Natural Resources and Depletion: Videos & Practice Problems

Natural resources are long-term assets that deplete as they are extracted, similar to depreciation. Examples include oil, minerals, and forests. The depletion expense is calculated using the Units of Production Method, where the cost per unit is determined by dividing the total cost by the estimated total units. For instance, if an oil reserve costs $50,000,000 and contains 10,000,000 barrels, the depletion expense for extracting 2,500,000 barrels would be $12,500,000. This amount reduces the net book value of the asset, which is calculated as the original cost minus accumulated depletion.

Natural Resources and Depletion

Natural resources represent a unique category of long-term assets that deplete as they are extracted, similar to how depreciation applies to fixed assets. Examples of natural resources include minerals like iron ore and gold, oil deposits, and forests used for lumber. As these resources are utilized, they incur a depletion expense, which is analogous to depreciation but calculated based on the units of production method.

The units of production method focuses on the quantity of the resource rather than a time period. For instance, if a company purchases an oil reserve for \$50,000,000, which contains an estimated 10,000,000 barrels of oil, the initial accounting entry would involve debiting the natural resources asset account for the purchase price and crediting cash for the same amount. This establishes the net book value of the oil reserve at \$50,000,000 until extraction begins.

When the company extracts oil, the depletion expense is calculated based on the cost per unit. In this case, the cost per barrel is determined by dividing the total cost of the oil reserve by the total estimated barrels:

Cost per barrel = \(\frac{50,000,000}{10,000,000} = 5\) dollars per barrel.

If the company extracts 2,500,000 barrels in the first year, the depletion expense would be:

Depletion Expense = \(2,500,000 \times 5 = 12,500,000\) dollars.

To record this depletion, the company can use the accumulated depletion method, debiting depletion expense and crediting accumulated depletion for \$12,500,000. This method is similar to how accumulated depreciation is recorded for fixed assets. Alternatively, the inventory method can be used, where the extracted amount is debited to inventory instead of depletion expense, reflecting that the resource is still an asset until sold.

Regardless of the method chosen, the net book value of the oil reserve will decrease as depletion occurs. After the first year of extraction, the net book value would be calculated as follows:

Net Book Value = Initial Cost - Accumulated Depletion = \(50,000,000 - 12,500,000 = 37,500,000\) dollars.

As extraction continues, the net book value will keep decreasing, reflecting the ongoing depletion of the natural resource. Understanding these concepts is crucial for accurately accounting for natural resources and their impact on financial statements.

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?

• A. \$0
• B. \$475,200
• C. \$528,000
• D. \$594,000

Answer: (C)

Here’s what students ask on this topic:

What are natural resources in financial accounting?

In financial accounting, natural resources are long-term assets that deplete as they are extracted. Examples include oil reserves, mineral deposits, and forests. These resources are recorded on the balance sheet and are subject to depletion, similar to how fixed assets are subject to depreciation. The depletion expense is calculated using the Units of Production Method, which allocates the cost of the resource over the estimated total units that can be extracted. This method ensures that the expense matches the revenue generated from the resource extraction.

How is depletion expense calculated for natural resources?

Depletion expense for natural resources is calculated using the Units of Production Method. First, determine the total cost of the resource and the estimated total units available for extraction. The cost per unit is calculated by dividing the total cost by the estimated total units. For example, if an oil reserve costs \$50,000,000 and contains 10,000,000 barrels, the cost per barrel is \$5. The depletion expense is then calculated by multiplying the cost per unit by the number of units extracted. If 2,500,000 barrels are extracted, the depletion expense would be \$12,500,000.

What is the difference between depletion and depreciation?

Depletion and depreciation are both methods of allocating the cost of long-term assets over their useful lives. The key difference is that depletion applies to natural resources that deplete as they are extracted, such as oil, minerals, and forests. Depreciation, on the other hand, applies to tangible fixed assets like buildings and machinery. Depletion is typically calculated using the Units of Production Method, while depreciation can be calculated using various methods such as straight-line, declining balance, or units of production.

What is the Units of Production Method in accounting?

The Units of Production Method is a way to allocate the cost of a long-term asset based on its usage or output. This method is commonly used for both depreciation and depletion. To calculate the expense, divide the total cost of the asset by its estimated total units of production or extraction. This gives the cost per unit. Multiply the cost per unit by the number of units produced or extracted during the period to determine the expense. This method ensures that the expense matches the revenue generated from the asset's use.

How do you record depletion expense in journal entries?

To record depletion expense in journal entries, you typically use the accumulated depletion method. First, calculate the depletion expense for the period. Then, debit the Depletion Expense account and credit the Accumulated Depletion account. For example, if the depletion expense is \$12,500,000, the journal entry would be:
Debit: Depletion Expense \$12,500,000
Credit: Accumulated Depletion \$12,500,000. This entry reduces the net book value of the natural resource on the balance sheet and records the expense on the income statement.