11 7: Natural Resources and Depletion Business LibreTexts
The amount included in the depletion base is the fair value of the obligation to restore the property after extraction. Companies sometimes incur substantial costs to restore the property to its natural state after extraction has occurred. 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. They do so because they have new information or more sophisticated production processes available.
Understanding Depreciation, Depletion, and Amortization (DD&A)
Instead, they use separate depreciation charges to allocate the costs of such equipment. Analysts and investors in the energy sector should be aware of this expense and how it relates to cash flow and capital expenditure. Third, the experience with RRA highlights the problems that accompany any proposed change from a historical cost to a fair value approach.
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. As a result, a company in the extractive industries, like ExxonMobil, frequently adopts a conservative the accumulated depletion of a natural resource is reported on the policy in accounting for the expenditures related to finding and extracting natural resources. 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.
Natural resources
A percentage of the purchase price is deducted over the course of the asset’s useful life. Accrual accounting permits companies to recognize capital expenses in periods that reflect the use of the related capital asset. In other words, it lets firms match expenses to the revenues they helped produce.
To record depletion, debit a Depletion account and credit an Accumulated Depletion account, which is a contra account to the natural resource asset account. Depletion expense is commonly used by miners, loggers, oil and gas drillers, and other companies engaged in natural resource extraction. Enterprises with an economic interest in mineral property or standing timber may recognize depletion expenses against those assets as they are used. Depletion can be calculated on a cost or percentage basis, and businesses generally must use whichever provides the larger deduction for tax purposes.
Financial Accounting I
- Using RRA would make a substantial difference in oil companies’ balance sheets and income statements.
- The amount not sold remains in inventory and is reported in the current assets section of the balance sheet.
- Depreciation, depletion, and amortization (DD&A) is an accounting technique that enables companies to gradually expense various different resources of economic value over time in order to match costs to revenues.
- 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.
It requires the method that yields the highest deduction to be used with mineral property, which it defines as oil and gas wells, mines, and other natural deposits, including geothermal deposits. 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. The amount not sold remains in inventory and is reported in the current assets section of the balance sheet. 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.
Smaller oil and gas companies often capitalize on these exploration costs. 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. A company often owns a property from which it intends to extract natural resources as its only major asset.
Depletion also lowers the cost value of an asset incrementally through scheduled charges to income. Where it differs is that it refers to the gradual exhaustion of natural resource reserves, as opposed to the wearing out of depreciable assets or the aging life of intangibles. Depletion is an accrual accounting technique used to allocate the cost of extracting natural resources such as timber, minerals, and oil from the earth. On the other hand, intangible development costs are such items as drilling costs, tunnels, shafts, and wells.
Thus, statement users can see the percentage of the resource that has been removed. To determine the total cost of the resource available, we combine this depletion cost with other extraction, mining, or removal costs. We can assign this total cost to either the cost of natural resources sold or the inventory of the natural resource still on hand. Thus, we could expense all, some, or none of the depletion and removal costs recognized in an accounting period, depending on the portion sold.
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. 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. In the income statement, the depletion cost is part of the cost of goods sold.
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. As natural resources are extracted, they are counted and taken out from the property’s basis. One method of calculating depletion expense is the percentage depletion method. It assigns a fixed percentage to gross revenue—sales minus costs—to allocate expenses.