Economic life is the expected period of time during which an asset remains useful to the average owner. When an asset is no longer useful to its owner, then it is said to be past its economic life. The economic life of an asset could be different than its actual physical life. Thus, an asset can be in optimal physical condition but may not be economically useful. For example, technology products often become obsolete when their technology becomes obsolete. The obsolescence of flip phones occurred due to the advent of smartphones and not because they ran out of utility.
Estimating the economic life of an asset is important for businesses so that they can determine when it’s worthwhile to invest in new equipment, allocating appropriate funds to purchase replacements once the equipment’s useful life is met.
Understanding Economic Life
The economic life of an asset under the Generally Accepted Accounting Principles (GAAP) requires a reasonable estimate of the time involved. Businesses can shift their measurements based on the anticipated daily usage and other factors. The concept of economic life is also connected to depreciation schedules. Accounting standard setting bodies usually set generally accepted guidelines for estimating and adjusting this time period.
Finance and Economic Life
Financial considerations regarding the economic life of an asset include the cost at the time of purchase, the amount of time the asset can be used in production, the time at which it will need to be replaced, and the cost of maintenance or replacement. Changes in industry standards or regulations may also be involved.
New regulations may render current equipment obsolete or raise the required industry standards for an asset beyond the specifications of a business’s existing assets. Further, the economic life on one asset may be tied to the useful life of another. In cases where two separate assets are required to complete a task, the loss of one asset may render the second asset useless until the first asset is repaired or replaced.
Economic Life and Depreciation
Depreciation refers to the rate at which an asset deteriorates over time. The depreciation rate is used to estimate the effects of aging, daily use, and wear and tear on the asset. When related to technology, depreciation can also include the risk of obsolescence.
In theory, businesses recognize depreciation expenses on a schedule that approximates the rate at which economic life is used up. This is not always true for tax purposes, however, as owners may have superior information about specific assets. The economic life used in internal calculations may differ significantly from the depreciable life required for tax purposes.
Many businesses evaluate depreciation expenses differently based on management’s goals. For example, a business might want to recognize costs as quickly as possible in order to minimize current tax liabilities and may do this by choosing accelerated depreciation schedules.