Determining the useful life of an asset is a matter of judgment. No formula can provide a quantifiable way to determine useful life; instead, the business may refer to IRS Publication 946 or Accounting Standards Codification 350 for guidance. If you want a quick and easy way to determine useful life, the IRS provides standard useful lives for specific classes of assets that must be used for calculating tax depreciation. Otherwise, you may estimate useful life by examining the factors stated in ASC 350.
Determining the useful life of an asset is an important step in calculating depreciation, regardless of the depreciation method that you choose. You can learn more about calculating depreciation in our comprehensive guide on what depreciation is and how it works.
How To Determine the Useful Life of Assets for Tax Purposes
Publication 946 provides specific guidance on the useful lives of specific asset classes. Unlike the United States generally accepted accounting principles (GAAP) guidelines, which we cover below, IRS guidelines for determining useful lives are not a matter of judgment. For example, automobiles and office equipment have a five-year useful life while qualified rent-to-own property and tractor units for overhead use have a three-year useful life.
For detailed information about IRS guidelines recovery periods (asset lives), see the table in the IRS’s Appendix B of Publication 946.
How To Determine the Useful Life of Assets under GAAP
If your business is required to follow GAAP, then determining the useful life of assets is important and will require some judgment and then documentation of how that judgment was made. You can learn more about this in our detailed article on what GAAP is.
Generally, only companies with publicly traded stock or debt have to follow GAAP but some banks might also require GAAP as part of the loan agreement. Hence, to provide an authoritative basis on how to determine the useful life of an asset, we’ll borrow the major factors listed in Accounting Standards Codification 350 ASC 350 is the accounting standard for intangible assets, specifically covering goodwill and other intangibles. This standard provides the factors for determining the useful life of an intangible asset, which can also be applied to tangible assets. .
1. Expected Use of the Asset
There are two applications for determining the expected use of an asset as a basis for useful lives.
1. Asset’s expected use by its expected output: If an asset is expected to produce a certain number of units, its expected use is for the production of those units. Hence, its useful life will depend on how many units it can produce without compromising quality and efficiency.
- Let’s say that a machine is estimated to produce 500,000 bottles throughout its life. If annual production estimates are 20,000 bottles per year, we can estimate that the machine’s useful life is around 25 years (500,000 units ÷ 20,000 units per year).
2. Asset’s expected use by its purpose: If the asset has a single intended use, you can estimate it to have a longer useful life. But if the asset can be used for other purposes or projects, it may have a shorter useful life due to wear and tear and constant use.
- For example, a mechanical drill may have multiple uses for a construction company because it can be used for multiple projects. On the contrary, a mechanical drill intended for minor repairs in a digital marketing firm’s office building may have no other use for the company.
2. Expected Use of Another Asset or Group of Assets
If determining the asset’s expected use is difficult, you can refer to a related asset’s expected use. In our previous example, say the mechanical drill’s expected use can be related to the expected use of other tools like saws, vises, or grinders. Since all of these tools have similar uses, you use the same useful life for newer assets.
3. Legal, Regulatory, or Contractual Provisions Limiting the Useful Life
Laws may affect and limit the useful life of an asset. For example, intangible assets such as patents have a useful life of only 20 years. Moreover, copyrights have a useful life of 70 years after the author’s death. These are some examples of legal and regulatory provisions limiting the asset’s useful life.
In some cases, capital leases can also limit the useful life of an asset. In lease accounting, the depreciation of the leased assets under capital leases will be the shorter between the lease term or the asset’s useful life. For example, if the asset’s useful life is 20 years but the lease term is five years, the applicable useful life is five years.
4. Historical Experience
The useful life may be determined through historical experience in similar assets. In the capital leases example above, we can use the 20-year useful life—instead of the five-year lease period—if based on historical experience, we can expect that the lessor will renew the lease contract.
Historical experience may also refer to your experience in handling similar assets in the past. If a similar asset lasted 10 years, we can use it as the useful life for a similar asset. However, be careful in using past experience—it’s possible that an asset may last longer than expected in exchange for higher maintenance costs. Keep your estimates as practical as possible.
5. Economic Factors and Technological Advancements
Economic factors, such as changes in the industry, enactment of new legislation, or economic movements, may influence useful lives. For example, COVID-19 was a triggering event that required companies to reassess their estimates of useful lives and valuation of assets since property, plant, and equipment were under-utilized or idle because of lockdowns and slow production. It was a triggering event for impairment wherein some assets may have lost value because of the pandemic.
Aside from economic factors, the risk of obsolescence and exposure to competition may also influence the useful life. The popularity of artificial intelligence or AI nowadays may render some assets with no AI capabilities at a higher risk of obsolescence. The same is true for competitors who are using new and improved technology that uses AI to maximize efficiency, which may affect similar technology that doesn’t use AI.
6. Level of Maintenance
An asset’s useful life may also be based on the level of maintenance needed to keep it in good operating condition. Assets that require high maintenance costs after several years may imply a shorter useful life. Another indication would be the asset’s output. If the asset isn’t producing at the same level of output but is incurring higher maintenance costs, this instance may indicate a short useful life.
How Small Businesses Determine the Useful Life of Assets
There’s no definitive way or mathematical model that can solve how to calculate the useful life of an asset. To keep things simple and straightforward for small businesses, using tax lives under the IRS’s Appendix B of Publication 946 is the most convenient option since there’s no guesswork involved.
Since small businesses aren’t required to follow GAAP, they have more leeway or options. Using tax lives also makes book and tax depreciation the same as long as you use the same depreciation method.
An alternative way to determine useful life is your use case of the asset. For example, if you think you’ll use an asset for 10 years before upgrading to a newer model, you can set the useful life to 10 years. However, past experience will suffice.
For instance, say office computers usually last six years before you observe a decline in performance, such as starting to slow down, experiencing frequent repairs, and having incompatibilities with newer software. Hence, you can set the useful life at six years.
Fixed asset accounting is a crucial part of bookkeeping. You can see our guide to fixed asset accounting for more information, and if you want to learn more about bookkeeping in general, head to our in-depth bookkeeping guide.
Frequently Asked Questions (FAQs)
There is no quantitative way to calculate the useful life of an asset, as useful life is determined through estimates or by referring to the IRS guidelines on useful lives. But for output-based assets, the calculation of useful life can be computed as dividing estimated production throughout its life by estimated annual production.
The easiest way to determine useful lives is to refer to Publication 946 because it specifically shows the useful life of each property. This is required for tax purposes and is also good for small businesses that aren’t required to follow GAAP.
Bottom Line
Knowing how to determine the useful life of an asset is a matter of judgment because there’s no direct way to do it. Small businesses can either use tax lives or use the factors mentioned in ASC 350. But for practicality, we recommend using tax lives for most small businesses unless there’s a better way available.
