Depreciation, Depletion & Amortization - Practical

Application of Units of Production Method

The practical application of the units of production method gives rise to the following issues that
require entities to exercise a considerable degree of judgment in determining the:
(a) units of production formula;
(b) reserves base;
(c) unit of measure; and
(d) joint and by-products.

The asset base that is subject to depreciation should be consistent with the reserves base that is used,
which may require an entity to exclude certain costs from (or include future investments in) the
depreciation pool.

Units of production formula

There are a number of different ways in which an entity could calculate a depreciation charge under the
units of production method. The most obvious of these is probably the following formula:

The reserves estimate used in the above formula is the best estimate of the reserves at the beginning of
the period, but by the end of the period a revised and more accurate estimate is often available.
Therefore, it may be considered that in order to take into account the most recent information, the
opening reserves should be calculated by adding the ‘closing reserves estimated at the end of the
period’ to the ‘current period’s production’. However, reserves estimates might change for a number of
reasons:

1.more detailed knowledge about existing reserves (e.g. detailed engineering studies or drilling of
additional wells which occurred after the commencement of the period);
2.new events that affect the physical quantity of reserves (e.g. major fire in a mine); and
3.changes in economic assumptions (e.g. higher commodity prices).
It is generally not appropriate to take account of these events retrospectively. For example, changes in
reserves estimates that result from events that took place after the end of the reporting period (such as
those under (b) and (c)) are non-adjusting events that should be accounted for prospectively in
accordance with IFRS. [IAS 8.32-38, IAS 10.3]. Changes in reserves estimates that result from new
information or new developments which do not offer greater clarity concerning the conditions that
existed at the end of the reporting period (such as those under (a)) are not considered to be corrections
of errors; instead they are changes in accounting estimates that should be accounted for prospectively
under IFRS. [IAS 8.5, 32-38].

Determining whether actual changes in reserves estimates should be treated as adjusting or non-
adjusting events will depend upon the specific facts and circumstances and may require significant
judgment.

Usually, an entity will continue to invest during the year in assets in the depreciation pool that are used
to extract minerals. This raises the question as to whether or not assets that were used for only part of
the production during the period should be depreciated on a different basis. Under the straight-line
method, an entity will generally calculate the depreciation of asset additions during the period based on
the assumption that they were added (1) at the beginning of the period, (2) in the middle of the period
or (3) at the end of the period. While method (2) is often the best approximation, methods (1) and (3)
are generally not materially different when the accounting period is rather short (e.g. monthly or
quarterly reporting) or when the level of asset additions is relatively low compared to the asset base.

The above considerations explain why the units of production formula that is commonly used in the
extractive industries is slightly more complicated than the formula given above:

This units of production formula is widely used in the oil and gas sector by entities that apply US
GAAP or did apply the former OIAC SORP. In the mining sector, however, both the first and the
second units of production formulae are used in practice.

Reserves base

An important decision in applying the units of production method is selecting the reserves base that
will be used. The following reserves bases could in theory be used:
(a) proved developed reserves;
(b) proved developed and undeveloped reserves;
(c) proved and probable reserves;
(d) proved and probable reserves and a portion of resources expected to be converted into reserves; and
(e) proved, probable and possible reserves.

The term ‘possible reserves’, which is used in the oil and gas sector, is associated with a probability of
only 10%. Therefore, it is generally not considered acceptable to include possible reserves within the
reserves base in applying the units of production method.

It is important that whatever reserves base is chosen the costs applicable to that category of reserves are
included in the depreciable amount to achieve a proper matching of costs and production. For example,
‘if the cost center is not fully developed ... there may be costs that do not apply, in total or in part, to
proved developed reserves, which may create difficulties in matching costs and reserves. In addition,
some reserve categories will require future costs to bring them to the point where production may
begin’. 

IFRS does not provide any guidance on the selection of an appropriate reserves base or cost center (i.e.
unit of account) for the application of the units of production method. The relative merits for the use of
each of the reserves bases listed under (a) to (c) above are discussed in detail below.

(a) Proved developed reserves

Under some national GAAPs that have accounting standards for the extractive industries, an entity is
required to use proved developed reserves as its reserves base for the depreciation of certain types of
assets. An entity would therefore calculate its depreciation charge on the basis of actual costs that have
been incurred to date. However, the cost center frequently includes capitalized costs that relate to
undeveloped reserves. To calculate the depreciation charge correctly, it will be necessary to exclude a
portion of the capitalized costs from the depreciation calculation. Table 1 below, which is taken from
the IASC’s Issues Paper, illustrates how this might work.

Table 1. Exclusion of capitalized costs relating to undeveloped reserves

In an offshore oil and gas field a platform may be constructed from which 20 development wells will
be drilled. The platform’s cost has been capitalized as a part of the total cost of the cost center. If only 5
of the 20 wells have been drilled, it would be inappropriate to depreciate that portion of platform costs,
as well as that portion of all other capitalized costs, that are deemed to be applicable to the 15 wells not
yet drilled. Only 5/20ths of the platform costs would be subject to depreciation in the current year,
while 15/20ths of the platform costs (those applicable to the 15 undrilled wells) would be withheld
from the depreciable amount. The costs withheld would be transferred to the depreciable amount as the
additional wells are drilled. In lieu of basing the exclusion from depreciation on the number of wells,
the exclusion (and subsequent transfer to depreciable amount) could be based on the quantity of
reserves developed by individual wells compared with the estimated total quantity of reserves to be
developed.

Similarly, an appropriate portion of prospecting costs, mineral acquisition costs, exploration costs,
appraisal costs, and future dismantlement, removal, and restoration costs that have been capitalized
should be withheld from the depreciation calculation if proved developed reserves are used as the
reserves base and if there are undeveloped reserves in the cost pool.

By withholding some of the costs from the depreciation pool, an entity is able to achieve a better
matching of the costs incurred with the benefits of production. This is particularly important in respect
of pre-development costs, which provide future economic benefits in relation to reserves that are not
yet classified as ‘proved developed’.

However, excluding costs from the depreciation pool may not be appropriate if it is not possible to
determine reliably the portion of costs to be excluded or if the reserves that are not ‘proved developed’
are highly uncertain. It may not be necessary to exclude any costs at all from the depreciation pool if
those costs are immaterial, which is sometimes the case in mining operations.

(b) Proved developed and undeveloped reserves

Another approach that is common under IFRS is to use ‘proved developed and undeveloped reserves’
as the reserves base for the application of the units of production method. This approach reflects the
fact that it is often difficult to allocate costs that have already been incurred between developed and
undeveloped reserves and has the advantage that it effectively straight-lines the depreciation charge per
unit of production across the different phases of a project. For example, if the depreciation cost in
phase 1 of the development is $24/barrel and the depreciation cost in phase 2 of the development could
be $18/barrel, an entity that uses proved developed and undeveloped reserves as its reserves base might
recognize depreciation of, say, $22/barrel during phase 1 and phase 2.

Application of this approach is complicated by the fact that phase 1 of the project will start production
before phase 2 is completed. To apply the units of production method on the basis of proved developed
and undeveloped reserves, the entity would need to forecast the remaining investment related to phase
2. The approach does not appear unreasonable at first sight, given that the proved reserves are
reasonably certain to exist and ‘the costs of developing the proved undeveloped reserves will be
incurred in the near future in most situations, the total depreciable costs can also be estimated with a
high degree of reliability’. Nevertheless, the entity would therefore define its cost pool (i.e. unit of
account) as including both assets that it currently owns and certain future investments. Although there
is no specific precedent within IFRS for using such a widely defined unit of account, such an approach
is not prohibited, while in practice it has gained a broad measure of acceptance within the extractive
industries.

c) Proved and probable reserves

The arguments in favor of using ‘proved and probable reserves’ as the reserves base in applying the
units of production method are similar to those discussed at (b) above. The IASC’s Issues Paper
summarized the arguments in favor of this approach as follows:

‘Proponents of [using “proved and probable reserves” as the reserve base] use the same arguments
given for including proved undeveloped reserves and related future costs in calculating depreciation.
They point out that in a cost center in which development has only begun a large part of capitalized
prospecting, mineral acquisition, exploration, and appraisal costs may apply to probable reserves. Often
in this situation there are large quantities of probable reserves, lacking only relatively minor additional
exploration and/or appraisal work to be reclassified as proved reserves. They argue that, in calculating
depreciation, it would be possible to defer all costs relating to the probable reserves if either proved
developed reserves only, or all proved reserves, were to be used as the quantity on which depreciation
is based. They contend that using probable and proved reserves in the reserve base and including in the
depreciable costs any additional costs anticipated to explore and develop those reserves provides more
relevant and reliable information.’

The main drawbacks of this approach are that estimates of probable reserves are almost certainly
different from actual reserves that will ultimately be developed and estimates of the costs to complete
the development are likely to be incorrect because of the potentially long time scales involved.
Nevertheless, this approach has also found a considerable degree of acceptance under IFRS among
mining companies and oil and gas companies that were permitted to apply the approach under their
national GAAP before (e.g. UK GAAP).

d) Proved and probable reserves and a portion of resources expected to be converted into reserves
(mining entities only)

We observe in practice that some mining entities adopt a slightly different approach when depreciating
some of their mining assets. They use proven and probable reserves and a portion of resources expected
to be converted into reserves. Such an approach tends to be limited to mining companies where the type
of mineral and the characteristics of the ore body indicate that there is a high degree of confidence that
those resources will be converted into reserves. For example, this is very common for underground
operations that only perform infill drilling just prior to production
commencing. This is done so that capital is not spent too early before it is really needed.

Such resources can comprise measured, indicated and inferred resources, and even exploration
potential. Determining which of those have a high degree of confidence of being extracted in an
economic manner will require judgement. Such an assessment will take into account the specific
mineralization and the ‘reserves to resource’ conversion that has previously been achieved for a mine.

Such an approach is generally justified on the basis that it helps to ensure the depreciation charges
reflect management’s best estimate of the useful life of the assets and provides greater accuracy in the
calculation of the consumption of future economic benefits.

An entity preparing its financial statements under IFRS will need to choose between using ‘proved
developed reserves’, ‘proved developed and undeveloped reserves’, ‘proved and probable reserves’
and, for mining entities in relation to certain mines, ‘proved and probable reserves and a portion of
resources expected to be converted into reserves’ as its reserves base. Each of these approaches is
currently acceptable under IFRS. Preparers of financial statements should, however, be aware of the
difficulties that exist in ensuring that the reserves base and the costs that are being depreciated
correspond. Users of financial statements need to understand that comparability between entities
reporting under IFRS may sometimes be limited and need to be aware of the impact that each of the
approaches has on the depreciation charge that is reported. Given this, detailed disclosures are essential.

Unit of measure

Under the units of production method, an entity assigns an equal amount of cost to each unit produced.
Determining the appropriate unit by which to measure production requires a significant amount of
judgement. An entity could measure the units of production by reference to physical units or, when
different minerals are produced in a common process, cost could be allocated between the different
minerals on the basis of their relative sales prices.

(a) Physical units of production method

If an entity uses the physical units of production method, each physical unit of reserves (such as
barrels, tons, ounces, gallons, and cubic meters) produced is assigned a pro rata portion of
undepreciated costs less residual value.

Table 2. Physical units of production method

If an entity produces 100 units during the current period and the estimated remaining commercial
reserves at the end of the period are 1,900 units, the units available would be 2,000. The fractional part
of the depreciable basis to be charged to depreciation expense would be 100/2,000. Therefore, if the
depreciable basis was 5,000 monetary units, the depreciation for the period would be 250 monetary
units. 

In applying the physical units of production method a mining company needs to decide whether to use
either the quantity of ore produced or the quantity of mineral contained in the ore as the unit of
measure. Similarly, an oil and gas company needs to decide whether to use either the volume of
hydrocarbons or the volume of hydrocarbons plus gas, water and other materials. When mining
different grades of ore, a mining company’s gross margin on the subsequent sale of minerals will
fluctuate far less when it uses the quantity of minerals as its unit of measure. While a large part of the
wear and tear of equipment used in mining is closely related to the quantity of ore produced, the
economic benefits are more closely related to the quantity of mineral contained in the ore. Therefore,
both approaches are currently considered to be acceptable under IFRS.

(b) Revenue-based units of production method

Another possible approach in applying the units of production method that may have been used by
some entities previously is to measure the units produced based on the gross selling price of mineral.
However, this approach is no longer permitted. This is because as part of the 2011-2013 cycle of annual
improvements the IASB approved an amendment to IAS 16 and IAS 38 to clarify that a revenue-based
depreciation or amortization method would not be appropriate.

Joint and by-products

In the extractive industries it is common for more than one product to be extracted from the same
reserves (e.g. copper mines often produce gold and silver; lead and zinc are often found together; and
many oil fields produce both oil and gas). When the ratio between the joint products or between the
main product and the by-products is stable, this does not pose any complications. Also, if the value of
the by-products is immaterial then it will often be acceptable to base the depreciation charge on the
main product. In other cases, however, it will be necessary to define a unit of measure that takes into
account all minerals produced. The IASC’s Issues Paper listed the following approaches in defining
conversion factors for calculating such a unit of measure:
Calculation of a conversion factor based on volume or weight has the benefit of being easy to apply and
can lead to satisfactory results if the relative value of the products is fairly stable. For example, some
mining companies that produce both gold and silver from the same mines express their production in
millions of ounces of silver equivalent. This is calculated as the sum of the ounces of silver produced
plus their ounces of gold produced multiplied by some ratio of the gold price divided by the silver
price. For example, if the gold price was $900 and the silver price was $12, this would provide a ratio
of 1/75 – so the quantity of gold would be multiplied by 75 to determine the equivalent ounces of
silver. However these ratios can change depending on the relationship between gold and silver.

Calculation of a conversion factor based on other physical characteristics is quite common in the oil
and gas sector. Typically production and reserves in oil fields are expressed in millions of barrels of oil
equivalent (mmboe), which is calculated by dividing the quantity of gas expressed in thousands of
cubic feet by 6 and adding that to the quantity of oil expressed in barrels. This conversion is based on
the fact that one barrel of oil contains as much energy as 6,000 cubic feet of gas. While this approach is
commonly used, it is important to recognize two limiting factors: the actual energy conversion factor
will not always be 1:6 but may vary between 1:5½ to 1:6½ and the market price of gas per unit of
energy (typically BTU) is often lower than that of oil because of government price controls and the
need for expensive infrastructure to deliver gas to end users.

An approach that is commonly used (more so in the mining sector than the oil and gas sector) in
calculating a conversion factor when joint products are extracted, is to base it on gross revenues. The
main drawback of this method is that it requires an entity to forecast future commodity prices. Despite
this drawback, there will be situations where no other viable alternative exists for calculating an
appropriate conversion factor.

Finally, it is possible to calculate a conversion factor based on net revenue after deducting certain direct
processing costs. An argument in favor of this method is that gross revenues do not necessarily measure
the economic benefits from an asset. However, taken to an extreme this argument would lead down a
path where no depreciation is charged in unprofitable years, which is clearly not an acceptable practice.