Depletion of Natural Resources and Amortization of Intangibles

Depletion of Natural Resources (Learning Objective 3)

  • General Concepts and Comparison to Depreciation

    • Depletion is the process of allocating the cost of natural resources to the periods in which they are consumed.

    • Unlike Property, Plant, and Equipment (PP&E) like buildings, which are often depreciated using time-based methods, natural resources typically use activity-based methods.

    • Logic for Activity-Based Allocation: A resource (e.g., a coal mine or oil well) generates revenue only as it is harvested/extracted and sold on the market. Therefore, the expense should follow the extraction usage.

  • Calculation of the Depletion Base

    • Formula: Depletion Base=Cost of Natural Resource−Residual Value\text{Depletion Base} = \text{Cost of Natural Resource} - \text{Residual Value}

    • Components of Cost: The cost of a natural resource includes:

      • The right to explore the land.

      • Actual exploration costs (e.g., geologists, engineers, testing).

      • Intangible development costs (e.g., digging, constructing mine shafts).

      • Restoration costs (obligations to restore land for appropriate use after extraction is complete).

  • Determining the Depletion Rate and Expense

    • Depletion Rate per Unit: Depletion BaseTotal Estimated Units to be Extracted\frac{\text{Depletion Base}}{\text{Total Estimated Units to be Extracted}}

    • Units may be measured in barrels (oil/gas), pounds (minerals), or tons (coal).

    • Annual Depletion Expense: Depletion Rate×Units Extracted during the period\text{Depletion Rate} \times \text{Units Extracted during the period}

  • Journal Entry and Accounting Treatment

    • Debit: Depletion Expense.

    • Credit: The Natural Resource asset account directly (e.g., Coal Mine).

    • Note on Methodology: Unlike depreciation, which typically uses a contra asset account (Accumulated Depreciation), depletion is traditionally recorded by directly crediting the asset account.

Case Study: Jackson Mining Company (Natural Resource Depletion)

  • Initial Cost Data for Coal Mine:

    • Right to explore: 1,000,0001,000,000

    • Exploration costs: Include geologists and engineers.

    • Intangible development costs: Mine shaft construction.

    • Restoration costs: Required land restoration.

    • Total Resource Cost (Depletion Base): 2,768,3602,768,360

    • Equipment Distinction: A separate purchase of equipment for 600,000600,000 was made, but because this equipment will be used for other projects in the future, it is not included in the depletion base for the coal mine asset.

  • Calculation for 2021:

    • Estimated extractable units: 1,000,000 tons1,000,000\text{ tons}

    • Depletion Rate Calculation: 2,768,3601,000,000=2.76836\frac{2,768,360}{1,000,000} = 2.76836

    • Rounded Depletion Rate: 2.77 per ton2.77\text{ per ton}

    • Tons extracted in 2021: 300,000300,000

    • Depletion Expense: 300,000×2.76836=830,508300,000 \times 2.76836 = 830,508

  • 2021 Journal Entry:

    • Debit Depletion Expense: 830,508830,508

    • Credit Coal Mine: 830,508830,508

  • Future Projections:

    • Remaining tons: 700,000700,000

    • This entry procedure is repeated annually based on the specific amount of tons extracted each year until the mine is empty.

Depreciation of Mining Equipment

  • Method Alignment:

    • Equipment used in resource extraction is usually depreciated using the Units-of-Production method to match the pattern of depletion.

  • Example Calculation using Jackson Mining Data:

    • Equipment Cost: 600,000600,000

    • Residual Value: 60,00060,000

    • Depreciable Base: 600,000−60,000=540,000600,000 - 60,000 = 540,000

    • Depreciation Rate per Ton: 540,0001,000,000=0.54 per ton\frac{540,000}{1,000,000} = 0.54\text{ per ton}

    • Extraction for 2021: 300,000 tons300,000\text{ tons}

    • 2021 Depreciation Expense: 300,000×0.54=162,000300,000 \times 0.54 = 162,000

  • Journal Entry for Equipment:

    • Debit Depreciation Expense: 162,000162,000

    • Credit Accumulated Depreciation: 162,000162,000

    • Differentiation: While the resource asset itself is credited directly for depletion, the equipment uses the traditional contra asset account (Accumulated Depreciation).

Biological Assets: US GAAP vs. IFRS

  • Biological assets include animals, plants, fruit orchards, or trees in timber operations.

  • US GAAP: These assets are handled via standard depletion or depreciation methods.

  • IFRS: Biological assets are valued at fair value less estimated costs to sell. Changes in fair value are reported in profit or loss as they occur.

Amortization of Intangible Assets (Learning Objective 4)

  • Key Amortization Principles:

    • Legal vs. Useful Life: Amortization should be recorded over the shorter of the legal life or the useful life. In technological fields, the useful life is often significantly shorter than the legal life.

    • Residual Value: Typically assumed to be zero for intangibles, especially when technology changes rapidly, rendering the asset obsolete by the end of its useful life.

    • Allocation Method: Should reflect the pattern of use (Straight-Line is standard if the pattern cannot be determined).

  • Case Study: Hollins Corporation:

    • Franchise Acquisition: Purchased for 200,000200,000 with a 10-year useful life.

      • Amortization Calculation: 200,00010=20,000 per year\frac{200,000}{10} = 20,000\text{ per year}

    • Patent Acquisition: Purchased for 50,00050,000 with a legal life of 13 years but a useful life of only 8 years.

      • Amortization Calculation: 50,0008=6,250 per year\frac{50,000}{8} = 6,250\text{ per year}

  • Recording Entries:

    • Amortization for Franchise: Debit Amortization Expense (Franchise) 20,00020,000; Credit Franchise 20,00020,000.

    • Amortization for Patent: Debit Amortization Expense (Patent) 6,2506,250; Credit Patent 6,2506,250.

    • Note: While it is acceptable to use a contra asset account (Accumulated Amortization), it is common practice to credit the intangible asset directly.

Software Development Costs

  • Accounting Phases:

    1. Prior to Technological Feasibility: All costs are expensed as Research and Development (R&D).

    2. After Technological Feasibility: Costs are capitalized as an intangible asset.

  • Amortization Selection Rule: Companies must calculate amortization using two methods and choose the one that results in the greater expense for the period:

    1. Percentage of Revenue Method.

    2. Straight-Line Method.

  • Case Study: Astro Corp Example:

    • Scenario Data:

      • Prior to 06/30/2021 (Pre-feasibility): 1,200,0001,200,000 (Expensed as R&D).

      • Post-feasibility Capitalized Costs: 800,000800,000.

      • Anticipated sales duration: 4 years (2022, 2023, 2024, 2025).

      • Total anticipated sales: 10,000,00010,000,000.

      • Current Year Sales: 3,000,0003,000,000.

    • Calculation 1: Percentage of Revenue:

      • Revenue Ratio: 3,000,00010,000,000=30%\frac{3,000,000}{10,000,000} = 30\%

      • Expense: 0.30×800,000=240,0000.30 \times 800,000 = 240,000

    • Calculation 2: Straight-Line:

      • Time Ratio: 14=25%\frac{1}{4} = 25\%

      • Expense: 0.25×800,000=200,0000.25 \times 800,000 = 200,000

    • Decision: Astro Corp must use the Percentage of Revenue method (240,000240,000) because it is the greater of the two calculations.

Indefinite-Life Intangibles

  • Definition: Assets where there is no foreseeable limit to the period over which the asset is expected to generate cash flows.

  • Example: Trademarks: Items like the Nike Swoosh or McDonald's Golden Arches can be re-registered every 10 years indefinitely.

  • Accounting Treatment:

    • These assets are not amortized.

    • Indefinite does not mean permanent; status must be reviewed as circumstances change.

    • Companies must regularly check for impairment of these assets.