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Useful Life

DEFINITION

The term useful life is used in accounting to approximate the amount of time in years that an asset owned by a business will remain in operation and will continue contributing cost-effectively to revenue generation within the company.

EXPLANATION

The useful life of an asset is a crucial metric that is used by businesses and the Internal Revenue Service (IRS) to determine the amount of depreciation that can be deducted each year for most equipment and machinery. The useful life of an asset is very crucial to the depreciation expenses recognized by businesses each year. As an illustration, a business has a fixed asset such as a packaging machine whose useful life was initially estimated as 3 years, but a later assessment reveals that the machine’s useful life is 6 years. In such a scenario, the company’s yearly depreciation expense will drop to half the initial amount.

How to Determine the Useful Life of Different Assets

The useful life of an asset is typically estimated as the number of years that the equipment shall remain in operation before being rendered obsolete by new technology, or before its stops producing results economically, or before it needs expensive repairs. Most businesses typically group their equipment and machinery into various classes and then assign different useful life periods for each category of assets. Therefore, whenever the business acquires a new capital asset, the controller simply assigns it to the class of assets that have similar characteristics, which automatically allocates a useful life estimate to the asset.

The Impact of Useful Life Estimates on Depreciation Schedules

There are two methods used to calculate the depreciation of a fixed asset, which are the straight line method, and the accelerated model. According to the straight line model, the yearly depreciation expense of an asset is determined by taking the initial value of the asset and dividing it by the asset’s useful life duration measured in years.

On the other hand, the accelerated method of computing the depreciation expense typically involves recognizing higher depreciation expenses in the early years of an asset’s useful life followed by lower depreciation write-offs in later years. The most common accelerated model is the one based on the reducing balance where the depreciation rate declines over the years up to the zero mark.

Can The Useful Life Estimate Change Over Time?

A business can change the useful life estimate of some of its fixed assets mainly due to the product being rendered obsolete by the emergence of new technology. In such cases, the IRS has a provision that allows the affected companies to change the useful life estimate of such equipment. However, the company has to supply the IRS with documentation detailing the characteristics of the new technology and how it will make the firm’s current equipment obsolete. Qualified businesses are then allowed to fast-track the depreciation schedule for the affected machine in order to match the period by which new technology is expected to make the utility obsolete.

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