What is useful life?
The useful life of an asset is an estimate of the number of years it will remain in profitable service.
Business assets—such as machinery, equipment, vehicles, and even buildings—depreciate over time. The purpose of a useful life estimate is to determine how long an asset will remain in useable condition. From a financial standpoint, this means the period of time in which an asset will generate an economic benefit for the business.
It’s worth noting that “useful life” is not the same as the actual life of an asset. A piece of equipment may last far longer than its estimated useful life, but it will need more and more maintenance as it reaches that point. In addition, an asset may become obsolete or require major repairs. An especially old asset, while technically functional, may be more of a liability than a benefit if it requires frequent repair work.
In asset management, useful life estimates are used to determine how long an asset should be kept before it’s replaced. This is especially important in maintenance planning since it can help inform decisions about whether to conduct major repairs on an older piece of equipment. For instance, if a mechanical asset is nearing its useful life and breaks down, a maintenance director may deem it to be more cost effective to replace it than to repair it.
In terms of financial planning, an asset’s useful life is used to calculate depreciation for tax purposes. As an asset depreciates, businesses can subtract the amount of depreciation from their taxable income for the useful life of the asset.
How useful life is determined
The useful life of an asset is rarely the same from one company to another. Various factors, such as frequency of usage, working environment, and maintenance performed on the asset all affect its useful life, so it can be difficult to calculate an absolute value.
Businesses may determine an asset’s useful life through a variety of means, including the following:
- Standard industry practices
- Engineering estimates
- Past experience with similar assets
- Statistics related to the asset
In addition, the IRS has compiled a list of useful life estimates for most tangible assets, and accountants may use those when calculating depreciation. These estimates categorize assets into different classes based on industry, and they may be useful when it comes to determining useful life.
That said, the estimated values set forth by the IRS are not absolute, and the numbers can be adjusted based on various factors, such as technological advancements, economic changes, and actual usage of the asset.
Example of useful life
A paper manufacturer purchases a new boiler for use in their processes, namely steaming wood chips. Their previous unit lasted them 25 years, which is expected for large industrial boilers. As such, the asset management team might determine that the useful life of this boiler will be the same.
However, the IRS lists paper and pulp manufacturing equipment with a class life of 13 years, and the GDS (general depreciation system) period is only 7 years. Useful life is not the same as the actual life expectancy, and if the company insists on a 25 year useful life on their taxes, they could end up paying more taxes than they should.
Their useful life estimate will impact their maintenance planning. As the boiler nears the end of its useful life, the company is less likely to pour money into fixing it, especially if they can no longer claim depreciation for the asset on their taxes. The longer the boiler’s useful life, the longer it will make sense to keep repairing it.
How useful life affects depreciation
Useful life is central to depreciation. In general, the longer the useful life of an asset, the slower it will depreciate.
For instance, suppose an asset valued at $50,000 with a salvage value of $12,000 has a useful life of 10 years. Using the straight line depreciation method, the asset’s depreciation would be calculated as follows:
($50,000 cost – $12,000 salvage value) ÷ 10 years = $3,800 per year
If the asset has a slightly longer useful life of 15 years, the calculations look like this:
($50,000 – $12,000) ÷ 15 years = about $2,533 per year
The asset provides a lower exemption amount, but the company would be able to claim that exemption for five more years.
Useful life represents how long an asset is likely to be profitable to the business. It is used to calculate an asset’s depreciation while also helping inform maintenance and purchasing decisions. The longer the asset’s useful life, the lower its depreciation rate will be, but also the longer the company will benefit from it.