minerals is handled in accounting. For this lesson, we will travel with Lydia, who is the owner of Profits, Inc., as she goes into the business of purchasing land and selling the natural resources.

For her first purchase, Lydia finds a plot of land that consists of 1,000 acres and is estimated to contain 600,000 tons of coal. She purchases the land through her company for a price of $300,000.

Depreciation and Depletion
When a company purchases a piece of machinery, the value of the machine decreases as it is used until it eventually reaches its salvage value. The salvage value is what the item is worth at the end of its useful life. The process of decreasing the value of equipment is called depreciation. Accepted accounting procedures allow many methods of depreciation, such as the straight-line method, the double-declining method, and the sum of years' method.

When the asset happens to involve land with an estimated amount of natural resources, the same concept of depreciation applies but in this case, it is called depletion because the resources are being depleted (removed) from the land. Depletion is also different because it does not depend on any length of time but is directly related to the amount of resources removed. Depletion would be used when resources such as coal, precious metals, timber, or petroleum are to be extracted.

Accounting for Depletion
When the land was purchased on October 11 by Profits, Inc., the accountants created and debited the Land account for $300,000 and credited the Cash account for the same amount. At the end of the year, Profits, Inc. removed 100,000 tons of coal from the land. Lydia knows that the land is not worth the same amount now as when she purchased it, but she needs to figure out how much it is worth as she begins to prepare her taxes.

Steps to Compute Depletion
Lydia knows she must follow three steps to make her calculations:

She must divide the amount paid for the land by the estimated units of measure of the natural resource (in Lydia's case, tons)
The result of that computation will give you the price for each unit of measure (the price per ton for Lydia)
She must multiply the number of units of measure extracted by the cost for each unit
In this case Lydia, would divide the $300,000 she paid for the land by 600,000 tons of estimated coal to come up with $.50 per ton. She would now multiply the $.50 per ton times the number of tons removed (100,000) to come up with a depletion amount of $50,000.

Lydia can now update the value of her land by debiting the Depletion Expense account and credit the Accumulated Depletion - Land account. The Accumulated Depletion - Land account is considered a contra-asset account and will offset the asset 'Land' on her balance sheet. A contra-asset account typically has a credit balance and is attached to an asset to give it its current value. Note that the asset account itself (Land) still has a debit balance of $300,000, but its true value can only be found when taking the contra-asset account into consideration, as well. The real value of the Land account is the $300,000 minus its associated Accumulated Depletion account of $50,000 for an end-of-year value of $250,000.

Additional Examples
Here's a question for you: What is the value of the land Lydia purchased at the end of the second year after her company has removed another 250,000 tons of coal?

Remember that we have already completed the first two steps of the process to figure out the cost per ton; therefore, we only need to follow the last step. The amount used for each ton is still $.50 and we would just need to multiply that by the amount of tons extracted the second year.

$.50 x 250,000 tons = $125,000

The $125,000 represents the amount of depletion expense for year two. At the end of the year, Lydia would debit the Depletion Expense account for $125,000 and credit the Accumulated Depletion - Land account for the same amount. The balance in the Accumulated Depletion - Land account would be a credit balance of $175,000 ($50,000 from year one and $125,000 from year two). The Land account does not change and still has a debit balance of $300,000. The value of the land is $300,000 minus the total accumulated depletion of $175,000 for a value at the end of year two of $125,000.

If you were able to answer the previous question, congratulations! Here is another challenge for you! What if the original estimate for 600,000 tons of coal is wrong? At the end of year two, Profits, Inc. has extracted a total of 350,000 tons. An expert states now that they have a better view of the site, they see only an estimated 200,000 tons remaining (instead of the 250,000 tons that they thought should be there). What should Lydia do?

At this point, it is too late to adjust any of the previous years' expenses. The only thing that is left is to adjust the depletion amount based on the revised estimate. This means that we take the value calculated at the end of year two ($125,000) and divide it by the remaining quantity of coal (200,000 tons) and come up with a revised depletion rate.

$125,000 divided by 200,000 tons is $.625 per ton. Lydia would then use $.625 as the base cost per ton in calculating the depletion expense for year three.

Lesson Summary
Depletion is the process of adjusting the value of a natural resource asset so that it accounts for the removal of the natural resources during the asset's life. Depletion differs from depreciation in that it is not linked to any length of time and changes based on the amount of resources removed.

The three steps to compute depletion expense are:

Divide the cost of the asset by the amount of natural resources it contains
Determine the cost per unit
Multiply the cost per unit times the number of units depleted (removed) to determine the depletion expense for that year.
The accumulated depletion account is a contra-asset account that contains the total depletion amount for the life of the asset and must be subtracted from the asset's original debit balance in order to obtain the current asset value.