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.
