Definition of economic life
What is economic life?
The 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, it is said to have passed its economic life. The economic life of an asset may be different from its actual physical life. Thus, an asset may 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 is due to the advent of smartphones, not their exhaustion.
Estimating the economic life of an asset is important for companies so that they can determine when it is worth investing in new equipment, allocating appropriate funds to purchase replacements once the useful life of the equipment is reached.
Understanding economic life
The economic life of an asset according to generally accepted accounting principles (GAAP) requires a reasonable estimate of the time required. Businesses can change their measurements based on expected daily usage and other factors. The notion of economic life is also linked to depreciation schedules. Accounting standard setters generally establish generally accepted guidelines for estimating and adjusting this period.
Finance and economic life
Financial considerations regarding the economic life of an asset include the cost at the time of purchase, how long the asset will be in production, when 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 can render current equipment obsolete or raise the industry standards required for an asset beyond the specifications of a company’s existing assets. In addition, the economic life of one asset may be linked to the useful life of another. In cases where two separate assets are needed to accomplish a task, the loss of one asset can render the second asset unusable until the first asset is repaired or replaced.
Key points to remember
- The economic life of an asset is the length of time it remains useful to its owner.
- The financial considerations required to calculate the economic life of an asset include its cost at the time of purchase, the length of time an asset has been used in production, and relevant regulations.
- There may be interdependencies in the economic lifespan of two assets in which the lifespan of one depends on the lifespan of the other.
Economic life and amortization
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 linked to technology, depreciation can also include the risk of obsolescence.
In theory, companies account for depreciation expenses on a schedule that approximates the economic life exhaustion rate. However, this is not always true for tax purposes, as owners may have superior information on specific assets. The economic life used in internal calculations may differ significantly from the depreciation period required for tax purposes.
Many companies value depreciation expense differently based on management’s goals. For example, a business may want to recognize costs as quickly as possible to minimize taxes payable and may do so by choosing accelerated depreciation schedules.