Table of Contents
Definition and Meaning
The term “estimate” means to evaluate or judge the value of something roughly. When it comes to bookkeeping, there are many things to estimate, and one of those things is assets.
An asset’s estimated useful life is the duration for which it is expected to remain in productive use before it becomes outdated or completely broken. Firms use it to estimate how long the asset will be valuable to them.
Many financial statement items cannot be measured accurately because of the uncertainty of the business environment. Estimation relies on current information and historical trend analysis to make judgments. There are times when estimates are needed for provisions, valuations, inventory, depreciation, etc.
Examples
For a better understanding of the concept, let’s look at the following examples.
Example 1 – Estimated useful life of a tangible asset
Car: Imagine you buy a brand-new car for your taxi business. You estimate that this car will be able to run smoothly and efficiently for about 10 years before it starts experiencing significant breakdowns or becomes outdated. The scrap value is estimated to be nil.
In this case, the estimated useful life of the car is 10 years. After 10 years, the car might not be as reliable or cost-effective to operate, so you might consider replacing it with a newer model.
Example 2 – Estimated useful life of an intangible asset
According to an agreement, ABC Ltd. registers a copyright for five years. In this case, the cost of the asset can be amortized for only five years, and it is expensed on a straight-line basis.
Example 3 – Estimated useful life of a ‘Land’ (exceptional case)
In the case of land, as there is no wear and tear and obsolescence, the useful life is indefinite. As a result, land is not a depreciable asset.
Related Topic – Why is Depreciation Not Charged on Land?
How to Determine Useful Life?
The task of determining the estimated useful life of an asset is handed over to the Managers or Accounting Committee (if any) or the Senior officers.
There is no standardized process or an absolute formula. Instead, it is a matter of professional judgment by considering the data available.
Points that might be considered for determining the useful life of an asset:
- Related Laws – Refer to the applicable tax laws for depreciation/amortization and follow the guidelines mentioned there.
- Manufacturer Specifications – The manufacturer may be able to provide information based on the asset’s experience with other clients.
- Industry Benchmarks – An industry benchmark is a performance measure or guideline set in a particular industry.
- Past Experience – Historical data about how long similar assets have lasted in the past within your own company can provide valuable insights. If you have records of when similar assets were purchased and when they needed to be replaced or repaired, you can use this information to make a more accurate estimate of the useful life of an asset.
Related Topic – Difference Between Asset and Inventory
Useful Life and Depreciation
Depreciation: The useful life of an asset is closely related to depreciation. It refers to the gradual decrease in the value of an asset over its estimated useful life. Wear and tear, obsolescence and changes in market conditions reduce an asset’s value as it ages. When the useful life of an asset ends, it becomes fully depreciated.
The estimated useful life of an asset is a key component in calculating depreciation. Assets with longer useful lives will have lower annual depreciation expenses, while assets with shorter useful lives will have higher depreciation expenses.
Matching Principle: Depreciation aligns with the accounting principle of matching expenses with revenues. As an asset contributes to generating revenue over its useful life, its cost is gradually matched with the related revenues in the income statement.
Overall, depreciation is built upon the understanding of an asset’s useful life. It guides how the asset’s cost will be spread over time to accurately reflect its diminishing value. It is crucial for businesses to understand this concept so that they can plan for replacements, upgrades, and financial reporting.
Related Topic – How to Calculate the Scrap Value of an Asset?
Change in Estimated Useful Life
An estimate is a prediction based on circumstantial evidence, but due to the dynamic business environment, things might change. These modifications can be due to changes in external factors like the economic environment, laws, technology, etc.
Changes can also be due to internal factors like the company’s change in vision, change in policy, manufacturing process, etc.
For example, if a piece of machinery was initially estimated to have a useful life of 10 years, but after a year of use, it becomes clear that it will remain operational for only 5 more years, the estimated useful life has reduced.
In addition, this change may affect how depreciation is calculated and the depreciation method. It may potentially extend the depreciation period.
Related Topic – Fixed Assets Ratio
Factors Affecting the Useful Life of an Asset
An asset’s useful life may be affected by the following factors:
- Usage & Maintenance
- Environment
- Technological Advancements
- Government Policies
- Type of Asset, etc.
Impact on Income Statement
The effect of a change in the useful life of assets should be included in the determination of net profit or loss in the:
- The period of the change, if the change affects one period only
- The period of the change and future periods (if both are affected)
The effect of a change in an accounting estimate should be classified using the same classification in the statement of profit and loss used previously for the estimate.
This is to ensure the comparability of financial statements of different periods, the effect of a change in an accounting estimate which was previously included in the profit or loss from ordinary activities is included in that component of net profit or loss.
Disclosure Requirements
The nature and amount of a change in an accounting estimate which has a material effect in the current period or which is expected to have a material effect in subsequent periods should be disclosed. If it is impractical to quantify the amount, this fact should also be disclosed.
Related Topic – Calculate Depreciation Rate Percentage from Depreciation Amount
How to extend the useful life of an asset?
- Repair & Maintenance
- Machine Operator Training
- Following User Manuals & Guidelines
- Buying the right asset in the first place
- Using Original Spare Parts, etc.
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