Definition, Method, and Accounting of Depletion of Natural Resources

What are Natural Resources?

Nature provides natural resources. Natural resources are valuable assets with a long lifespan.

These assets have two distinct characteristics:

  1. They are physically removed in activities (such as digging, cutting, or pumping), and
  2. They can only be replaced by a natural disaster.

As a consequence of continuous extraction, the amount of such assets is decreasing. This type of natural resource is referred to as a perishable resource.

For Example Minerals such as gas, oil, coal, etc.

Depreciation is the process of reducing the value of a long-term visible asset. Depletion refers to the actual depletion of natural resources.

What is Depletion?

Depletion is the logical and systematic distribution of the expense of natural resources over the resource’s useful life.

The physical reduction of a natural resource is known as depletion.

For example, an oil field depletes over time as the oil is extracted. Both forms of mining, as well as petroleum drilling and timberland use, are all related to depletion.

What are the Five Main Causes of Natural Resource Depletion?

The following are 5 (five) basic causes for natural resource depletion:

  1. Rapid population growth
  2. Pollution of the environment
  3. Unregulated and unplanned industrial growth
  4. Rapid material consumptions
  5. Land degradation

What Methods are Used to Calculate Depletion?

The following are the two (two) methods for calculating depletion:

  1. Percentage Depletion Method
  2. Units of Activity Method

1.Percentage Depletion Method:

The percentage depletion method is one method of calculating depletion cost. To allocate costs, the percentage depletion method assigns a fixed percentage to gross revenue.

For example: If $20 million of oil is extracted and the fixed amount of depletion is 10%, the capitalized cost of extracting the natural resource is depleted by $2 million ($20,000,000*10%)

Since the percentage depletion method relies heavily on projections, it is not widely used or recognized as a method of depletion.

2. Units of activity Method:

The second method of calculation depletion is the units of activity method. Companies use the units-of-activity method to divide the overall cost of a natural resource, minus salvage value, by the estimated number of units in the resource.

As a consequence, there is a per-unit depletion cost. The cost per unit is then multiplied by the number of units extracted to calculate depletion.

The formula for calculating depletion cost under units of activity method:

Depletion expense per unit= (Total cost-Salvage value)/ Total available estimated units

For example, Assume Mike Coal Company invests $20 million in a coal mine with a capacity of 2 million tons and no salvage value.

Here, Depletion Cost per unit= ($20,000,000-0)/2,000,000 =$10

If Mike extracts 500,000 tons in the first year, then the depletion for the year is $5,000,000 (500,000 tons * $10).

To calculate depletion, most companies use the units-of-activity method. The explanation for this is that depletion is usually determined by the number of units extracted over the course of a year.

How to Record the depletion in an Accounting Book?

We can record the adjusting journal entry by debiting depletion expenses and crediting natural resource assets.

DateParticularsDebit
(Amount)
Credit
(Amount)
Depletion Expenses***
Natural Resources Assets***

Alternatively, some companies might use an accumulated depletion account, rather than crediting the natural resource asset directly.

This isn’t necessary like it is with plant assets since the natural resource asset will be gone once it’s fully depleted.

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