Another disadvantage of the depletion method is that it can be time-consuming to calculate. Companies that use this method must carefully track the amount of resource that has been extracted and calculate depreciation based on this information. This can be a labor-intensive process and may require significant resources. The Michigan Mining Company has acquired a coal mine for a cost of $4,500,000.
Types of assets that can be depreciated using the depletion method
Therefore, the output-oriented units of production approach is widely used to allocate the cost to the materials and the time periods in which they are used. Depreciation records an expense for the value of an asset consumed and removes that portion of the asset from the balance sheet. We also address some of the terminology used in depreciation determination that you want to familiarize yourself with.
- A percentage of the purchase price is deducted over the course of the asset’s useful life.
- Therefore, the output-oriented units of production approach is widely used to allocate the cost to the materials and the time periods in which they are used.
- Kenzie pays shipping costs of $1,500 and setup costs of $2,500, assumes a useful life of five years or 960,000 pages.
Change in expected units
These expenditures may relate to legal, environmental, and laboratory studies, as well as tangible property such as buildings and processing equipment. While the numerator (units produced in the period) is usually reliably measurable, the denominator (units available from the property) is often impossible to measure precisely. The usefulness of resources to a firm is generally directly proportional to the amount extracted (or otherwise removed).
Step 1: Determination of the depletion base:
The expense recognition principle that requires that the cost of the asset be allocated over the asset’s useful life is the process of depreciation. For example, if we buy a delivery truck to use for the next five years, we would allocate the cost and record depreciation expense across the entire five-year period. He estimates that he can use this machine for five years or 100,000 presses, and that the machine will only be worth $1,000 idnotify identity theft protection review at the end of its life. He also estimates that he will make 20,000 clothing items in year one and 30,000 clothing items in year two. Determine Liam’s depreciation costs for his first two years of business under straight-line, units-of-production, and double-declining-balance methods. Cost depletion is calculated by estimating the total quantity of a given resource and then dividing the percentage withdrawn by the total quantity.
What is the approximate value of your cash savings and other investments?
Depletion is the process by which natural resources lose their benefits as they are removed. It follows the same process used in Depreciation, which is an accounting technique used to allocate the cost of tangible assets over their useful lives. Cost depletion is typically used when the cost of acquiring and developing the resource is high relative to the value of the resource itself. In these cases, the cost of acquiring and developing the resource is spread out over the estimated amount of the resource that can be extracted.
Depreciation applies to expenses incurred for the purchase of assets with useful lives greater than one year. A percentage of the purchase price is deducted over the course of the asset’s useful life. More than one person (or company) can have an economic interest in a mineral deposit or timber land. The IRS defines an economic interest as having any interest in mineral deposits or standing timber and a legal right to income from mineral extraction or timber harvesting. A side issue related to depletion concerns the amortization and depreciation of costs incurred to prepare the property for production.
At the end of five years, the asset will have a book value of $10,000, which is calculated by subtracting the accumulated depreciation of $48,000 (5 × $9,600) from the cost of $58,000. The estimated amount of a natural resource that can be recovered will change constantly as assets are gradually extracted from a property. As you revise your estimates of the remaining amount of extractable natural resource, incorporate these estimates into the unit depletion rate for the remaining amount to be extracted. Like depreciation and amortization, depletion is a non-cash expense that lowers the cost value of an asset incrementally through scheduled charges to income.
Any mischaracterization of asset usage is not proper GAAP and is not proper accrual accounting. Both US GAAP and International Financial Reporting Standards (IFRS) account for long-term assets (tangible and intangible) by recording the asset at the cost necessary to make the asset ready for its intended use. Additionally, both sets of standards require that the cost of the asset be recognized over the economic, useful, or legal life of the asset through an allocation process such as depreciation. However, there are some significant differences in how the allocation process is used as well as how the assets are carried on the balance sheet.
Finally, in terms of allocating the costs, there are alternatives that are available to the company. We consider three of the most popular options, the straight-line method, the units-of-production method, and the double-declining-balance method. 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. The journal entry to record the purchase of a fixed asset (assuming that a note payable is used for financing and not a short-term account payable) is shown here. Assets are recorded on the balance sheet at cost, meaning that all costs to purchase the asset and to prepare the asset for operation should be included.
See Form 10-K that was filed with the SEC to determine which depreciation method McDonald’s Corporation used for its long-term assets in 2017. Cost depletion (which is required under GAAP) should not be confused with percentage depletion deductions allowed by the income tax laws. 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. As the estimated output has changed as a result of new survey conducted at the start of year 2, we must compute a new depletion rate to be used for year 2 and year 3.
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