Natural Resources and Depletion - Online Tutor, Practice Problems & Exam Prep

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

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 going to be similar. We're going to be dealing with this in a similar way to how we did with depreciation. But let's consider some examples of what natural resources are. Right? So natural resources, think of a company that extracts iron ore out of a mountain. They're pulling iron out of a mountain or deposits of gold or some kind of mineral. Or oil. They might buy 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 going to start to deplete, right? There's going to be less and less of this forest left. So you're going to 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 going to last us a certain amount of years, well, it's going to last us a certain amount of units, right? 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 going to 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 going to purchase it. Right? We're going to purchase whatever natural resources it was. We're going to purchase the forest. We're going to purchase the oil deposit. So let's check it out. Greenhouse Gases purchased an oil reserve for $50,000,000 and estimated that the reserve contained 10,000,000 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 cost that gets it ready for use. Right? In this case, and in most cases, they're just going to 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. Whatever it is. It's going to be some asset account that holds the oil reserve value. Right? And we paid 50,000,000 for it. So that's going to be the value on the books, 50,000,000. And the credit in this transaction, well, we're going to say we paid for it with cash here. Alright? So Greenhouse Gases buys it with cash, and they're going to credit it off their books, so they no longer have the cash. Cool? So this is a very simple entry, very similar to what we're used to, right? We see our assets going up by 50,000,000 and then also down by 50,000,000. 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 net book value. Just we talked about net book value with fixed assets like, equipment or buildings. They had a net book value, right? And that was the cost of what we paid for it, minus any accumulated depreciation. Well, this is going to be the same, except it's going to be cost minus accumulated depletion, right? So at this point, well, the net book value of the oil reserve is going to be the 50,000,000, 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 got to lower that net book book value and we'll 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 another way that is a little more complicated, but it isn't really that crazy. So let's go ahead and 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 1st year, Greenhouse Gases extracted 2,500,000 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 10,000,000 barrels of oil estimated in this reserve, right? So in the 1st year, well they went and they extracted 2,500,000 barrels of oil, Right? So what we want to 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 So our cost was 50,000,000. So our cost was 50,000,000. Generally, with natural resources, there's not going to be a salvage value, we're not going to have a salvage value, you know, you're just going to deplete the whole thing and there's nothing left. So 50,000,000 and we divide by the total number of units, right? This is like the useful life of the natural resource. And they told us there's 10,000,000 barrels. So 50,000,000 divided by 10,000,000, well, that comes out to \$5 per barrel extracted, right? So every time they extract the barrel, well that's going to be \$5 of the depletion expense.

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

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.