How to estimate the useful life of a fixed asset

2. Fixed asset useful life factors

The useful life of a fixed asset is often different from its physical life. For example, a fixed asset can be physically capable of producing goods (beyond its useful life) but it might be retired by the company because the asset is inadequate, technically obsolete, etc. In other words, such an asset is no longer useful to the company.

There are two main types of factors that can affect the useful life a fixed asset:

  1. Physical factors:† expiration, wear and tear, decay, casualty (fire, flood, theft)
  2. Economic factors:
    1. Inadequacy: a fixed asset becomes not useful when the demands of a company change
    2. Supersession: a fixed asset is replaced with a more efficient or economical asset
    3. Obsolescence: unforeseen physical or technical obsolescence

For different types of fixed assets, different factors might be considered when estimating the useful life. That is, for some fixed assets physical factors are more important than economic factor, and vice versa.

For example, physical factors are usually more important in estimating the useful life of buildings: for example, wear and tear, decay, and casualty (e.g. fire, flood) are more likely to be the cause of retiring a building. In this case, maintenance plays an important role in prolonging (or shortening) the useful life of the fixed asset.

Economic factors, on the other hand, are more likely to affect the useful lives of equipment, machinery, factories, etc. A piece of machinery might become technically obsolete well before its physical life is over. Important to note, economic factors might also effect the residual value of a fixed asset. For example, technical obsolescence often affects not only the useful life of computers but also their salvage values.

When the utility (i.e., usefulness) of a fixed asset drops below its book value, the fixed asset should be written down. In other words, when the fair value of a fixed asset is below its book value, a company should recognize an impairment loss on the fixed asset: this loss should not be reported as an extraordinary item. For example, according to the US GAAP, a fixed asset should be written down when the estimated future cash flows from using the asset are less than the assetís book value. This is an example of a conservative accounting practice.

To learn more about accounting for fixed assets, refer to the tutorial on Accounting for Long-term Assets.

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