Causes, Effects And Solution Of Depletion Of Natural Resources

People are clearing forests primarily for agricultural reasons due to the increase in the population pressure. Some farming practices such as excessive use of pesticides, fungicides, and herbicides equally kill important soil micro-organisms that are essential in replenishing nutrients in the soil.

However, special rules apply when the predominant property is hydrocarbon gas. Another point to remember is that the depletion deduction under the percentage depletion method cannot exceed 100 percent of the taxable income from the property computed without the deduction for depletion. The depletion allowance is claimed either on a cost-per-unit basis or as a percentage of gross income from the disposal of the resource. I.R.C. §611.Cost depletion allocates to each unit of production a pro rata portion of the original cost or investment in the resource. Many companies use what’s known as depreciation for tax and accounting purposes. Depreciation is a method of allocating the cost of an asset over the course of its useful life.

How Oil Cos Treat Reserves On A Balance Sheet

To record depletion, debit a Depletion account and credit an Accumulated Depletion account, which is a contra account to the natural resource asset account. To calculate the depletion per unit you take the total cost less salvage value and divide it by the total number of estimated units. The expense is calculated by multiplying the depletion per unit by the number of units consumed or sold during the current period. Depletion is an accounting and tax concept used most often in mining, timber, petroleum, or other similar industries. “The depletion deduction” allows an owner or operator to account for the reduction of a product’s reserves.

Straight line basis is the simplest method of calculating depreciation and amortization, the process of expensing an asset over a specific period. 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. Accrual accountingpermits 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. Percentage depletion is a federal tax deduction for depreciation related to the business of extracting nonrenewable resources from the earth. Amortization is an accounting term that refers to the process of allocating the cost of an intangible asset over a period of time.

What Is Depletion Time?

It’s calculated by taking the total quantity of a natural resource available to a company and assigning a proportionate amount of that total to the amount consumed over a given accounting period. Depletion is the movement of the cost of natural resources from a company’s balance sheet to its income statements. The objective is to match on the income statement the cost of the natural resources that were sold with the revenues of the natural resources that were sold. The cost of the natural resources sold is referred to as depletion expense. 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. Like depreciation and amortization, depletion is a non-cash expense that 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. Still, there is a consistent increase in the overall earth populace and this has been a critical factor in accelerating the depletion of natural resources. An increase in the populace expands the need for resources and conditions necessary to sustain it. In some parts of the country, the IRS permits a depletion allowance for water deposits in an aquifer beneath the surface. In these areas, the water is being pumped at a level exceeding the recharge rate for the underlying aquifer. The IRS permits a depletion allowance on water in these areas where it can be shown that the rate of recharge in the underlying aquifer is extremely low. In 1965, the Fifth Circuit Court of Appeals held that groundwater in the Ogallala formation in the Southern High Plains of Texas and New Mexico was a depletable mineral and natural deposit.

The reason is that cash was expended during the acquisition of the underlying fixed asset; there is no further need to expend cash as part of the depreciation process, unless it is expended to upgrade the asset. The land asset is not depreciated, because it is considered to have an infinite useful life. Further, due to the scarcity of land, its value tends to increase over time, as opposed to the decline in value of most other types of fixed assets. Studies by the United States Geological Survey also indicate that there is an increase in non-renewable resources consumption of natural minerals and construction materials such as copper, sand, gravel, and stone. There has been an increase in the exploitation of minerals such as phosphorus, gasoline, copper, and zinc among others to sustain the seven billion people on earth. Studies by Global Phosphorus Research Institute, for example, shows that the earth could run out of phosphorus – an essential element for plant growth, in the next 50 to 100 years.

Depletion

For instance, we can’t measure how many barrels of oil are underground. Amortization is an accounting technique used to periodically lower the book value of a loan or intangible asset over a set period of time. Since the asset is part of normal business operations, depreciation is considered an operating expense.

In tax “lingo” it’s a deductible allowance for the exhaustion of mineral deposits, timber and other natural resources. If a taxpayer has an economic interest in the resource, the cost of the diminishing resource can be recovered through the depletion allowance.

Accounting Topics

Wetlands are regions saturated with groundwater that serve a significant role in sustaining vegetation cover. The coastal and wetland ecosystems are thus vital in sustaining the food chain as they replenish water sources and avail minerals and nutrients for primary producers , essential for maintaining plant and animal biodiversity. Also when coastal ecosystems are protected, they aid in controlling marine overfishing and protect coral reefs. Income taxes and their accounting is a key area of corporate finance. There are several objectives in accounting for income taxes and optimizing a company’s valuation. Now, we use the $1.00 expense per unit as the basis of our total expense calculation. Let’s assume that the lumber company cuts down 8,500 trees this year.

Depletion is a form of depreciation for mineral resources that allows for a deduction from taxable income to reflect the declining production of reserves over time. For oil and natural gas producers, percentage depletion is a small producer issue. The taxpayer has the choice of using the higher of cost depletion or percentage depletion and may make the choice each year.

How To Use Depletion In A Sentence

Depletion can be calculated on a cost or percentage basis, and businesses generally must use whichever provides the larger deduction for tax purposes. The second method of calculating depletion is thecost depletion method. Cost depletion is calculated by taking the property’s basis, total recoverable reserves and number of units sold into account.

The main purpose of creating awareness would be to encourage people to preserve and restore the natural environment by getting involved in conservation efforts. A resource that is rare on earth due to depletion has a higher value than a natural resource which is in abundance.

Percentage Depletion Method

Actions like Deforestation remove more than enough trees from their environments that topsoil can be eroded, making the area unsuitable for plants and animals. Another example of how resource depletion occurs is through overfishing, limiting the species’ ability to repopulate each year because the population is reduced due to unsustainable fishing practices. Chevron Corp. 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. 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 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. Programs aimed at checking against deforestation such as REDD created by the World Bank, the New York Declaration on Forests, and the United Nations are initiatives that could help reduce the depletion of natural resources. 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. In each accounting period, the depletion recognized is an estimate of the cost of the natural resource that was removed from its natural setting during the period.

How Is Oil Depletion Allowance Calculated?

It would record depletion expense of $8,500 (8,500 trees x $1 per unit) for the year. Capitalization is an accounting method in which a cost is included in the value of an asset and expensed over the useful life of that asset. The percentage depletion method requires a lot of estimates and is, therefore, not a heavily relied upon or accepted method of depletion. The time it takes to use up about 80% of the mineral reserves at a given rate. Other devastating effects of deforestation include soil erosion, an increase in the greenhouse gases leading to global warming, loss of biodiversity, increased flooding, and drought.

• Investopedia requires writers to use primary sources to support their work.
• For example, the exact tax structure is not important; the tax may be a percentage tax or a lump-sum tax.
• Let’s assume that the lumber company cuts down 8,500 trees this year.
• For example, let’s say a company discovers that an oil well will produce 400,000 barrels of oil, spends $200,000 to extract that oil, and removes 50,000 barrels over the course of a year.
• Depletion can be calculated on a cost or percentage basis, and businesses generally must use whichever provides the larger deduction for tax purposes.
• Depreciation is a method of allocating the cost of an asset over the course of its useful life.

That means that the taxpayer will have to indicate how the depletion was computed. The taxpayer should complete Form T to show the depletion computation. For example, let’s say a company discovers that an oil well will produce 400,000 barrels of oil, spends $200,000 to extract that oil, and removes 50,000 barrels over the course of a year.

What Is The Depletion Of Natural Resources?

Cost depletion is one of two accounting methods used to allocate the costs of extracting natural resources, such as timber, minerals, and oil, and to record those costs as operating expenses to reduce pretax income. It’s a method for allocating extraction costs, charged as an expense. The goal of percentage depletion is to help a company recover its investment costs of obtaining the property that supplies the natural resources from which it makes money. If a company’s gross income is $5 million and the fixed percentage of the resource consumed is 15% for a given period, its depletion deduction under this method is $750,000. 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.

The depletion deduction it can claim for that period is $25,000 ($200,000 x 50,000/400,000). Activities such as logging and mining deplete our natural resources. Therefore, if Company ABC generates $10 million in revenue, and the percentage depletion is 2%, then it can assume that $200,000 of that revenue is a result of resource depletion. For our example, the rate would depend on various oil industry factors.

Non-cash charges are expenses unaccompanied by a cash outflow that can be found in a company’s income statement. Approximately 18 million acres of forest cover are destroyed annually. This means that half of the world’s natural forest cover has already been cleared. Furthermore, studies indicate an increase in deforestation in the past three decades has resulted in a 12% to 17% rise in greenhouse gases globally. Because the rules of depletion are quite complex, most companies rely heavily on accounting professionals to implement it for tax and reporting purposes. It also underscores groundwater depletion as a risk to both national and global food markets.

The general formula for cost depletion substitutes future investment for the initial investment. In the example above, suppose that at the end of the first year, a new company looking to extract oil from Company ABC’s oil well would need to make an initial investment of $80,000.

Proven reserves are the best estimate of oil that will be extracted from a formation given the current technology, economic evaluation, and available data. David Kindness is a Certified Public Accountant and an expert in the fields of financial accounting, corporate and individual tax planning and preparation, and investing and retirement planning. David has helped thousands of clients improve their accounting and financial systems, create budgets, and minimize their taxes. Oil is an essential commodity in manufacturing, planting, mining, and transportation among many activities, and its depletion would be devastating. The adverse effects of oil depletion include the fall of the business, the high cost of living in developing countries, and uncertainty in the transport sector. Millions of different animal and plant species have thus lost their natural habitats and are on the verge of extinction.