Depletion is the systematic write-off of the cost of natural resources. The units of activity method are generally used to compute depletion because periodic depletion is generally a function of the units extracted during the year.
Depletion: Learn Natural Resource Accounting
Natural Resource Accounting
Natural resources, often called wasting assets, include petroleum, minerals, and timber.
They have two main features;
- the complete removal (consumption) of the asset, and
- replacement of the asset only by an act of nature.
Unlike plants and equipment, natural resources are consumed physically over the period of use and do not maintain their physical characteristics.
Still, the accounting problems associated with natural resources are similar to those encountered with fixed assets. The questions to be answered are: –
- How do companies establish a cost basis for the write-off?
- What pattern of allocation should companies employ?
Recall that the accounting profession uses the term depletion to allocate the cost of natural resources.
Establishing a Depletion Base
How do we determine the depletion base for natural resources? For example, a company like ExxonMobil makes sizable expenditures to find natural resources, and for every successful discovery, there are many failures.
Furthermore, it encounters long delays between the time it incurs costs and the time it obtains the benefits from the extracted resources.
As a result, a company in the extractive industries, like ExxonMobil, frequently adopts a conservative policy in accounting for the expenditures related to finding and extracting natural resources.
Acquisition Costs
ExxonMobil pays the acquisition cost to obtain the property right to search and find an undiscovered natural resource. It also can be the price paid for an already-discovered resource.
A third type of acquisition cost can be lease payments for property containing a productive natural resource; these acquisition costs include royalty payments to the property owner.
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.
Exploration Costs
As soon as a company has the right to use the property, it often incurs exploration costs needed to find the resource. When exploration costs are substantial, some companies capitalize on the depletion base.
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.
Smaller oil and gas companies often capitalize on these exploration costs. We examine the unique oil and gas industry issues on pages.
Development Costs
Companies divide development costs into two parts;
- tangible equipment costs and
- intangible development costs.
Tangible equipment costs include all the transportation and other heavy equipment needed to extract the resource and prepare it for the market.
Because companies can move heavy equipment from one extracting site to another, companies do not normally include tangible equipment costs in the depletion base.
Instead, they use separate depreciation charges to allocate the costs of such equipment.
However, some tangible assets (e.g., a drilling rig foundation) cannot be moved. Companies depreciate these assets over their useful life or the life of the resource, whichever is shorter.
On the other hand, intangible development costs are such items as drilling costs, tunnels, shafts, and wells. These costs have no tangible characteristics but are needed for the production of natural resource. Intangible development costs are considered pail of the depletion base.
Restoration Costs
Companies sometimes incur substantial costs to restore the property to its natural state after extraction has occurred.
These are restoration costs. Companies consider restoration costs part of the depletion base. The amount included in the depletion base is the fair value of the obligation to restore the property after extraction.
A complete discussion of the accounting for restoration costs and related liabilities (sometimes referred to as asset retirement obligations). Like other long-lived assets, companies deduct from the depletion base any salvage value to be received on the property.
Write-Off of Resource Cost
Once the company establishes the depletion base, the next problem is determining how to allocate the cost of the natural resource to accounting periods.
Normally, companies compute depletion (often referred to as cost depletion) on a units-of-production method (an activity approach).
Thus, depletion is a function of the number of units extracted -during the period. In this approach, the total cost of the natural resource less salvage value is divided by the number of units estimated to be in the resource deposit to obtain a cost per product unit.
The cost per unit is then multiplied by the number of units extracted to compute depletion.
For example, MaClede Co. acquired the right to use 1,000 acres of land in Alaska to mine for gold. The lease cost is $50,000, and the related exploration costs on the property are $00.000.
Intangible development costs incurred in opening the mine are $850,000.
Total costs related to the mine before the first ounce of gold is extracted are, therefore, $1,000,000. MacLeod estimates that the mine will provide approximately 100,000 ounces of gold. The illustration below shows the computation of the depletion cost per unit (depletion rate).
| Depletion cost per unit = (Total Cost-Salvage value / Total estimated, units available) = $1,000,000 / 100,000 = $10 per ounce. |
If MacLeod extracts 25,000 ounces in the first year, then the depletion for the year is $250,000 (25,000 ounces x $10). It records the depletion as follows;
Depletion reduces the carrying value of the natural resource. MacLeod credits Inventory when it sells the inventory. The amount not sold remains in inventory and is reported in the current assets section of the balance sheet.
Sometimes companies do not use an Accumulated Depletion account.
In that case, the credit goes directly to the natural resources asset account. MacLeod’s balance sheet would present the cost of the natural resource and the amount of accumulated depletion entered to date as follows;
| Gold mine (at cost) | 1,000,000 | |
| Less: Accumulated depletion | 250,000 | 750,000 |
In the income statement, the depletion cost is part of the cost of goods sold.
MacLeod may also depreciate on a units-of-production basis the tangible equipment used in extracting the gold. This approach is appropriate if it can directly assign the estimated lives of the equipment to one given resource deposit.
If MacLeod uses the equipment on more than one job, other cost allocation methods, such as straight-line or accelerated depreciation methods, would be more appropriate,
Estimating Recoverable Reserves
Sometimes companies need to change the estimate of recoverable reserves. They do so because they have new information or more sophisticated production processes available.
Natural resources such as oil and gas deposits and some rare metals have recently provided the greatest challenges. Estimates of these reserves are, in large measure, merely “knowledgeable guesses.”
This problem is the same as accounting for changes in estimates for the useful lives of plants and equipment.
The procedure is to revise the depletion rate on a prospective basis: A company divides the remaining cost by the new estimate of the recoverable reserves.
This approach has many merits because the required estimates are so uncertain.
Liquidating Dividends
A company often owns a property from which it intends to extract natural resources as its only major asset.
Suppose the company does not expect to purchase additional properties. In that case, it may gradually distribute to stockholders its capital investments by paying liquidating dividends, which are dividends greater than the amount of accumulated net income.
The major accounting problem is to distinguish between dividends that are a return of capital and those that are not.
Because the dividend is a return on the investor’s original contribution, the company issuing a liquidating dividend should debit Paid-in Capital in Excess of Par for that portion related to the original investment instead of debiting Retained Earnings.
To illustrate, at year-end, Callahan Mining had a retained earnings balance of $1,650,000, accumulated depletion on mineral properties of $2,100.000, and paid-in capital in excess of par of $5,435,493.
Callahan’s board declared a dividend of $3 a share on the 1,000,000 shares outstanding. It records the $3.000.000 cash dividend as follows.
| Retained Earnings | 1,650,000 | |
| Paid-in Capital in Excess of Par | 1,350,000 | |
| Cash | 3,000,000 |
Callahan must inform stockholders that the $3 dividend per share represents a $1.65 ($1,650,000 – 1,000,000 shares) per share return on investment and a $1.35 ($1,350,00C / 1,000,000 shares) per share liquidating dividend.
Continuing Controversy
A major controversy relates to the accounting for exploration costs in the oil and gas industry. Conceptually, the question is whether unsuccessful ventures are a cost to those that are successful.
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 is the successful-efforts concept.
Its proponents believe that the only relevant measure for a project is the cost directly related to it and that companies should report any remaining costs as period charges.
In addition, they argue that an unsuccessful company will end up capitalizing on many costs that will make it, over a short period of time, show no less income than a successful one.
The FASB has attempted to narrow the available alternatives with little success. Here is a brief history of the debate.
- 2977—The FASB required oil and gas companies to follow successful-efforts accounting. Small oil and gas producers, voicing strong opposition, lobbied extensively in Congress. Governmental agencies assessed the implications of this standard from a public interest perspective and reacted contrary to the FASB’s position.
- 1978—In response to criticisms of the FASB’s actions, the SEC reexamined the issue and found both the successful efforts and full-cost approaches inadequate. Neither method, said the SEC, reflects the economic substance of oil and gas exploration.
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.
Thus, RRA is a fair value approach, in contrast to full-costing and successful efforts, which are historical cost approaches. Using RRA would make a substantial difference in oil companies’ balance sheets and income statements.
For example, Atlantic Richfield Co., at one time, reported net producing property of $2.6 billion. Under RRA, the same properties would be valued at $11.8 billion.
- 1979-1981—As a result of the SEC’s actions, the FASB issued another standard that suspended the requirement that companies follow successful-efforts accounting.
Therefore, full costing was again permissible. In attempting to implement RRA, however, the SEC encountered practical problems in estimating;
- the amount of the reserves,
- the future production costs.
- the periods of expected disposal,
- the discount rate, and
- the selling price.
Companies needed an estimate for each of these to arrive at an accurate valuation of existing reserves.
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.
- 1981 – The SEC abandoned RRA in the primary financial statements of oil and gas producers. The SEC decided that RRA did not possess the required degree of reliability for use as a primary method of financial reporting.
However, it continued to stress the stored for some form of fair value-based disclosure for oil and gas reserves. As a result, the profession now requires fair value disclosures for those natural resources.
Currently, companies can use either the full-cost approach or the successful-efforts approach.
It does seem ironic that Congress directed the FASB to develop one method of accounting for the oil and gas industry, and when the FASB did so, the government chose not to accept it. Subsequently, the SEC attempted to develop a new approach, failed, and then urged the FASB to develop the disclosure requirements in this area.
After all these changes, the two alternatives still exist. This controversy in the oil and gas industry provides a number of lessons.
First, it demonstrates the federal government’s strong influence on financial reporting matters.
Second, the concern for economic consequences places pressure on the FASB to weigh the economic effects of any required standard.
Third, the experience with RRA highlights the problems that accompany any proposed change from a historical cost to a fair value approach.
Fourth, this controversy illustrates the difficulty of establishing standards when affected groups have differing viewpoints.
Finally, it reinforces the need for a conceptual framework with carefully developed guidelines for the recognition, measurement, and reporting so that interested parties can more easily resolve issues of this nature in the future.
Computation of Depletion
The formulas for computing depiction expense are;
- Total / Total Estimated Units = Depletion Cost per unit.
- Depletion Cost per Unit X Number of Units Extracted and Sold = Depletion Expense.
To record depletion expense. Depletion Expense is debited and a contra asset account. Accumulated Depletion is credited.
- Depletion expense is reported as the cost of producing the product.
- Accumulated Depletion is deducted from the cost of the natural resource in the balance sheet.