Additionally, both sets of standards require that the cost of the asset be recognized over the economic, useful, or legal life of the asset through an allocation process such as depreciation. However, there are some significant differences in how the allocation process is used as well as how the assets are carried on the balance sheet. It is important to note, however, that not all long-term assets are depreciated. For example, land is not depreciated because depreciation is the allocating of the expense of an asset over its useful life. It is assumed that land has an unlimited useful life; therefore, it is not depreciated, and it remains on the books at historical cost. Depletion is an accounting method that allows individuals or companies to reflect the declining value of a natural resource over time.
Write-Off of Resource Cost
Book value is the amount of the asset that has not been allocated to expense through depreciation. 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.
Fundamentals of Depletion of Natural Resources
Accumulated depreciation is a contra account, meaning it is attached to another account and is used to offset the main account balance that records the total depreciation expense for a fixed asset over its life. In this case, the asset account stays recorded at the historical value but is offset on the balance sheet by accumulated depreciation. Accumulated depreciation is subtracted from the historical cost of the asset on the balance sheet to show the asset at book value.
Managing depletion expenses
- The estimated amount of a natural resource that can be recovered will change constantly as assets are gradually extracted from a property.
- 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.
- The amount included in the depletion base is the fair value of the obligation to restore the property after extraction.
- We consider three of the most popular options, the straight-line method, the units-of-production method, and the double-declining-balance method.
- There are a number of different methods that can be used to account for depletion.
- The units-of-production depreciation method bases depreciation on the actual usage of the asset, which is more appropriate when an asset’s life is a function of usage instead of time.
In this case, a new remaining depreciation expense would be calculated based on the remaining depreciable base and estimated remaining economic life. Accountants need to analyze depreciation of an asset over the entire useful life of the asset. As an asset supports the cash flow of the organization, expensing its cost needs to be allocated, not just recorded as an arbitrary calculation.
As natural resources are extracted, they are counted and taken out from the property’s basis. The percentage depletion method gives a fixed percentage of the gross income obtained from a natural resource. It aims to help a company recoup its investment costs in a natural resource. If a company has $5 million in gross income from a resource and wants to use a 15% depletion rate over a given period, its depletion deduction would amount to $750,000 million. The company can calculate the depletion expense with the formula of using the total cost to deduct the salvage value and dividing the result with the total estimated units in the resource to get the cost per unit.
Choosing Appropriate Depreciation Methods
It follows the same process used in Depreciation, which is an accounting technique used to allocate the cost of tangible assets over their useful lives. Cost depletion allocates the costs of extracting natural resources and those costs are recorded as operating expenses to lower pre-tax income. When using the cost depletion method, the client estimates the total quantity of the resource, calculates the cost per unit of the resource, and then multiplies the cost per unit by the number of units sold in a particular period.
Instead, they use separate depreciation charges to allocate the costs of such equipment. ExxonMobil pays the acquisition cost to obtain the property right to search and find an undiscovered natural resource. See Form 10-K that was filed with the SEC to determine which depreciation method McDonald’s Corporation used for its long-term assets in 2017. 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.
As a substitute, the SEC argued in favor of a yet-to-be-developed method, reserve recognition accounting (RRA), which it believed would provide more useful information. Under RRA, as soon as a company discovers oil, it reports the value of the oil on the balance sheet and in the income statement. The cost per unit is then multiplied by the number of units extracted to compute depletion. In the oil and gas industry, where the costs of finding the resource are high, and the risks of finding the resource are very uncertain, most large companies expense these costs. Unlike plants and equipment, natural resources are consumed physically over the period of use and do not maintain their physical characteristics. Depreciation records an expense for the value of an asset consumed and removes that portion of the asset from the balance sheet.
Suppose your company owns a single building that you bought for $1,000,000. Under US GAAP, this is how this building would appear in the balance sheet. Even if the fair value of the building is $875,000, the building would still appear on the balance sheet at its depreciated historical cost of $800,000 under US GAAP. Alternatively, if the company used IFRS and elected to carry real estate on the balance which method should be used to calculate depletion for a natural resource company? sheet at fair value, the building would appear on the company’s balance sheet at its new fair value of $875,000. Recall that determination of the costs to be depreciated requires including all costs that prepare the asset for use by the company. He estimates that he can use this machine for five years or 100,000 presses, and that the machine will only be worth $1,000 at the end of its life.
The tax implications of depletion depend on the country in which the natural resources are located. In some countries, depletion is treated as a deductible expense for tax purposes. In other countries, depletion may be subject to special taxes or royalties. In situations where the consumption of the usefulness of these assets parallels the production of the resource, they may be amortized and depreciated using the units of production approach.
For example, a company like ExxonMobil makes sizable expenditures to find natural resources, and for every successful discovery, there are many failures. Assume in the earlier Kenzie example that after five years and $48,000 in accumulated depreciation, the company estimated that it could use the asset for two more years, at which point the salvage value would be $0. The company would be able to take an additional $10,000 in depreciation over the extended two-year period, or $5,000 a year, using the straight-line method. At the start of the year 2, a new survey is conducted and it is found that the expected extraction of minerals is only 160,000 tons (i.e.,40,000 tons less then the original estimate). The company decided to workout a new depletion rate on the basis of information provided by revised survey.