Assets are categorized as fixed when they are utilized in the business over a long period of time to generate long term benefits and revenues for the entity. Fixed assets are capitalized in the books of accounts as their benefits are expected to accrue beyond a single accounting period. The matching principle of accounts requires that expenses should be recorded in the books in the same period in which their related revenues are recognized. Accordingly, certain proportion of the costs of the fixed assets are required to be expensed out in each accounting period. This can be done through a number of methods like depreciation, depletion or amortization depending on the nature of the fixed asset.
This article looks at meaning of and differences between two of these terms – depreciation and depletion.
Definitions and meanings
Depreciation is the periodic allocation of the cost of a tangible fixed asset over its useful life. Every tangible fixed asset has a specific useful life over which its related benefits accrue. For example, a plant manufacturing paper may be expected to have a useful life of 25 years. Thus, in accordance with the ‘matching’ principle of accounts, the cost of the asset ought to be allocated over its useful life. This periodic charge is calculated and charged as an expense to the profit and loss account each year as ‘depreciation’.
Apart from adherence to the matching principle, depreciation is accounted for as it represents a reduction in the value of the fixed asset which can occur for the following reasons:
- Wear and tear due to use
- Obsolescence due to introduction of newer and better technologies
- Exhaustion of productive capacity of the asset
There are primarily three methods for calculating depreciation:
1. Straight line method:
In this method, a constant charge of depreciation is made to the profit and loss account each year. The formula for calculating depreciation under this method is based on the useful life of the asset:
Annual charge of depreciation = (Cost of asset – Salvage value)/Estimated useful life
2. Units of production method:
In this method, depreciation is charged on the basis of production each year. The formula is
Annual charge of Depreciation = [(Cost of asset – Salvage value)/Production capacity in units] × No. of units produced
This method is suitable for assets whose value is directly linked to its production capacity.
3. Reducing balance method:
In this method, depreciation is charged on a % basis, with a higher charge being made in the initial years, subsequently reducing each year. The % of depreciation to be charged is calculated on the basis of its estimated life and the annual charge is calculated as:
Annual charge of Depreciation = (Cost of asset – Accumulated depreciation) × Percentage rate of depreciation
*Residual value is the cost of the asset less accumulated depreciation of each year
M/s ABC manufactures tyres, its plant has an estimated life of 10 years with no salvage value. The plant was purchased for $1,00,000. Under straight line method, an annual depreciation charge of $10,000 would thus be made each year for 10 years. The journal entry to be passed in the books is:
Depreciation a/c…..10,000 [Dr]
Accumulated depreciation a/c….. 10,000 [Cr]
(Being annual depreciation on plant charged to profit and loss account)
The depreciation is debited to the profit and loss account as an expense and accumulated depreciation is reported as reduction from the value of the fixed asset in the balance sheet.
Depletion is the allocation of the cost of acquiring natural resources over its estimated useful life. Several entities are engaged in the extraction of natural resources such as coal mines, oil reserves, mineral reserves etc. This requires incurrence of costs such as cost of acquiring rights in the resource, cost of preparing the resource for extraction etc. Extraction from natural resources are expected to give benefits over several years and thus these costs are initially capitalized. The capitalized cost is subsequently allocated as expense as and when the resources are extracted and utilized. This periodic charge to the profit and loss of the cost of the natural resource is termed as depletion.
Natural resources, especially non-renewable resources are likely to have a limited output capability – for e.g. a coal mine can be expected to have an output capacity of a specific tonnage which would keep depleting with each extraction. Depletion thus occurs due to the exhaustion of supply of the specific natural resource.
The formula for calculating depletion is:
Annual depletion charge = (Total capitalized cost of resource less salvage value/Total extraction capacity in units) × No. of units extracted each year
There may be instances, where the acquisition of the resource requires a restoration cost at the end of its useful life. For example, in case of extraction of timber from a forest, the entity might be required to restore the forest’s plantation which may involve an additional cost. In such cases the formula for depletion would be modified to include this restoration cost.
The accounting entry for depletion is similar to that of depreciation, with a charge to profit and loss account and accumulation in accumulated depletion account.
Difference between depreciation and depletion
Some key points of difference between depreciation and depletion have been detailed below:
- Depreciation is the periodic charge of the capitalized cost of a tangible fixed asset over its estimated useful life.
- Depletion is the allocation of the total cost of acquiring natural resources for exploitation over its useful life.
2. Asset applicability
- Depreciation is charged on any fixed tangible asset such as plant and machinery, furniture and fittings, office equipment, computers etc.
- Depletion is applicable only to wasting assets, namely natural resources such as oil reserves, coal mines, mineral reserves, timber forests etc.
3. Industry applicability
- Depreciation has a wide scope as it applies across industries – namely to any entity that employs fixed assets.
- Depletion has limited scope as it is applicable only to entities engaged in the mining of natural resources.
- Depreciation can occur due to several reasons such as wear and tear in use, obsolescence due to new technology or exhaustion of productive capacity.
- Depletion occurs due to only one reason – exhaustion of supply of the natural resource.
5. Base for calculation
- The base for calculation of depreciation is its estimated useful life or its estimated production capacity.
- The base for calculation of depletion is the estimated number of units of the natural resource that can be extracted.
6. Restoration cost
- Calculation of depreciation does not include consideration of any restoration cost.
- Where a restoration cost is involved, it must be considered while calculating depletion charge for the period
7. Calculation of estimated life
- The calculation of estimated life in case of depreciable assets is simpler and is based on several documents such as production engineer’s certification, manufacturers’ certification, internal assessments etc.
- The calculation of estimated life of wasting assets for depletion is more complex and is done on the basis of extensive survey of the capacity of the natural resource.
- Depreciation can be calculated on straight line, units of production or reducing balance methods.
- Depletion is calculated primarily on one method which is based on the resource’s extraction capacity.
Conclusion – depreciation vs depletion:
Both depreciation and depletion are cost allocations and thus non-cash expenses as they do not impact the cash flow of the entity. These allocations however impact both the profitability and the balance sheet position of the entity. Thus, appropriate calculation and accounting of depreciation and depletion is essential so that the financial statements prepared reflect the true and fair view of the entity’s financial position.