What do you call to the decrease in value of a property due to gradual extraction of its contents *?

What is Depletion?

Depletion is an accrual accounting technique used to allocate the cost of extracting natural resources such as timber, minerals, and oil from the earth. 

Like depreciation and amortization, depletion is a non-cash expensethat lowers the cost value of an asset incrementally through scheduled charges to income. Where depletion differs is that it refers to the gradual exhaustion of natural resource reserves, as opposed to the wearing out of depreciable assets or aging life of intangibles.

How Depletion Works

Depletion for accounting and financial reporting purposes is meant to assist in accurately identifying the value of the assets on the balance sheet and recording expenses in the appropriate time period on the income statement.

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. The costs are held on the balance sheet until expense recognition occurs.

Key Takeaways

• Depletion is an accrual accounting method 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.
• There are two basic forms of depletion allowance: percentage depletion and cost depletion.

Recording Depletion

To calculate what expenses need to be spread out for the use of natural resources, each different phase of production must be taken into consideration. The depletion base is the capitalized costs depleted across multiple accounting periods. There are four main factors that affect the depletion base:

• Acquisition: Costs associated with purchasing or leasing the property rights to land that the company believes has natural resources.
• Exploration: Expenses linked to digging under the land that was leased or bought.
• Development: Thecosts necessary to prepare the land for natural resource extraction, such as tunneling or developing wells.
• Restoration: Expenses associated with restoring the land to its original condition after completion.

Percentage Depletion Method

One method of calculating depletion expense is the percentage depletion method. It assigns a fixed percentage to gross revenue — sales minus costs — to allocate expenses. For example, if $10 million of oil is extracted and the fixed percentage is 15%, $1.5 million of capitalized costs to extract the natural resource are depleted.

The percentage depletion method requires a lot of estimates and is, therefore, not a heavily relied upon or accepted method of depletion.

Cost Depletion Method

The second method of calculating depletion is the cost depletion method. Cost depletion is calculated by taking the property's basis, total recoverable reserves and number of units sold into account. The property’s basis is distributed among the total number of recoverable units. As natural resources are extracted, they are counted and taken out from the property’s basis.

For example, the capitalized costs of $1 million yields 500,000 barrels of oil. In the first year, if 100,000 barrels of oil are extracted, the depletion expense for the period is $200,000 (100,000 barrels * ($1,000,000 / 500,000 barrels)

Reporting Requirements

The Internal Revenue Service (IRS) requires the cost method to be used with timber. It requires the method that yields the highest deduction to be used with mineral property, which it defines as oil and gas wells, mines and other natural deposits, including geothermal deposits.

Because the percentage depletion looks at the property's gross income and taxable income limit, as opposed to the amount of the natural resource extracted, it is not an acceptable reporting method for certain natural resources.

What Is Depreciation, Depletion, and Amortization (DD&A)?

Depreciation, depletion, and amortization (DD&A) is an accounting technique that enables companies to gradually expense various different resources of economic value over time in order to match costs to revenues.

Depreciation spreads out the cost of a tangible asset over its useful life, depletion allocates the cost of extracting natural resources, such as timber, minerals, and oil from the earth, and amortization is the deduction of intangible assets over a specified time period; typically the life of an asset.

Depreciation and amortization are common to almost every industry, while depletion is usually used only by energy and natural-resource firms. The use of all three, therefore, is often associated withthe acquisition, exploration, and development of new oil and natural gas reserves.

Key Takeaways

• Depreciation, depletion, and amortization (DD&A) are accounting techniques that enable companies to gradually expense resources of economic value.
• Depreciation relates to the cost of a tangible asset, depletion to the cost of extracting natural resources, and amortization to the deduction of an intangible asset.
• The use of all three expensing strategies is typically associated with the acquisition, exploration, and development of new oil and natural gas reserves.
• DD&A charges can be found on a company's net income statement.

Understanding Depreciation, Depletion, and Amortization (DD&A)

Accrual accounting permits companies to recognize capital expenses in periods that reflect the use of the related capital asset. In other words, it lets firms match expenses to the revenues they helped produce.

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.

DD&A is a common operating expense item for energy companies. Analysts and investors in the energy sector should be aware of this expense and how it relates to cash flow and capital expenditure.

Depreciation

Depreciation applies to expenses incurred for the purchase of assets with useful lives greater than one year. A percentage of the purchase price is deducted over the course of the asset's useful life. 

Depletion

Depletion also lowers the cost value of an asset incrementally through scheduled charges to income. Where it differs is that it refers to the gradual exhaustion of natural resource reserves, as opposed to the wearing out of depreciable assets or the aging life of intangibles.

Depletion expense is commonly used by miners, loggers, oil and gas drillers, and other companies engaged in natural resource extraction. Enterprises with an economic interest in mineral property or standing timber may recognize depletion expenses against those assets as they are used. Depletion can be calculated on a cost or percentage basis, and businesses generally must use whichever provides the larger deduction for tax purposes.

Amortization

Amortization is very similar to depreciation, in theory, but applies to intangible assets such as patents, trademarks, andlicenses, rather than physical property and equipment. Capital leases are also amortized.

Recording Depreciation, Depletion, and Amortization (DD&A)

If a company uses all three of the above expensing methods, they will be recorded in its financial statement as depreciation, depletion, and amortization (DD&A). A single line providing the dollar amount of charges for the accounting period appears on the income statement.

Explanations may also be supplied in the footnotes, particularly if there is a large swing in the depreciation, depletion, and amortization (DD&A) charge from one period to the next.

An entry is made on the balance sheet, too. The dollar amount represents the cumulative total amount of depreciation, depletion, and amortization (DD&A) from the time the assets were acquired. Assets deteriorate in value over time and this is reflected in the balance sheet. 

Real World Example

Chevron Corp. (CVX) reported $19.4 billion in DD&A expense in 2018, more or less in line with the $19.3 billion it recorded in the prior year. In its footnotes, the energy giant revealed that the slight DD&A expense increase was due to higher production levels for certain oil and gas producing fields.

What do you call to the decrease in value of a property due to gradual extraction of its contents?

What refers to the lessening of the value of an asset due to the decrease in the quantity available?

Is the decrease in value of physical properties with the passage of time and use?

What do you call to the worth of the property as an operating unit?