Depletion is an

accounting Accounting, also known as accountancy, is the process of recording and processing information about economic entity, economic entities, such as businesses and corporations. Accounting measures the results of an organization's economic activit ...

and

tax A tax is a mandatory financial charge or levy imposed on an individual or legal entity by a governmental organization to support government spending and public expenditures collectively or to regulate and reduce negative externalities. Tax co ...

concept used most often in the

mining Mining is the Resource extraction, extraction of valuable geological materials and minerals from the surface of the Earth. Mining is required to obtain most materials that cannot be grown through agriculture, agricultural processes, or feasib ...

timber Lumber is wood that has been processed into uniform and useful sizes (dimensional lumber), including beams and planks or boards. Lumber is mainly used for construction framing, as well as finishing (floors, wall panels, window frames). ...

, and

petroleum Petroleum, also known as crude oil or simply oil, is a naturally occurring, yellowish-black liquid chemical mixture found in geological formations, consisting mainly of hydrocarbons. The term ''petroleum'' refers both to naturally occurring un ...

industries. It is similar to

depreciation In accountancy, depreciation refers to two aspects of the same concept: first, an actual reduction in the fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wears, and second, the allocation i ...

in that it is a cost recovery system for accounting and tax reporting: "The depletion deduction" allows an owner or operator to account for the reduction of a product's reserves.

Types of depletion

For tax purposes, the two types of depletion are percentage depletion and cost depletion. For mineral property, the method leading to the largest deduction is generally used. For standing timber, use of the cost depletion method is required.Publication 535 (2007), Business Expenses
/ref> Depletion, for both accounting purposes and United States tax purposes, is a method of recording the gradual expense or use of

natural resource Natural resources are resources that are drawn from nature and used with few modifications. This includes the sources of valued characteristics such as commercial and industrial use, aesthetic value, scientific interest, and cultural value. ...

s over time. Depletion is the using up of natural resources by

quarrying A quarry is a type of open-pit mine in which dimension stone, rock, construction aggregate, riprap, sand, gravel, or slate is excavated from the ground. The operation of quarries is regulated in some jurisdictions to manage their s ...

drilling Drilling is a cutting process where a drill bit is spun to cut a hole of circular cross section (geometry), cross-section in solid materials. The drill bit is usually a rotary Cutting tool (machining), cutting tool, often multi-point. The bit i ...

, or felling. According to the

IRS The Internal Revenue Service (IRS) is the revenue service for the Federal government of the United States, United States federal government, which is responsible for collecting Taxation in the United States, U.S. federal taxes and administerin ...

Newswire,IRS Issues Guidance on Recoverable Reserves
/ref> over 50 percent of oil and gas extraction businesses use cost depletion to figure their depletion deduction. Mineral property includes oil and gas wells, mines, and other natural resource deposits (including geothermal deposits). For that purpose, property is each separate interest businesses own in each mineral deposit in each separate tract or parcel of land. Businesses can treat two or more separate interests as one property or as separate properties.

Percentage depletion

To figure percentage depletion, a certain percentage, specified for each mineral, is multiplied by

gross income For households and individuals, gross income is the sum of all wages, salaries, profits, interest payments, rents, and other forms of earnings, before any deductions or taxes. It is opposed to net income, defined as the gross income minus taxes ...

from the property during the tax year. The rates to be used and other conditions and qualifications for oil and gas wells are discussed below under ''Independent Producers and Royalty Owners'' and under ''Natural Gas Wells''. Rates and other rules for percentage depletion of other specific minerals are found later in ''Mines and Geothermal Deposits''.

Cost depletion

Cost depletion is an accounting method by which costs of natural resources are allocated to depletion over the period that make up the life of the

asset In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that can b ...

. Cost depletion is computed by estimating the total quantity of mineral or other resources acquired and assigning a proportionate amount of the total resource cost to the quantity extracted in the period. For example, assume Big Texas Oil, Co. had discovered a large reserve of oil and estimates that the oil well will produce 200,000 barrels of oil. If the company invests $100,000 to extract the oil and extracts 10,000 barrels the first year, the depletion deduction is $5,000 ($100,000 X 10,000/200,000). Cost depletion for tax purposes may be completely different from cost depletion for accounting purposes: :

CD = S/(R+S) \times AB = AB/(R+S) \times S

:CD = Cost Depletion. :S = Units sold in the current year :R = Reserves on hand at the end of the current year :AB =

Adjusted basis In tax accounting, adjusted basis is the net cost of an asset after adjusting for various tax-related items. Adjusted Basis or Adjusted Tax Basis refers to the original cost or other basis of property, reduced by depreciation deductions and increas ...

of the property at the end of the current year

Accounting

Adjusted basis is the basis at end of year adjusted for prior years depletion in cost or percentage. It automatically allows for adjustments to the basis during the taxable year. By using the units remaining at the end of the year, the adjustment allows for revised estimates of the reserves. Depletion is based upon sales and not production. Units are considered sold in the year the proceeds are taxable under the taxpayer's accounting method.

Reserves

Reserves generally include proven developed reserves and "probable" or "prospective" reserves if there is reasonable evidence to have believed that such quantities existed at that time.

Example

If producer X has capitalized costs on property A of $40,000, originally consisting of the lease bonus, capitalized exploration costs, and some capitalized carrying costs, and the lease has been producing for several years and during this time, X has claimed $10,000 of allowable depletion. In 2009, X's share of production sold was 40,000 barrels and an engineer's report indicated that 160,000 barrels could be recovered after December 31, 2009. The calculation of cost depletion for this lease would be as follows: :Cost depletion = S/(R+S) × AB or AB/(R+S) × S :CD = 40,000/(40,000 + 160,000) × ($40,000 − $10,000) : = 40,000/200,000 × $30,000 : = $6,000

References

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