How to estimate the useful life of a fixed asset

Useful life estimates 

To determine the depreciation expense on a fixed asset, companies must estimate the useful (service) life of the fixed asset as well as its salvage value.

To estimate the useful life, a company might use (i.e., non-exhaustive list):

• Its past experience with the same or similar assets
• Engineering estimates
• Industry practices
• Statistical methods
• Judgmental estimates

Typical ranges of useful life estimates are as follows:

• Automotive equipment: 3-6 years
• Furniture and fixtures: 5-12 years
• Machinery and equipment: 3-20 years
• Buildings and improvements: 10-50 years

Useful life estimates are subject to management’s judgment and can be revised during the life of the fixed asset.  

Because estimating the useful life of a fixed asset represents an uncertainty, a business should follow conservative accounting practices in doing so. 

The understatement of the useful life when a fixed asset is purchased is one of the window dressing techniques used by companies to improve their performance appearance: during the life of the fixed asset, the company can prolong its useful life estimates, and as the result, it can decrease its depreciation expense and increase its net income. When analyzing the useful life estimate, in such a case, one can look at industry norms to see whether a company is overstating its earnings by using useful life estimates that are unjustifiably long.

Fixed asset useful life factors 

The useful life of a fixed asset is often different from its physical life. For example, a fixed asset can be physically capable of producing goods (beyond its useful life) but it might be retired by the company because the asset is inadequate, technically obsolete, etc. In other words, such an asset is no longer useful to the company.

There are two main types of factors that can affect the useful life a fixed asset:

1. Physical factors:  expiration, wear and tear, decay, casualty (fire, flood, theft)
2. Economic factors:
   1. Inadequacy: a fixed asset becomes not useful when the demands of a company change
   2. Supersession: a fixed asset is replaced with a more efficient or economical asset
   3. Obsolescence: unforeseen physical or technical obsolescence

For different types of fixed assets, different factors might be considered when estimating the useful life. That is, for some fixed assets physical factors are more important than economic factor, and vice versa.

For example, physical factors are usually more important in estimating the useful life of buildings: for example, wear and tear, decay, and casualty (e.g. fire, flood) are more likely to be the cause of retiring a building. In this case, maintenance plays an important role in prolonging (or shortening) the useful life of the fixed asset.

Economic factors, on the other hand, are more likely to affect the useful lives of equipment, machinery, factories, etc. A piece of machinery might become technically obsolete well before its physical life is over. Important to note, economic factors might also effect the residual value of a fixed asset. For example, technical obsolescence often affects not only the useful life of computers but also their salvage values.

When the utility (i.e., usefulness) of a fixed asset drops below its book value, the fixed asset should be written down. 

 In other words, when the fair value of a fixed asset is below its book value, a company should recognize an impairment loss on the fixed asset: this loss should not be reported as an extraordinary item. For example, according to the US GAAP, a fixed asset should be written down when the estimated future cash flows from using the asset are less than the asset’s book value. This is an example of a conservative accounting practice.