Q11SE - Horngren'S Financial And Managerial Accounting

Question

Accounting for depletion of natural resources Ajax Petroleum holds huge reserves of oil assets. Assume that at the end of 2018, Ajax Petroleum’s cost of oil reserves totaled $27,000,000, representing 3,000,000 barrels of oil.

 Requirements

1. Which method does Ajax Petroleum use to compute depletion?
2. Suppose Ajax Petroleum removed and sold 500,000 barrels of oil during 2019. Journalize depletion expense for 2019.

Step-by-Step Solution

Answer

Depletion expenses for the year are equal to $4,500,000 calculated using the units of production method.

Step 1: Definition of Natural Resources

Natural resources are assets that come from the natural earth and are consumed. Examples include iron ore, oil, natural gas, diamonds, gold, and timber these are the natural resources. Depletion is the process by which businesses spread the allocation of a natural resource’s cost over its usage.

Step 2: A method that must be used for calculation of depletion

Ajax petroleum must use the units of production method to calculate the depletion expenses because it will provide more relevant figures and useful life in terms of barrels is given. 

Step 3: Journalizing depletion expenses

Date	Accounts & Explanation	Debit ($)	Credit ($)
Dec 31st 2019	Depletion Expenses – oil reserves	4,500,000
	Accumulated Depletion- oil reserve		4,500,000
	(To record depletion expenses)

Working note: Calculation of depletion expenses

$\begin{array}{c}\mathrm{Depletion} \mathrm{expenses}=\frac{\mathrm{Cost}-\mathrm{Salvage} \mathrm{value}}{\mathrm{Useful} \mathrm{life} \mathrm{in} \mathrm{barrels}}\times \mathrm{Barrels} \mathrm{of} \mathrm{oil} \mathrm{removed} \mathrm{during} \mathrm{year}\\ =\frac{\mathrm{\$}27,000,000-\mathrm{\$}0}{3,000,000}\times 500,000\\ =\mathrm{\$}4,500,000\end{array}$