The importance of service life estimates
Estimated useful life has long-term implications for many different aspects of your business:
- Bookkeeping:Depreciation rates have a significant impact on balance sheets, income statements, tax liabilities and (indirectly) cash flows. To calculate depreciation, it is necessary to know the useful life of the asset.
- Financial planning:Useful life and depreciation tell you how long it will be before a significant investment is needed to replace your major assets. This will have a major impact on medium and long-term financial and budget planning.
- Maintenance and Security:To ensure maximum safety in the workplace, you mustperform routine maintenanceequipment and facilities. Failure to do so increases the risk of catastrophic equipment failure and accidents. Monitoring the estimated useful lives of assets will be useful todevelop appropriate preventive maintenance schedules.
- Value of the recovered property:it is often possible to recover at least part of the initial investment in an asset by selling it at the end of its useful life. This residual value is another key element of the depreciation calculation. To accurately estimate the value of a residual asset, you need to be aware of its useful life.
The end of useful life does not necessarily mean the end of the useful life of the asset. It's more like retirement. Assets at the end of their useful lives may still have value to others outside the company. Many companies routinely recover old machines and vehicles through auctions and other means. This helps to reduce or prevent accounting financial losses, returning residual value to the company through resale.
How to determine the useful life of an asset
The useful life of an asset is an estimate and not an exact number. All fixed assets are assumed to have a useful life of at least one year. While there is no need for a high accuracy of weeks or months, care should always be taken when estimating service life.
Even a change of a few years in the estimated useful life of a fixed asset will constitute a significant change in the accounting books in the form of depreciation. Therefore, due diligence is always recommended in determining the useful life of an asset.
Factors that affect the useful life of the asset
Various internal and external factors can affect the useful life of an asset. Some of them will be physical, others may be financial or even technological.
Here is a list of important factors to consider when assessing the useful (remaining) life of an asset:
- State of the property at the time of purchase:the new feature will obviously last longer than the one used previously.
- Usage patterns:Assets subject to heavy use are more likely to experience increased wear. Likewise, the useful life of some equipment/buildings that remain unused for long periods of time may be reduced.
- Climate/geography:Assets located in areas with extreme weather or prone to natural disasters (fires, floods, etc.) may require a shorter estimated useful life.
- Technology:technological progress can lead to more rapid obsolescence of some assets. Computers and other digital devices are a good example of goods that age relatively quickly.
- Government/Compatibility:especially in the face of the ongoing climate crisis, this aspect has become more important. The service life of equipment and vehicles that do not meet the latest environmental standards will be shortened.
Incidents and major failures can shorten the life of assets. Maintenance professionals must monitor the condition of assets and alert you to potential needs.review estimates of the useful lives of assets.
Estimated useful lives of fixed assets
From an accounting point of view, the main body responsible for estimating the useful life of corporate assets is the government's finance department. For example, in the United States, this is done by the Internal Revenue Service (IRS).set depreciation standardsfor most fixed asset classes.
Here are some highlights from a long list of assets:
Depending on your asset type, you may also benefit from guidance from widely respected industry organizations. For example, you can use Association of Building Owners and Managers (BOMA)for office properties or RSMeans Gordian Databasefor construction-related assets. Based on this, you can make reasonable adjustments based on factors relevant to your case.
How to calculate the useful life of an asset
There are two main approaches to calculating depreciation:straight line depreciationEUaccelerated depreciation.
Before picking up the calculator, you need to know the following information:
- The cost of the asset: the cost of the asset includes the total acquisition cost - acquisition cost, transportation expenses, installation expenses, personnel training costs, etc.
- Asset useful life:estimated using the resources mentioned above and/or based on information available in the OEM (Original Equipment Manufacturer) manual.
- Recovery value:the asset's resale value at the end of its useful life, often available in guidelines from reputable industry bodies.
Straight line depreciation
The straight-line depreciation method consists in the fact that annual depreciation is deducted in equal installments over the life of the fixed asset. The result is a steady decline in value as you amortize the same amount each year.
Straight-line depreciation is the easiest and simplest method of calculating asset depreciation. As a result, it is also less prone to errors, making it the preferred model in most cases. It's perfect foractive permanentwhose value is expected to continuously decrease over the years.
Example of straight-line depreciation: office building
Consider a new $1,000,000 warehouse building with a standard lifespan of 30 years. The estimated value of the land is US$ 200,000. By subtracting the land value from the asset cost, you get $800,000. Divide that by lifetime to get $26,666. This is the annual depreciation value of the warehouse over these 30 years.
Here are some more readsif you want to know more about this model.
Within the accelerated depreciation category, there are several different methods (you can see two in the image above – DDBM and SYDM). Despite the complexity of these methods, there are reasons to use the accelerated model:
- This is the most appropriate approach for assets such as computers that age faster than other assets. The sharp decline in asset values in the early years reflects this trend.
- It reflects a common usage pattern where a newly acquired asset is used heavily in the early years, resulting in increased wear and tear.
- Companies may opt for accelerated depreciation due to specific tax strategies.
Example of accelerated depreciation: CNC machine
Suppose a company purchases a CNC machine for a total cost of $200,000. For a 3-axis production milling machine, we can define a service life of 10 years.
Due to intensive use in the early years, the company wants to apply accelerated depreciation to this asset. They estimate the value of the survivors at $20,000. Using the straight-line method, we get an annual depreciation of $18,000, or about 9%. Increasing this by 150% we get a depreciation rate of 13.5%
In the first year, the value of the CNC machine will drop by $27,000. In the second year, depreciation will be 13.5% of the current book value of $173,000, which is $23,350. Using the formula, here's a quick depreciation chart for the following years:
- Also 1: $ 27.000
- Also 2: $ 23.350
- Also 3: $ 20.190
- Also 10: $ 7.317
At the end of year 10, accelerated depreciation will bring the value of the CNC machine to $46,935. The difference between this amount and the salvage value – $26,935 – is generally recognized as an expense on the books.
More information on accelerated depreciation can be found here in this guide.
5 practices to extend the useful life of key assets
Life estimates and guidelines are not fixed. Companies can take some forward-looking steps to extend the useful lives of their assets and save money in the long run.
Best practices for extending equipment life include:
- Proactive maintenance:proactive asset management strategies such as prevention andpredictive maintenanceare necessary to avoid failures. This is important because severe failures shorten the useful life of an asset.Use CMMSplan proactive maintenance tasks and ensure they are completed in a timely manner.
- Machine operator training:invest in suitable training modules for operators working with heavy machinery or other specialized equipment. Set up the onboarding process for new operators to familiarize them with all the resources they will come into contact with.
- The following OEM guidelines:When running features, be sure to diligently follow the user manual or vendor guidelines and make appropriate changes depending on your working environment.
- First, buy the right asset:exercise due diligence during the asset purchase process to ensure the acquired asset is perfect for your use case scenarios.
- Using original spare parts:purchase replacement parts and tools from the supplier or authorized dealers to ensure that the quality of these components does not deteriorate.
Please note that the useful life of some assets cannot be extended. For example, fire extinguishers, smoke detectors and similar safety devices must be replaced after a certain number of years. This is required by law, regardless of the actual state of the property.
Under these circumstances, proactive maintenance and other methods are still needed to ensure that assets reach their expected useful lives and do not need to be replaced prematurely.
Take care of your possessions so they can take care of you.
A company cannot function properly if important assets are in poor condition. Investing in proactive measures not only extends the life of assets and reduces costs, but also improves safety, productivity and employee satisfaction.
any businesstries to be productively efficientyou can't keep maintenance out of the way.