Question

On May 1, 2021, Hecala Mining entered into an agreement with the state of New Mexico to obtain the rights to operate a mineral mine in New Mexico for $10 million. Additional costs and purchases included the following: 

Development costs in preparing the mine.........................$3,200,000 

Mining equipment.............................................................................140,000 

Construction of various structures on site....................................68,000 

After the minerals are removed from the mine, the equipment will be sold for an estimated residual value of $10,000. The structures will be torn down. Geologists estimate that 800,000 tons of ore can be extracted from the mine. After the ore is removed the land will revert back to the state of New Mexico. 

The contract with the state requires Hecala to restore the land to its original condition after mining operations are completed in approximately four years. Management has provided the following possible outflows for the restoration costs: 

Cash Outflow................Probability 

$600,000................................30%   

700,000..................................30%   

800,000.................................40% 

Hecala’s credit-adjusted risk-free interest rate is 8%. During 2021, Hecala extracted 120,000 tons of ore from the mine. The company’s fiscal year ends on December 31. 

 

Required: 

1. Determine the amount at which Hecala will record the mine. 

2. Calculate the depletion of the mine and the depreciation of the mining facilities and equipment for 2021, assuming that Hecala uses the units-of-production method for both depreciation and depletion. Round depletion and depreciation rates to four decimals. 

3. How much accretion expense will the company record in its income statement for the 2021 fiscal year? 

4. Are depletion of the mine and depreciation of the mining facilities and equipment reported as separate expenses in the income statement? Discuss the accounting treatment of these items in the income statement and balance sheet. 

5. During 2022, Hecala changed its estimate of the total amount of ore originally in the mine from 800,000 to 1,000,000 tons. Briefly describe the accounting treatment the company will employ to account for the change and calculate the depletion of the mine and depreciation of the mining facilities and equipment for 2022 assuming Hecala extracted 150,000 tons of ore in 2022.

 

 

Answer 1

Depreciation

It is the amount of reduction in the value of a tangible fixed asset due to tear and wear, maintenance and passage of time. This expense reduces the carrying value of asset on the financial statements and provides the true value of asset. It is charged as an expense on the income statement. Different methods of calculating depreciation expense include straight-line method, double declining method, sum of year’s digits method etc.

 

Natural resources:

The asset which comes from the earth and consumed is known as natural resource. For example; coal mines, petroleum, iron ores.

 

Depletion:

Depletion refers to the proportionate allocation of the cost of extracting natural resources to the units extracted.

 

Depletion Cost per Unit = cost of the asset – Residual value/Estimated Number of Units

Depletion Expense = (Depletion Cost per Unit × Number of units Extracted and Sold)

 

Units of production method:

The units of production method, is also called as units of activity method. Under this depreciation calculated based on the proportion of the assets usage for production. More depreciation will be charged to income statement, when there is more usage. As well as less depreciation charged when assets are used less. It is the most accurate method for charging depreciation, since in this method depreciation charged based on the assets usage that is based on the units produced. This method is most useful to calculate depreciation for the assets which are used in the manufacturing process.

 

Formula:

Depreciation per unit = Cost – Residual value/Estimated units of useful life

Depreciation Expense = Depreciation per unit × Usage

 

(1)

Determine the amount at which H will record the mine.

The total cost of the mine is the sum of mining site value, development costs and restoration costs.

 

Particulars	Amount ($)
Mining site	10,000,000
Development	3,200,000
Restoration Costs	521,781
Total	13,721,871

 

 

Working note

1. Determine the present value of the restoration costs.

Cash flows		Probability		Total
$600,000	×	30%	=	180,000
$700,000	×	30%	=	210,000
$800,000	×	40%	=	320,000
Total				710,000

The present value of the total restoration cost is determined as follows:

Present value of $710,000 = $710,000 × 0.73503

                                           = $521,871

Note: PV factor (Present value of $1: n = 4, i = 8%) is taken from the table value (Table 2 in Appendix from textbook).

 

2.

Calculate the depletion and depreciation on the mine and mining facilities and equipment for 2021.

 

Step 1: Calculate depletion per pound.

Depletion cost per unit is calculated by dividing cost of the asset with estimated number of units.

Depletion Cost per Unit = Cost of the asset/Estimated Number of Units

                                       = $13,721,871/800,000 tons

                                       = $17.1523 per ton

 

Step 2: Calculate depletion expense for 2021.

Depletion expense is calculated by multiplying depletion cost per unit with number of units extracted and sold.

 

Depletion Expense = (Depletion Cost per Unit × Number of units Extracted and Sold)

                                = $17.1523 × 120,000 tons

                                = $2,058,276

 

Hence, the depletion expense for the year 2021 is $2,058,276.

 

Step 3: Determine the depreciation per unit for machinery using units of production method.

The depreciation is calculated by dividing the difference between cost of the asset and residual value with estimated useful life of the asset.

 

Depreciation per ton = Cost – Residual value/Estimated units of useful life

                                  = $140,000 - $10,000/8,000,000 tons

                                  = $0.1625 per ton

 

Step 4: Determine the depreciation expense for machinery for the year 2021.

The depreciation expense for machinery is calculated by multiplying depreciation per unit with usage.

 

Depreciation Expense = Depreciation per unit × Usage

                                     = $0.1625 × $120,000 tons

                                     = $19,500

 

Hence, the depreciation expense for the year 2021 is $19,500.

 

Step 5: Determine the depreciation per unit for structure using units of production method.

Depreciation per unit is calculated by dividing cost of the asset with estimated number of units.

 

Depreciation per ton = Cost/Estimated units of usefule life

                                  = $68,000/800,000 tons

                                  = $0.85 per ton

 

Step 6: Determine the depreciation expense for structure for the year 2021.

The depreciation expense for structure is calculated by multiplying depreciation per unit with usage.

 

Depreciation Expense = Depreciation per unit × Usage

                                    = $0.85 × $120,000 tons

                                    = $10,200

Hence, the depreciation expense for the year 2021 is $10,200.

 

3.

Determine the accretion expenses recorded in the income statement for the 2021 fiscal year (May 1, 2021-December 31, 2021).

The accretion expense is calculated by multiplying restoration cost with credit adjusted risk free interest rate and time period.

 

Accretion expense = {Restoration cost × Credit adjusted risk free interest rate

                        × (Number of months/12)}

                                = $521,871 × 0.08 × 8/12

                                = $27,833

 

Hence, the accretion expense for the year 2021 is $27,833.

4.

Accounting Treatment for Depreciation and Depletion

• Depletion is an extraction cost. It is a part of product cost. It is included in the inventory cost of mineral.

• The depreciation of equipment is included in the cost of inventory.

• The depletion and depreciation are reported in the income statement under cost of goods sold.

 

5.

Calculate the depletion of the mine and depreciation for mining facilities and equipment for the year 2022.

The accounting principle is changed the accounting estimate. The changes made are effective only for the assets that are being placed in service after the date the changes have been made. The changes made for the remaining depreciable base of the asset over the remaining service life (revised).

 

Year 2022- Depletion

Step 1: Determine the remaining depreciable cost.

The remaining depreciable cost is calculated by deducting 2019 depletion from original cost.

 

Remaining depreciable cost = Original cost – 2019 depletion

                                             = $13,721,871 - $2,058,276

                                             = $11,663,595

 

Step 2: Determine the revised estimate of tons remaining.

The revised estimate of tons remaining is calculated by deducting extracted from new estimate.

 

Revised estimate of tons remaining = New estimate – Extracted

                                                         = 1,000,000 tons – 120,000 tons

                                                         = 880,000 tons

 

Step 3: Determine the depletion rate.

Depletion rate is calculated by dividing remaining depreciable cost with revised estimate of tons remaining.

Depletion rate = Remaining depletable cost (Step 1)/Revised estimate of tons remaining

                                (Step 2)

                          = $111,663,595/880,000 tons

                          = $13.2541

 

Step 4: Determine depletion for the year 2022.

Depletion for the year 2022 is calculated by multiplying depletion rate with tons extracted.

 

2022 depletion = Depletion rate (Step 3) × Tons extracted

= $13.2541 × 150,000 tons

= $1,988,115

 

Thus, the depletion for the year 2022 is $1,988,115

 

Year 2022- Depreciation for equipment

 

Step 1: Determine the remaining depreciable cost.

The remaining depreciable cost is calculated by deducting the sum of 2021 depreciation and residual value from original cost.

 

Remaining depreciable cost = (Original cost – 2021 depreciation – Residual value)

                                             = $140,000 - $19,500 - $10,000

                                             = $120,500

 

Step 2: Determine the revised estimate of tons remaining.

The revised estimate of tons remaining is calculated by deducting extracted from new estimate.

 

Revised estimate of tons remaining = New estimate – Extracted

                                                          = 1,000,000 tons – 120,000 tons

                                                          = 880,000 tons

 

Step 3: Determine the depreciation rate.

The depreciation rate is calculated by dividing remaining depreciable cost with revised estimate of tons remaining.

 

Depletion rate = Remaining depreciable cost (Step 1)/Revised estimate of tons remaining

                              (Step 2)

                          = $110,500/880,000 tons

                          = $0.1256 tons

 

Step 4: Determine depreciation for the year 2022.

The depreciation for the year 2022 is calculated by multiplying depreciation rate with number of tons extracted.

 

2022 depreciation = Depreciation rate (Step 3) × Tons extracted

                              = $0.1256 per ton × 150,000 tons

                              = $18,840

 

Thus, the depreciation for the year 2022 is $18,840.

 

Year 2022- Depreciation for structure

Step 1: Determine the remaining depreciable cost.

The remaining depreciable cost is calculated by deducting 2021 depreciation from original cost.

 

Remaining depreciable cost = (Original cost – 2021 depreciation)

                                                = $68,000 - $10,200

                                                = $57,800

 

Step 2: Determine the revised estimate of tons remaining.

The revised estimate of tons remaining is calculated by deducting extracted tons from new estimate.

 

Revised estimate of tons remaining = New estimate – Extracted

                                                          = 1,000,000 tons – 120,000 tons

                                                          = 880,000 tons

 

Step 3: Determine the depreciation rate.

The depreciation rate is calculated by dividing remaining depreciable cost with revised estimate of tons remaining.

 

Depletion rate = Remaining depreciable cost (Step 1)/Revised estimate tons remaining

                           (Step 2)

                        = $57,800/880,000 tons

                        = $0.0657 tons

 

Step 4: Determine depreciation for the year 2022.

The depreciation for the year 2022 is calculated by multiplying depreciation rate with number of tons extracted.

 

2022 depreciation = Depreciation rate (Step 3) × Tons extracted

                                  = $0.0657 per ton × 150,000 tons

                                 = $9,855.

 

 Thus, the depreciation for the year 2022 is $9,855.

Depreciation

It is the amount of reduction in the value of a tangible fixed asset due to tear and wear