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Chapter11: Property, Plant, and Equipment and Intangible Assets: Utilization and Impairment

Depletion of Natural Resources

Allocation of the cost of natural resources is called depletion allocation of the cost of natural resources.. Because the usefulness of natural resources generally is directly related to the amount of the resources extracted, the activity-based units-of-production method is widely used to calculate periodic depletion. Service life is therefore the estimated amount of natural resource to be extracted (for example, tons of mineral or barrels of oil).



   Depletion base is cost less any anticipated residual value. Residual value could be significant if cost includes land that has a value after the natural resource has been extracted.

   The example in Illustration 11-3 was first introduced in Chapter 10.

Depletion of Natural Resources

The Jackson Mining Company paid $1,000,000 for the right to explore for a coal deposit on 500 acres of land in Pennsylvania. Costs of exploring for the coal deposit totaled $800,000 and intangible development costs incurred in digging and erecting the mine shaft were $500,000. In addition, Jackson purchased new excavation equipment for the project at a cost of $600,000. After the coal is removed from the site, the equipment will be sold for an anticipated residual value of $60,000.

   The company geologist estimates that 1 million tons of coal will be extracted over the three-year period. During 2011, 300,000 tons were extracted. Jackson is required by its contract to restore the land to a condition suitable for recreational use after it extracts the coal.

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   In Chapter 10 on page 508 we determined that the capitalized cost of the natural resource, coal mine, including the restoration costs, is $2,768,360. Since there is no residual value to the land, the depletion base equals cost and the depletion rate per ton is calculated as follows:

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Depletion of the cost of natural resources usually is determined using the units-ofproduction method.

   For each ton of coal extracted, $2.768360 in depletion is recorded. In 2011, the following journal entry records depletion.

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   Notice that the credit is to the asset, coal mine, rather than to a contra account, accumulated depletion. Although this approach is traditional, the use of a contra account is acceptable.

   Depletion is a product cost and is included in the cost of the inventory of coal, just as the depreciation on manufacturing equipment is included in inventory cost. The depletion is then included in cost of goods sold in the income statement when the coal is sold.

   What about depreciation on the $600,000 cost of excavation equipment? If the equipment can be moved from the site and used on future projects, the equipment's depreciable base should be allocated over its useful life. If the asset is not movable, as in our illustration, then it should be depreciated over its useful life or the life of the natural resource, whichever is shorter.

   Quite often, companies use the units-of-production method to calculate depreciation and amortization on assets used in the extraction of natural resources. The activity base used is the same as that used to calculate depletion, the estimated recoverable natural resource. In our illustration, the depreciation rate would be $.54 per ton, calculated as follows.

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The units-of-production method often is used to determine depreciation and amortization on assets used in the extraction of natural resources.

   In 2011, $162,000 in depreciation ($.54 × 300,000 tons) is recorded and also included as part of the cost of the coal inventory.

   The summary of significant accounting policies disclosure accompanying recent financial statements of ConocoPhilips shown in Graphic 11-7 provides a good summary of depletion, amortization, and depreciation for natural resource properties.

Depletion Method Disclosure—ConocoPhilips

Real World Financials


Summary of Significant Accounting Policies (in part)

Depletion and Amortization—Leasehold costs of producing properties are depleted using the units-of-production method based on estimated proved oil and gas reserves. Amortization of intangible development costs is based on the units-of-production method using estimated proved developed oil and gas reserves.

Depreciation and Amortization—Depreciation and amortization of properties, plants and equipment on producing oil and gas properties, certain pipeline assets, and on Syncrude mining operations are determined by the units-of-production method.


Percentage Depletion

Depletion of cost less residual value required by GAAP should not be confused with percentage depletion (also called statutory depletion) allowable for income tax purposes for oil, gas, and most mineral natural resources. Under these tax provisions, a producer is allowed to deduct the greater of cost-based depletion or a fixed percentage of gross income as depletion expense. Over the life of the asset, depletion could exceed the asset's cost. The percentage allowed for percentage-based depletion varies according to the type of natural resource.

   Because percentage depletion usually differs from cost depletion, a difference between taxable income and financial reporting income before tax results. These differences are discussed in Chapter 16.


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Biological Assets. Living animals and plants, including the trees in a timber tract or in a fruit orchard, are referred to as biological assets. Under U.S. GAAP, a timber tract is valued at cost less accumulated depletion and a fruit orchard at cost less accumulated depreciation. Under IFRS, biological assets are valued at their fair value less estimated costs to sell.8

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8“Agriculture,” International Accounting Standard No. 41 (IASCF), as amended effective January 1, 2009.

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