There is a very easy way to tell if you have been assigning appropriate lives to fixed asset in your company. Take the existing file and sort it by net book value (original cost less accumulated depreciation). The chances are very high that there will be a substantial number of assets that have been fully depreciated, that show zero net book value, or only salvage value, and the assets are still present and still in use.
By definition, then, a fully depreciated asset still in use had too short a life initially assigned. Of course, circumstances change. It is hard to project out 10, 15, or even 20 years out into the future. It is much easier simply to use the same life required by the IRS for financial reporting. Most companies, in practice, do exactly this.
The rules in GAAP for setting lives and computing depreciation for financial reporting are not prescriptive, unlike the IRS rules. You simply are supposed to assign a life that corresponds to your best estimate of the expected useful (economic) life. If you really expect a salvage value, that is to be set up; salvage values affect depreciation by reducing the total allowable amount charged to expense over the assets’ lives. Many companies do not assign a salvage value, anticipating that by the time an asset is replaced it will have little or no commercial value at that time.
Factors to Be Considered in Assigning Appropriate Lives to Fixed Assets
Experience has shown that very few assets truly wear out, that is, they have to be taken out of service because they simply cannot be held together. Unfortunately, individuals in an accounting department who make decisions concerning the lives of assets are all too familiar with one type of machinery and equipment, the private car that does have a short life due to physical wear and tear. Automobiles, however, are not typical of fixed assets in the average company.
As we all know, cars do wear out, and after 150,000 or 200,000 miles most owners decide to buy a new car, they trade in the old auto, because the cost of repairs is getting out of hand. Physical depreciation nonproductive assets used in the business world does exist, but to a much lesser degree than is usually thought of.
In a production environment preventive maintenance is carried out, while for office furniture and fixtures there is usually little actual wear and tear. Technology assets, computers and related assets, suffer functional obsolescence and thus may have a short economic life. But a 15-year-old computer will probably still perform the functions for which it was designed originally. It is just that developments in new technology rapidly outdate or obsolete older equipment.
Look at buildings, and you see a much different story. The IRS calls for a 39-year life for buildings and many managers then use that life for financial reporting. Taking 2011 as a measure, this would suggest that most buildings constructed prior to 1972 were supposedly at the end of their life. Obviously, many, if not most, structures used for business, retail, wholesale, transportation, and manufacturing last far longer than 39 years.
The assets that color individual understanding of asset lives are personal computers and consumer electronics. How many different computers have you had in the last 20 or 25 years? Many individuals probably have upgraded every two or three years, meaning that a two- or three-year life would have been appropriate for financial reporting.
Computers do not wear out. A computer from 15 years ago will still perform all the functions today it was capable of then. It may not be able to handle the ‘bloated’ software now in common usage, but the word processing program from that era will still turn out more than acceptable reports on the computer from that era.
Truth be told, today’s word processing software does very little more than the programs did from that period. Human typing skill has not changed and that is the real limiting factor, not computer speed or software features. Now today’s software for fixed assets probably would not run on a 15-year-old computer, but any of today’s programs on today’s personal computers undoubtedly will be completely functional ten or even 15 years from today.
From the value perspective, you may be safe if you keep in mind that the valuation of an asset is itself a function of how long it will continue to be used. Thus, the same asset, if it will become economically or functionally obsolete in five years, will have a lower ‘‘value’’ today than if the same asset could be used for the next 20 years. The value of the asset and the life of the asset are really the two sides of the same coin.
As a generalization, productive assets used in business do not wear out! Very few current capital expenditures are actually to replace existing assets on a one for one basis.
Before getting into the details of setting lives for specific assets or types of assets, let’s examine carefully why new assets are acquired. Many, if not most, larger companies have formal capital expenditure (capex) approval systems. Companies establish a budget for capital expenditures for the year, then individuals submit requests with justification; a higher level of management then approves or disapproves the request.
Companies have a number of different categories into which they slot capital expenditures, and some of the most common are:
1. Mandatory – Mandatory capital expenditures (capex) encompass health, safety, and environmental projects which have to be done irrespective of their return on investment (ROI). For this category the usual economic analysis as to future benefits and cash flow is usually omitted. If the Environmental Protection Agency tells you to clean up a site, and you have exhausted your legal defenses, you probably are going to have to spend the money.
2. Expansion (existing products) – Expansion projects are usually justified on the basis of incremental profits expected from the increased sales of current products that are already doing well. Inasmuch as these are usually based on current production methods, only scaling them up, the types of assets to be acquired are familiar.
3. New product – Capex for new products involves more risk and possibly unknown technology. The ultimate success of any new venture is far less secure than the expansion of presently successful activities. For this reason most companies have a higher hurdle rate for this type of proposal.
4. Cost reduction – Cost reduction projects usually involve a ‘‘make’’ versus ‘‘buy’’ decision, and if you can do something yourself, and hence not pay a supplier, it is possible for profits to increase. The success of such projects is quite certain because you already know the volumes at which the cost reduction project will run. What may not be as certain is whether or not you can ‘‘make’’ at lower cost than your existing supplier can. Thus there is some risk in terms of making the project work.
5. Replacement – Replacement projects are where existing equipment simply is worn out and it is uneconomical to try and fix it. This is the phenomenon we as consumers have with cars and consumer electronics and appliances. After six years it is probably time to trade in your car and in ten years it probably is time to get a new washing machine. These are what so-called “one-for-one” or “replacement decisions,” and for industry they simply permit the existing business to go along at current levels. But in practice these are fairly rare. It is my experience in the business world shows that, there is a very low percentage of replacement capex compared to the other four categories.
Good maintenance can keep equipment working for many years. This of course is why companies have so many fully depreciated assets physically still in use. The original life fell short of the actual economic utility.
Choosing Accounting Lives
The first place to start is to look at the existing file of fully depreciated assets, those with either zero book value or salvage value only. Take a sample of those items that had too short a life originally assigned, then determine what the real economic life is likely to be. This will involve dialog between the fixed-asset accountant and the appropriate production or IT managers responsible for actually using the asset.
I hate to say it, but the level of knowledge about manufacturing processes for most financial workers ranges from abysmal to none. Any accountants really should not be setting expected lives at all—other than for tax purposes. For financial reporting, where the underlying economics should govern, we—accountants and auditors—may fool ourselves if we believe we know enough to set lives appropriate for actual intended use.
For replacement capex, however, it would be appropriate to use as a life for the newly acquired asset, the actual elapsed time between the acquisition of the original asset and the current date when it is being replaced. If the new asset replaces a similar asset acquired 25 years ago, then assign a 25-year life to the new asset.
There have been many studies that suggest simply projecting what has happened in the past is the best estimate of the future. If it rained today, the best forecast for tomorrow is that it will rain then. This does not mean that it will rain continuously from here, but for a one-day forecast it may beat any other forecast. Assigning a 25-year life to the new asset on the basis that the old asset lasted 25 years is as supportable, if not more so, than any other choice.
Taking this approach, in effect lengthening the accounting lives of replacement assets, will have no effect on cash flow, but will have the impact of reporting increased income. Earnings before interest, taxes, depreciation, and amortization (EBITDA)—as well as earnings before depreciation—is also not affected by the choice of accounting lives for calculating depreciation. But having correct economic depreciation will give a better picture of true profitability.
Understating profitability (the result of overly aggressive depreciation charges) may lead to incorrect product pricing, as well as incorrect financial analysis of the relative profitability of different product lines. This is a point made strongly in cost accounting courses in colleges and universities. Choosing economic reality is usually trumped by the feeling that ‘‘it is good to be conservative and even better to be overly conservative.’’
That bad decisions may arise is not contemplated by the desire for conservatism. But the actual rule for depreciation is very straightforward, as shown in Accounting Standards Codification (ASC) 360-10-35-3:
‘‘Depreciation expense in financial statements for an asset shall be determined based on the asset’s useful life.’’
It does not say to choose a life based on the Internal Revenue Code (IRC). It does not say to choose a life that will write the asset off as quickly as possible. It does say exactly what we are recommending. Use the expected useful life. Without parsing the words too closely ‘‘useful life’’ refers to the period over which the asset will perform its expected function. Thus, what we have to do is anticipate economic lives in order to determine accounting lives.