Decoding Depreciation and Depletion Before Investing

November 18, 20236 min read
Decoding Depreciation and Depletion Before Investing
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Key Takeaways

  • Depreciation is used in accounting to spread a physical asset’s cost over its useful life. 
  • Depletion in accounting permits investors to notate a natural resource’s value as it is harvested or extracted.
  • Understanding the concepts of depletion and depreciation can help investors determine companies’ value as well as likely future earnings prospects.

Understanding the accounting concepts “depreciation” and “depletion” can help investors assess a company’s earnings and asset value. In turn, this can help with investment decisions.

Here is all about decoding depreciation and depletion before investing.

Why Focus on Depreciation and Depletion?

In evaluating a company’s financial health, depreciation and depletion can play an important role. 

Depreciation impacts a company’s reported asset values and earnings. Depletion helps establish the value of assets on a company’s balance sheet in a certain period. It also helps with the recording of income-statement costs.  In investment analysis, such reports can influence investment decisions.

Below is an exploration of depletion vs. depreciation.

Understanding Depreciation 

Depreciation is used in accounting to spread a physical asset’s cost over its useful life. It represents the extent to which an asset’s value has been exhausted in any given period. During this period, the company can write off the asset’s value. Such assets commonly include equipment, machinery, or plants, which are expensive.

Companies regularly exercise depreciation so that they can shift asset costs from their balance sheets to their income statements. They can use a number of methods, including straight-line and accelerated.

New assets are usually more valuable than older ones. Depreciation evaluates the loss of asset value over time. Such loss can be due to normal wear and tear as well as inflation and new product models.

Writing off just part of the cost annually permits investors to report more net income in the purchase year. Such income exceeds what they would report otherwise.

There are common depreciation rates for various assets. For example, the rate for asset classes plants and machinery ranges from 15% to 45%, depending on the asset type. Such types can include cars, motorcycles, computers, or even books.

Now, what is depletion? Keep reading.

Exploring Depletion 

What is depletion? It is an accrual accounting practice used to allocate the expense of extracting natural resources from the earth. Such resources commonly include oil, minerals, and timber.

Depletion is meant to help accurately identify assets’ value on the balance sheet and record expenses in the proper period on the income statement.

Determining which expenses must be spread out for the use of natural resources requires calculation. In turn, that requires consideration of each different production phase. There are primary factors that affect the depletion base, which are the capitalized costs depleted across accounting periods. Those factors include expenses related to acquisition of property rights and exploration, and land development and restoration.

When it comes to depletion vs. depreciation, both are non-cash expenses that reduce an asset’s cost value incrementally. Depletion, though, refers to the exhaustion of natural resources over time. By contrast, depreciation refers to the wearing out of depreciable assets.

Depletion and Depreciation in Accounting

At the close of an accounting period, depreciation is booked for all capitalized assets that are not yet wholly depreciated. The accountant enters a debit to depreciation cost, which streams through to the income statement. They also enter a credit to accumulated depreciation, which goes on the balance sheet.

Because it does not represent a cash outflow, depreciation is considered a non-cash charge. While an asset might be paid in full when purchased, the expense is booked in increments. That is because assets benefit the company over a protracted period. However, the depreciation charges still lower a company’s earnings, which helps the company tax-wise.

In depletion, costs linked to natural resource extraction are capitalized. When that occurs, the expenses are allocated systematically based on the resources extracted, across different periods. Until expense recognition occurs, the costs are held on the balance sheet.

When conducting financial analysis, investors can use what these companies report on their financial statements to assess their financial conditions. They can also use a company’s dividend payout ratio to learn how much money it returns to shareholders. That can be found on financial statements as well. Depletion also permits investors to notate a natural resource’s value as it is harvested or extracted.  

Making Informed Investment Decisions 

Depletion vs. depreciation. While the accounting concepts are different, they both can be used in making investment decisions. Understanding the terms can help investors determine companies’ value as well as future earnings prospects. This can help them decide where to invest their capital.

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In Summary

When looking at depreciation vs. depletion, their differences stand out. However, they are both widely used in financial reporting, and can be used to make more strategic investments. After all, the two concepts are essential in assessing a company’s financial health.

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