Useful Life of Fixed Assets for Tax and Reporting Purposes
“How do you determine the useful life of a fixed asset?”
That question confronts just about every accountant and fixed asset manager. The proper answer depends upon the reason for determining useful life and the governing authority or standard that is being applied. Determining the useful life of an asset is necessary for calculating depreciation for tax as well as accounting and financial reporting.
The standards for financial reporting, Generally Accepted Accounting Principles (GAAP), are promulgated by the Financial Accounting Standards Board (FASB).
- The mission of the FASB is to provide standards that foster financial reporting that provides “decision-useful information” to investors and other users of financial reports. In a sense, the focus of accounting and financial reporting is to fairly state the financial position and profitability of a business.
So, when it comes to determining useful life under GAAP, the intent is to select a useful life that reflects the actual economic or service life of the asset. In the GAAP world, useful life is a reasonable and informed judgment made by management based upon a number of factors that will be discussed in this article.
- In essence, the Internal Revenue Service exists, among other things, to help business understand and meet their tax obligations—to properly determine and pay their taxes.
So, when it comes to useful life for tax reporting, Tax Code prescribes a “recovery period” based on the class into which an asset is categorized. The recovery period (useful life) is established by the Tax Code.
- Generally speaking, GAAP are concerned with issues of economic value and profitability while the Tax Code is concerned with the proper calculation of tax obligation.
Useful life is one of the key components of calculating depreciation along with the method and convention (for tax purposes). Depreciation is treated as a cost on the Income Statement. A reasonable determination of useful life is necessary in order to prepare an accurate profit and loss statement.
- Overestimated useful life = overstate Net Income.
Underestimated useful life = understate Net Income.
A fixed asset’s Useful Life under GAAP is based on a reasonable estimate and therefore requires some judgment. Useful life differs from physical life. A fixed asset just doesn’t fall apart into a pile of useless components when it reaches the end of its useful life. An asset has useful life for as long as it has economic utility to the owner. Economic utility includes the ability to create a product (service) or results in a reduction of costs. Output and cost-savings are economic benefits.
The following factors that can determine or reduce the useful life of a fixed asset:
Wear and tear from use (normal or excessive).
- Physical deterioration due to the passage of time.
Obsolescence due to changes in technology or the environment.
Inadequacy or the inability of the asset to keep up with demand that the business puts upon it.
Contractual terms such as the length of a lease with respect to leasehold improvements.
Limitations or restriction mandated by regulators.
There are a number of places where management can find information to support a reasonable judgment of an asset’s useful life:
- Previous experience with similar assets.
Engineering data and specifications (product manuals, warranty information).
Regardless of the source or sources of data that are drawn upon, the data need to be evaluated and synthesized into an actual estimate of useful life. The following questions can be used to help guide you to a supportable decision:
What is the reason for purchasing the asset? An asset can be acquired for any of the following reasons:
- Increase production output and revenues.
Replace worn-out equipment.
For compliance purposes (generally doesn’t result in output increases or cost savings).
Is the purchase for “general use” or tied to a contract that has a defined termination date?
What is the nature of the asset?
Is the asset new or used? If the asset is used, what is its condition?
Does the manufacturer provide information on the average life or productive output of the asset?
While land is generally non-depreciable, does it have any characteristics that would make it depreciable?
- For example, if the land has something akin to a quarry or serves as a landfill, it might be depreciable over the appropriate useful life.
Is the asset component or part of a group of assets? Is it a standalone asset?
- For assets depreciated as a group you may use an average useful life for all assets in the group. The advantage of asset groups is that when you assign an asset to a group, the group determines the asset’s useful life. Using asset groups with a large number of assets is also less time consuming than estimating useful lives on an asset-by-asset basis.
What is the span over which the company intends to utilize the fixed asset to produce income?
What is the most accurate standard of measurement for the asset’s utilization?
- Standards can be time-based such as years/months or hours of operation; activity-based such as units produced or miles driven; or any other reasonable standard.
Past practice can provide a helpful starting place for estimating the life of similar assets, provided that that such prior practice is accurate and reasonable. Here is a test to determine the reasonableness of useful lives of the company’s existing assets:
- Make a list of all assets include a description, date of service, and the net book value of the assets. (Net Book Value equals Original Cost minus Accumulated Depreciation for the asset.)
Export the list to Excel.
Sort the list in ascending value based upon Net Book Value.
Now, review the results. Are there a large number of assets with zero Net Book Value that are still in service? If so, that suggests that you are underestimating the Useful Life of your Fixed Assets. On the other hand, are there assets that have been retired or are near retirement that show significant Net Book Value? Such a review of historic Net Book Value might temper your judgment when applying prior practices when determining the Useful Life of a newly acquired asset.
This checklist list will help you consider many of the factors that go into determining a reasonable useful life for accounting and financial reporting. The next edition will take a closer look at fixed asset useful life from the tax perspective.