Plant Asset Disposals, Natural Resources, and Intangible Assets

This chapter details the events that need to be dealt with when disposing assets. There are balance sheet and income statement entries that must be recorded when getting rid of equipment by scrapping it or selling it. It also discusses intangible assets, how to record them, and how to account for their diminishing value. Many business entities will eventually have to dispose of a plant asset. When this happens, the company will either have a loss or show a gain depending on the difference between the asset's sale price and its book value. You will learn the journal entries for a variety of situations, including a gain on the sale of an asset, a loss on the sale of an asset, how to realize loss, and what to do when a fire or flood that destroys an asset.

Natural resources

Resources supplied by nature, such as ore deposits, mineral deposits, oil reserves, gas deposits, and timber stands, are natural resources or wasting assets. Natural resources represent inventories of raw materials that can be consumed (exhausted) through extraction or removal from their natural setting (e.g. removing oil from the ground).

On the balance sheet, we classify natural resources as a separate group among noncurrent assets under headings such as "Timber stands" and "Oil reserves". Typically, we record natural resources at their cost of acquisition plus exploration and development costs; on the balance sheet, we report them at total cost less accumulated depletion. (Accumulated depletion is similar to the accumulated depreciation used for plant assets). When analyzing the financial condition of companies owning natural resources, exercise caution because the historical costs reported for the natural resources may be only a small fraction of their current value.


An accounting perspective:

Business insight

Kerr-McGee Corporation is a global energy and chemical company engaged in oil and gas exploration and production, and the production and marketing of titanium dioxide pigment. In notes to its financial statements, Kerr-McGee states that the company's geologists and engineers in accordance with the Securities and Exchange Commission definitions have prepared estimates of proved reserves. These estimates include reserves that may be obtained in the future by improved recovery methods now in operation or for which successful testing has been exhibited.

By crediting the Accumulated Depletion account instead of the asset account, we continue to report the original cost of the entire natural resource on the financial statements. Thus, statement users can see the percentage of the resource that has been removed. To determine the total cost of the resource available, we combine this depletion cost with other extraction, mining, or removal costs. We can assign this total cost to either the cost of natural resources sold or the inventory of the natural resource still on hand. Thus, we could expense all, some, or none of the depletion and removal costs recognized in an accounting period, depending on the portion sold. If all of the resource is sold, we expense all of the depletion and removal costs. The cost of any portion not yet sold is part of the cost of inventory.Depletion is the exhaustion that results from the physical removal of a part of a natural resource. In each accounting period, the depletion recognized is an estimate of the cost of the natural resource that was removed from its natural setting during the period. To record depletion, debit a Depletion account and credit an Accumulated Depletion account, which is a contra account to the natural resource asset account.

Computing periodic depletion cost To compute depletion charges, companies usually use the units-of-production method. They divide total cost by the estimated number of units - tons, barrels, or board feet - that can be economically extracted from the property. This calculation provides a per-unit depletion cost. For example, assume that in 2010 a company paid USD 650,000 for a tract of land containing ore deposits. The company spent USD 100,000 in exploration costs. The results indicated that approximately 900,000 tons of ore can be removed economically from the land, after which the land will be worth USD 50,000. The company incurred costs of USD 200,000 to develop the site, including the cost of running power lines and building roads. Total cost subject to depletion is the net cost assignable to the natural resource plus the exploration and development costs. When the property is purchased, a journal entry assigns the purchase price to the two assets purchased - the natural resource and the land. The entry would be:

Land (+A)



Ore Deposits (+A)



Cash (-A)



To record purchase of land and mine.



After the purchase, an entry debits all costs to develop the site (including exploration) to the natural resource account. The entry would be:

Ore Deposits ($100,000 + $200,000) (+A)



Cash (-A)



To record costs of exploration and development.



The formula for finding depletion cost per unit is:

\text { Depletion cost per unit }=\frac{\text { Cost of site }-\text { Residual value of land }(\text { if owned })+\text { Costs develop site }}{\text { Estimated number of units that can be economically extracted }}

In some instances, companies buy only the right to extract the natural resource from someone else's land. When the land is not purchased, its residual value is irrelevant and should be ignored. If there is an obligation to restore the land to a usable condition, the firm adds these estimated restoration costs to the costs to develop the site.

In the example where the land was purchased, the total costs of the mineral deposits equal the cost of the site (USD 650,000) minus the residual value of land (USD 50,000) plus costs to develop the site (USD 300,000), or a total of USD 900,000. The unit (per ton) depletion charge is USD 1 (or USD 900,000/900,000 tons). The formula to compute the depletion cost of a period is:

\text { Depletion cost of a period }=\text { Depletion cost per unit } \times \text { Number of units extracted during period }

In this example, if 100,000 tons are mined in 2010, this entry records the depletion cost of USD 100,000 (USD 1 X 100,000) for the period:

Depletion (-SE)



Accumulated Depletion - Ore Deposits (-A)



To record depletion for 2010.



The Depletion account contains the "in the ground" cost of the ore or natural resource mined. Combined with other extractive costs, this cost determines the total cost of the ore mined. To illustrate, assume that in addition to the USD 100,000 depletion cost, mining labor costs totaled USD 320,000, and other mining costs, such as depreciation, property taxes, power, and supplies, totaled USD 60,000. If 80,000 tons were sold and 20,000 remained on hand at the end of the period, the firm would allocate the total cost of USD 480,000 as follows:

Depletion cost

USD 100,000


Mining labor costs



Other mining costs



Total cost of 100,000 tons mined (USD 4.80 per ton)

USD 480,000


 Less: One inventory (20,000 tons at USD 4.80)



Cost of ore sold (80,000 tons at USD 4.80)

USD 384,000



Note that the average cost per ton to mine 100,000 tons was USD 4.80 (or USD

480,000/100,000). The income statement would show cost of ore sold of USD 384,000. The mining company does not report depletion separately as an expense because depletion is included in cost of ore sold. The balance sheet would show inventory of ore on hand (a current asset) at USD 96,000 (or USD 4.80 X 20,000). Also, it would report the cost less accumulated depletion of the natural resource as follows:

One deposits



Less: Accumulated depletion


$ 800,000

Another method of calculating depletion cost is the percentage of revenue method. Because firms use this method only for income tax purposes and not for financial statements, we do not discuss it in this text.

Companies depreciate plant assets erected on extractive industry property the same as other depreciable assets. If such assets will be abandoned when the natural resource is exhausted, they depreciate these assets over the shorter of the (a) physical life of the asset or (b) life of the natural resource. In many cases, firms compute periodic depreciation charges using the units-of-production method. Using this method matches the life of the plant asset with the life of the natural resource. This method is recommended where the physical life of the plant asset equals or exceeds the resource's life but its useful life is limited to the life of the natural resource.

Assume a mining company acquires mining property with a building it plans to use only in the mining operations. Also assume that the firm uses the units-of production method for computing building depreciation. Relevant facts are:

Building cost



Estimated physical life of building



Estimated salvage value of building (after mine is exhausted)



Capacity of mine



Expected life of mine




Because the life of the mine (10 years or 1,000,000 tons) is shorter than the life of the building (20 years), the building should be depreciated over the life of the mine. The basis of the depreciation charge is tons of ore rather than years because the mine's life could be longer or shorter than 10 years, depending on how rapidly the ore is removed.

Suppose that during the first year of operations, workers extracted 150,000 tons of ore. Building depreciation for the first year is USD 45,000, computed as follows:

\text { Depreciation per unit }=\frac{\text { Asset cost }-\text { Estimated salvage value }}{\text { Total tons of ore } \in \text { mine that can be economically extracted }}

=\dfrac{\$ 310,000-\$ 10,000}{1,000,000} \text { tons }=\$ 0.30 \text { per ton }

\text { Depreciation for year }=\text { Depreciation per unit} \times \text{Units extracted }

\text { USD } 0.30 \text { per ton } \times 150,000 \text { tons }=\text { USD } 45,000

On the income statement, depreciation on the building appears as part of the cost of ore sold and is carried as part of inventory cost for ore not sold during the period. On the balance sheet, accumulated depreciation on the building appears with the related asset account.

Plant assets and natural resources are tangible assets used by a company to produce revenues. A company also may acquire intangible assets to assist in producing revenues.