Financial Accounting

Learn the toughest concepts covered in your Financial Accounting class with step-by-step video tutorials and practice problems.

8. Long Lived Assets

Natural Resources and Depletion



Natural Resources and Depletion

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Alright, let's talk about another kind of long term asset, natural resources. So natural resources, this is going to be a special category of our long term assets and this is going to be for long term assets that deplete as they are extracted. Okay, so this is gonna be similar, we're gonna be dealing with this in a similar way than we did with depreciation. Um but let's consider some examples of what natural resources are, right? So natural resources, think of a company that extracts iron or out of a mountain right there, pulling iron out of a mountain or deposits of gold or some kind of mineral right? Or oil, right? They might buy oil oil deposits and pull them out of the ground. And how about forests? That's another good example of a natural resource. So they might buy a whole forest and start chopping down all the trees to make lumber products. Right? So you think about it, this oil deposit or this forest as you keep chopping down those trees in the forest? Well, it's gonna start to deplete, right? There's gonna be less and less of this forest left. So you you're gonna have what we call depletion expense. And this is very similar to depreciation. Now, the depreciation method that it's similar to here is the units of production method. Okay, so we studied the units of production method in another video and that's where instead of thinking about a time period, like, oh, this is gonna last us a certain amount of years? Well, it's going to last us a certain amount of units, Right, So maybe the unit is, how many trees are there in the forest that we're going to cut down? Or how many barrels of oil are there in this deposit? Right. So it's gonna be very similar to that. You'll see once we start doing the depletion expense entries and we're going to use an accumulated depletion account in a very similar way to accumulated depreciation. Right? So the first entry when we're dealing with natural resources. Well that's when we're gonna purchase it, right? We're gonna purchase whatever natural resources is, what we're gonna purchase the forest, we're going to purchase the oil deposit. So let's check it out, greenhouse gasses, greenhouse gasses, purchase an oil reserve for $50 million and estimated that the reserve contained 10 million barrels of oil. Alright, so the first entry, Well this is just like when we purchase any fixed asset, right? We want to include the purchase price plus any costs that get it ready for use right in this case. And in most cases they're just gonna give you a number, right? They'll say we bought it for this amount and that's what we've got going on right here. Right? So we purchased an oil reserve what we got an oil reserve. So we're going to debit maybe something like oil reserve or debit natural resources uh whatever it is, it's going to be some asset account that holds the oil reserve value, right? And we paid 50 million for it. So that's gonna be the value on the books. 50 million. And the credit in this transaction. Well, we're gonna say we paid for it with cash here. Right? So greenhouse gasses buys it with cash and they're going to credit it off their books. So they no longer have the cash. So this is a very simple entry, very similar to what we're used to. Right? We see our our assets going up by 50 million And then also down by 50 million. So it's really just an exchange of assets here, right? Because we paid with cash but we got another asset oil reserves. So at this point we're going to talk about netbook value. Just we talked about netbook value with um fixed assets like uh equipment or buildings. They had a netbook value. Right? And that was the cost, what we paid for, it minus any accumulated depreciation. Well, this is gonna be the same except it's gonna be cost minus accumulated depletion. Right? So at this point, well, the netbook value of the oil reserve is going to be the 50 million, right? We haven't extracted any of the oil out of the ground. We've got the whole net book value there. Okay, So let's move on to the next entry. And that's where we start using up the natural resource. Right? So as we use up the natural resource. Well, we gotta lower that net book value and will generally make an entry like this. There's actually two ways that you might see this done. The most common is to use the accumulated depletion account and that's how I learned it back in school. But there's other ways that are a little more complicated, but I'll show you here. It's not really that crazy. So let's go ahead and let's let's first do the accumulated depletion method. So we'll do that over here on this side, accumulated depletion and then I'll show you the other method and I'll call it the inventory method over here. Okay, so the first thing we want to do during the first year greenhouse gasses extracted 2.5 million barrels of oil from its reserve. So remember we have to remember how many total units there were. Remember when we did units of production, we wanted to know the useful life of that, let's say a machine. Oh, that machine is going to produce us 100,000 units. How much of that 100,000 units got used up this year? Well, it's the same thing here up in our first entry, it told us that there were 10 10 million barrels of oil estimated in this reserve. Right? So in the first year, well they went and they extracted 2.5 million barrels of oil. Right? So what we wanna do is we want to get a cost per barrel of oil and then the amount of it that we used up. So let's do that right here, in between the two. So cost per barrel, Let's do this equation right here. So remember, we paid 50 million. So our cost was 50 million. Generally with natural resources, there's not gonna be a salvage value. Um, we're not gonna have a salvage value. You know, you're just gonna deplete the whole thing and there's nothing left. So 50 million. And we divide by the total number of units, right? This is like the useful life of the of the natural resource. And they told us there's 10 million barrels. So 50 million divided by 10 million. Well, that comes out to $5 per barrel extracted. Right? So every time they extract a barrel, well, that's gonna be $5 of the depletion expense. So, what happened here? Well, they tell us 2.5 million barrels, so the 2.5 million barrels Times $5 per barrel. Well, what does this give us? It comes out to 12,500,000 barrels, right? 12,500,000 or not barrels dollars. Sorry, it was 2.5 million barrels but $12,500,000. And that's what we're gonna use in our entry. Right? So that's the amount that we've depleted from our 50 million dollar investment into this natural resource. So let's start here on the left. Remember I told you there's two ways that we generally see this. Let's start with the accumulated depletion method, which is the most common way that you would, you would make this entry. So just like we did with depreciation. Well, it's very similar. We're gonna have depletion expense notice here, its depletion expense rather than depreciation expense, and that's gonna be for the 12 million, 500,000 and the other side of our entry. Well, that's accumulated depletion, right? So this is very similar to what we've learned with, uh, fixed assets in general. Right? So that's actually pretty easy. And that's why these questions are actually really easy. They just want to make sure you learn this extra little concept that's a little different than a fixed asset, right? But it's pretty simple. The other way that they like to do this is with the inventory method. Sometimes you see that instead of using a depletion expense, what they'll do is they'll put the, the amount that they extracted. So think about it this way, they're gonna extract this out of the ground, but they're not just gonna extract it and be like, hey, I've got all this oil, I'm just gonna sit here and have all this oil. No, they're gonna eventually sell that oil to someone else, right? That's why they're in business. So what they're gonna do is what once they've extracted it, Well, they haven't sold it yet in this example, it's like they extracted it and they just have barrels of oil, they're willing, they're ready to sell, but they haven't sold it yet. So instead of debating depletion expense, what they're gonna debit is inventory. So maybe something like oil inventory could be the debit in this situation And that would be for the 12,500,000. Right? So now they have this inventory, that's what they extracted it at their price. And then they're gonna credit the accumulated depletion, right? Because they're still gonna be depleting And I'm gonna put accumulated depletion right there. And that's gonna be the credit for 12,500,000. Right? So it's very similar except now we have this inventory, we still have an asset because we're waiting to sell it. And then once we finally sell it, so I'll do here in blue once we finally sell it, let's say we sell it later. Well we would get our revenue with whatever price we sell it at, right? We'd get some cash and the revenue entry and then we would make an entry to get the inventory out of our books. And we would debit our cost of goods sold, right? Maybe cost of oil sold or something like that. We would debit that for the 12,500,000. Let's say we sold it all in one big go. And we would credit our inventory, our oil inventory To get it out of our books, right? So that's kind of the other way they do it. I would double check with your professor or in your textbook just to make sure which one they use, I would say that 99% of the textbooks are doing this over here. Just an accumulated depletion, very simple entry. And then I know that there's a few professors that love to add this little extra step just to trick you a little more, but you're not gonna be tricked. This isn't too crazy. Right? The biggest uh step here is to understand the units of production method. Right? So if you had a little bit of trouble with that, I'd say the most important thing is to go back to the units of production video and make sure you have that and you you master the units of production method. Alright, So let's go ahead and quickly, we'll fill this out for our accumulated depletion because this is usually how we're going to see this. So remember accumulated depletion, that's going to be a contra asset, just like accumulated depreciation. So since this is a credit accumulated depletion has a credit, Well, that's lowering our assets value. Right? And the depletion expense. Well, that's an expense going to the income statement and that's going to lower our equity, right? All of all of our expenses, lower our equity. And that would be for the 12.5 million as well. Right? So the netbook value. Remember we have netbook value, just like we do with our fixed assets. So our net book value here, we have the 50 million that we originally paid for, it -12.5 million that we extracted. Well, our net book value is gonna be 37,500,000 at this point. Right? And as we continue extracting more oil out of the ground over time, well, that netbook value is gonna keep decreasing of our asset. Cool. All right. Why don't we take a quick pause here and then you guys practice some depletion expense. Alright, let's do that now.

Colorado Mining Company purchased a 300,000-ton mineral deposit for a contract price of $594,000. Related to the purchase, CMC paid a $4,000 licensing fee with the State of Colorado and paid $62,000 for a geological survey of the mine. The company expects the mineral deposit to have no residual value. During the first year of production, CMC extracted and sold 60,000 tons of ore. What is the net book value of the mineral deposit at the end of the first year?