How to Find the Useful Life of an Asset: Definition, Importance and Examples
Definition of Useful Life
The useful life of an asset is a fundamental concept in finance and accounting that refers to the estimated length of time that the asset can be used effectively and economically by a business.
Simply put, the useful life of an asset represents the period during which the asset provides value and contributes to the operations of the business before it becomes worn out, outdated, or needs to be replaced.
Knowing how to find the useful life of an asset is important for various financial reporting and decision making purposes.
Some of these reasons include:
Calculating Depreciation
Depreciation is the accounting process of spreading the cost of an asset over its useful life.
If a business knows the useful life of their assets, they can more accurately calculate the depreciation expense incurred for each accounting period.
Accurate depreciation calculations are vital for preparing financial statements and assessing the financial health of a company.
Evaluating Asset Value
The useful life of an asset plays a substantial role in determining its value.
Stakeholders such as investors and creditors rely on accurate asset valuations to make informed decisions such as whether or not to invest, or whether or not to lend money to the business.
Determining Return on Investment (ROI)
Determining the useful life of an asset allows businesses to evaluate the return on their investment in that asset.
By comparing the initial cost of the asset with the estimated future cash flows it is expected to generate over its useful life, businesses can evaluate the profitability and efficiency of their investment decisions.
Planning for Replacement or Upgrade
Assets have a limited useful life, after which they may become less efficient, technologically outdated, or require significant repairs.
By accurately determining the useful life, businesses can plan for future asset replacements or upgrades, allowing the business to continue functioning as normal and minimising any potential disruptions.
Also, understanding the useful life of an asset provides clarity into its maintenance requirements. This allows businesses to be proactive in allocating resources for repairs and upkeep.
This can help to avoid unexpected breakdowns, increase the asset’s longevity, and maximise its performance throughout its useful life.
Factors Influencing Useful Life
There are several factors that can influence the useful life of an asset, including:
Physical Wear and Tear
The way an asset is used and maintained can significantly impact its useful life.
Assets subject to heavy usage, such as machinery in a manufacturing plant, may experience higher levels of wear and tear, leading to a shorter useful life.
For example, a delivery vehicle that frequently travels long-distance would likely build up more mileage and mechanical stress, which could shorten its useful life compared to a vehicle used for shorter distance deliveries.
Technological Advancements
Rapid developments in technology can render certain assets obsolete sooner than expected.
For example, in the automotive industry, advancements in automation and robotics have led to faster and more precise production methods.
This means that older equipment may have a shorter useful life compared to newer, technologically advanced machinery.
External Changes
Changes in consumer preferences, market trends, or regulations can also affect the useful life of assets.
For example, in the energy sector, the useful life of renewable energy infrastructure, like solar panels, can be affected by technology advancements. As solar panel technology improves, older panels can become less efficient and outdated and might need to be replaced quickly.
Environmental Conditions
The environment in which an asset operates can impact its useful life.
Assets exposed to extreme temperatures, humidity, corrosive substances, or other adverse conditions may deteriorate more quickly.
For instance, equipment used in saltwater environments, such as offshore oil rigs or ships, may experience accelerated corrosion, reducing their useful life compared to similar assets used in less harsh environments.
Maintenance and Repair Practices
Thorough and regular maintenance and repair procedures can extend the useful life of an asset.
Proper upkeep, including regular inspections and replacement of worn parts, can help reduce wear and tear and prolong the useful life.
For example, regular oil changes and filter replacements in a vehicle can help maintain its engine’s longevity, ensuring a longer useful life.
Useful Life vs Physical Life
The useful life of an asset should not be confused with the physical life of an asset.
While the useful life refers to the period in which the asset is expected to provide productive service to the owner, the physical life represents the actual lifespan of an asset until it can no longer be used.
Consequently, the physical life is often much longer than the useful life.
Consider a piece of machinery used in a manufacturing facility. The estimated useful life of this asset could be determined based on factors such as the expected productivity, maintenance requirements, and technological advancements in the industry.
If the estimated useful life of the machinery is 10 years, it means that the business expects to receive economic value from it for a decade before it becomes less efficient or needs replacement.
During this period, the machinery is projected to contribute to the manufacturing processes, meet production targets, and generate revenue for the company.
However, the physical life of the machinery may not necessarily align with its estimated useful life.
The physical life represents the actual duration for which the machinery remains operational before it cannot function properly or stops working altogether.
It is influenced by factors such as the quality of construction, durability of components, and regular maintenance.
For example, let’s assume that the physical life of the machinery is 15 years.
This means that the machinery has the potential to continue functioning beyond its estimated useful life of 10 years.
Even though it may still be operational, it may become less efficient, require more frequent repairs, or not meet the production demands and technological advancements in the industry.
As a result, the machinery may no longer provide the same level of economic value or contribute optimally to the business.
Methods to Estimate the Useful Life of an Asset
The useful life of an asset can be estimated using various methods, such as:
Industry Standards
For certain types of assets, industry standards may exist that provide guidance on the expected useful life. For example, the useful life of a computer may be estimated to be three to five years, based on industry standards.
Experience
The experience of the business with similar assets can also be used to estimate the useful life. For example, if a business has purchased similar machinery in the past, it can use its experience with those assets to estimate the useful life of new machinery.
Technical Factors
Technical factors can also be used to estimate the useful life of an asset. For example, the manufacturer of the asset may provide information on the expected useful life based on the materials and components used in the asset.
Legal Factors
Legal factors may also impact the useful life of an asset. For example, a business may be required by law to replace a certain type of equipment after a certain number of years for safety reasons.
Physical Condition
The physical condition of the asset can also be used to estimate its useful life. For example, if an asset is well-maintained and in good condition, it may have a longer useful life than an asset that is poorly maintained and in poor condition.
Accounting Standards and Regulations
Various accounting standards, such as the International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP), play a crucial role in providing guidelines for useful life estimation in financial reporting.
These standards are designed to ensure consistency and accuracy in the way businesses report their financial information.
Both IFRS and GAAP provide specific principles and guidelines for businesses to follow when estimating the useful life of an asset.
These standards highlight the importance of using reasonable and justifiable assumptions based on factors such as historical data, industry practices, and technological advancements.
IFRS, issued by the International Accounting Standards Board (IASB), is widely used in many countries around the world.
It sets out detailed requirements for useful life estimation in its framework and specific standards, such as:
IAS 16 | Property, Plant, and Equipment |
IAS 38 | Intangible Assets |
Similarly, GAAP, primarily followed in the United States, provides guidance on useful life estimation issued by the Financial Accounting Standards Board (FASB).
GAAP’s guidelines are outlined in the Accounting Standards Codification (ASC), specifically in topics such as:
ASC 360 | Property, Plant, and Equipment |
ASC 350 | Intangibles—Goodwill and Other |
By complying with these accounting standards, companies ensure that their financial statements are prepared in accordance with a common set of rules and principles.
This allows investors, creditors, and other stakeholders to compare businesses more accurately and therefore make informed decisions based on reliable and consistent financial reports.