Useful life definition
/What is Useful Life?
Useful life is the estimated lifespan of a depreciable fixed asset, during which it can be expected to contribute to company operations. This is an important concept in accounting, since a fixed asset is depreciated over its useful life. Thus, altering the useful life has a direct impact on the amount of depreciation expense recognized by a business per period. For example, altering a useful life from two years to four years doubles the time over which depreciation is recognized, which cuts the amount of depreciation expense recognized per period in half.
If changing circumstances impact a fixed asset, it is possible that the remaining useful life will also be changed; this impacts the remaining amount of depreciation that has not yet been recognized, but has no impact on depreciation that has already been recognized in prior periods.
The useful life concept as employed within a business does not necessarily reflect the entire lifespan of an asset; it may be sold off to a third party, which then continues to use the asset for an extended period of time. Thus, the useful life figure used by a business may be a subset of an asset's actual usage period.
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Useful Life Best Practices
There are several best practices relating to the useful life concept, which are as follows:
Standardize the useful life. It is relatively common to assign a standard useful life to every asset recorded within an asset class (such as machinery, vehicles, or computer equipment). Doing so takes away the need to justify the useful life assigned to every individual asset. Instead, if an asset fits the definition of assets recorded within a particular asset class, then the assignment of a useful life is automatic. This reduces the time required to set up an asset record in the accounting system.
Use manufacturer guidelines. Manufacturer or vendor information often provides an estimated useful life based on typical usage. This can serve as a starting point for estimating an asset's useful life, and is much better than guessing at how long an asset will last.
Impact of Useful Life on Cash Flow
The useful life concept has no direct impact on cash flow, since depreciation is a non-cash expense. However, depreciation can reduce the tax liability of a business, resulting in lower tax payments. Therefore, depreciation has an indirect impact on cash flow. From this perspective, it makes sense to use accelerated depreciation whenever possible, in order to defer the payment of income taxes.
Impact of Asset Impairment on Useful Life
When an asset is declared to be impaired, the expected cash flows to be generated from it are likely to decline, which can trigger an impairment charge that greatly reduces its carrying amount. This is a good time to also examine the expected remaining useful life of the asset, which may have shrunken. If so, apply the revised useful life to its remaining carrying amount to devise a new periodic depreciation charge. This will likely be much smaller than the depreciation charge that had previously been applied to the asset.
Example of Useful Life
As an example of useful life, a fixed asset is purchased at a cost of $10,000. The company controller estimates its useful life to be five years, which means that the business will recognize $2,000 of depreciation expense per year in each of the next five years. If the controller had instead stated a useful life of six years, the annual depreciation would have been $1,667.