Generally, natural resource acquisition costs are recorded in an Undeveloped Property account. ExxonMobil later assigns that cost to the natural resource if exploration efforts are successful. If the efforts are unsuccessful, it writes off the acquisition cost as a loss. Notice that in year four, the remaining book value of $12,528 was not multiplied by 40%. Since the asset has been depreciated to its salvage value at the end of year four, no depreciation can be taken in year five. The journal entry to record the purchase of a fixed asset (assuming that a note payable is used for financing and not a short-term account payable) is shown here.
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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. Probably one of the most significant differences between IFRS and US GAAP affects long-lived assets. This is the ability, under IFRS, to adjust the value of those assets to their fair value as of the balance sheet date. The adjustment to fair value is to be done by “class” of asset, such as real estate, for example. Under US GAAP, almost all long-lived assets are carried on the balance sheet at their depreciated historical cost, regardless of how the actual fair value of the asset changes.
Accounting for Depreciation
Pensive’s geologists estimate that the proven oil reserves that are accessed by the well are 400,000 barrels, so the unit depletion charge will be $1.50 per barrel of oil extracted ($600,000 depletion base / 400,000 barrels). Depletion is the reduction in the amount of a natural resource, such as minerals or timber. From an accounting perspective, it is a charge against the recorded asset value of a natural resource. This charge is made in each reporting period, in an amount that reflects the level of asset usage during the period.
Estimating Useful Life and Salvage Value
We may earn a commission when you click on a link or make a purchase through the links on our site. All of our content is based on objective analysis, and the opinions are our own. While AI has evolved dramatically in recent months, the impact of technology on the accounting profession is nothing new. Companies needed an estimate for each of these to arrive at an accurate valuation of existing reserves.
How to calculate depletion expense
Those who hold the full-cost concept argue that the cost of drilling a dry hole is a cost needed to find commercially profitable wells. Others believe that companies should capitalize only on the costs of successful projects. This approach has many merits because the required estimates are so uncertain.
- A client can claim depletion if they have an economic interest in standing timber or mineral property, as explained by the IRS.
- 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.
- For example, this method could account for depreciation of a printing press for which the depreciable base is $48,000 (as in the straight-line method), but now the number of pages the press prints is important.
- For example, if we buy a delivery truck to use for the next five years, we would allocate the cost and record depreciation expense across the entire five-year period.
What Is Depreciation, Depletion, and Amortization (DD&A)?
At the end of the second year, there is still a depletion base of $321,200 that must be charged to expense in proportion to the amount of any remaining extractions. Depletion is an accrual accounting technique used to allocate the cost of extracting natural resources such as timber, minerals, and oil from the earth. However, over the depreciable life of the asset, the total depreciation expense taken will be the same, no matter which method the entity chooses.
Each year, the accumulated depreciation balance increases by $9,600, and the press’s book value decreases by the same $9,600. At the end of five years, the asset will have a book value of $10,000, which is calculated by subtracting the accumulated depreciation of $48,000 (5 × $9,600) from the cost of $58,000. The extraction of a large number of natural resources happens from beneath the ground for various purposes. Scientifically, the quantum of resources below the earth’s surface is not possible before their extraction. This aspect has made accounting authorities conclude that natural resources should be recapitalized at cost initially.
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. For example, if a large piece of machinery or property requires a large cash outlay, it can be expensed over its usable life, rather than in the individual period during which the cash outlay occurred.
These expenditures may relate to legal, environmental, and laboratory studies, as well as tangible property such as buildings and processing equipment. Highlights of the similarities and differences between accounting depreciation and tax depreciation. Be aware that, “A contractual relationship that allows [a client] an economic or monetary advantage from products of the mineral deposit or standing timber is not, in itself, an economic interest,” the IRS stated. For related information, read about how to account for depletion and other non-cash charges. Estimating the future selling price, appropriate discount rate and future extraction and delivery costs of reserves that are years away from realization can be a formidable task.
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. It is important to note that the depletion expense should be recorded in the period that the extracted natural resource (e.g. coal) is sold. The unsold part of the extracted natural resource should which method should be used to calculate depletion for a natural resource company? be recorded as inventory. Once the company establishes the depletion base, the next problem is determining how to allocate the cost of the natural resource to accounting periods. As a general rule, investors have to use the method that provides the largest deduction. But unless you’re an independent producer or royalty owner, the IRS says you usually can’t use the percentage depletion method for oil and gas wells.
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