Overview of how we make effective life determination
We determine the effective life of a depreciating asset by estimating the period (in years, including part years) the asset can be used by any entity for a specified purpose. If relevant for the asset, we:
- assume it will be subject to wear and tear at a rate that is reasonable for us to assume
- assume it will be maintained in reasonably good order and condition, and
- have regard to the period within which it is likely to be scrapped, sold for no more than scrap value or abandoned.
In determining an effective life, we consider the following factors:
- physical life
- manufacturing specifications and engineering information
- use of the asset in a particular industry
- use of the asset in different industries
- industry standards
- repairs and maintenance
- retention period
- obsolescence
- scrapping or abandonment practices
- lease periods
- financial analysis
- market value.
We may consider factors in addition to those listed. For example, in determining the effective life of horticultural plants, issues such as crop management techniques (crop regeneration and topworking or reworking where trees are cut back to the stump) are considered along with the listed factors.
Where appropriate, each factor is considered based on historical information and future expectations. No single factor is conclusive and the relative importance of each varies depending on the asset.
Physical life
An asset can be used while it continues to have a physical life; that is, until it is physically exhausted.
An effective life determination is an estimate of the period the asset can be used by any entity for a specified purpose. Often an asset is not used for a specified purpose for the whole of its physical life.
For example, an asset may be retired from use for a specified purpose but be retained as a source of spare parts. In this instance, the effective life ends when the asset is retired.
An asset’s physical life can be seen as the outer limit of its effective life. This is a useful starting point for analysing the factors to be considered in determining the effective life of the asset.
Manufacturing specifications and engineering information
The effective life of a new asset cannot be based solely on evidence of past use of the asset. The current design may differ for various reasons including advances in technology and different construction materials. Analysing manufacturing specifications and engineering information for the new asset is important when estimating its effective life.
Use of the asset in a particular industry
How intensively an asset is used in an industry would have a direct impact on the asset’s effective life. In establishing the industry norm, the relevant industry is consulted where possible.
Use of the asset in different industries
The use of an asset in different industries is another important factor.
For example, using a car in the taxi industry would subject the car to more wear and tear than using a car in another industry. The effective life we determined by in each industry would be different., reflecting that different use.
Industry standards
Industry standards and regulations may dictate when a particular asset must be retired from use in an industry.
There may also be industry standards and regulations that set the level of repairs and maintenance that must be carried out.
Repairs and maintenance
It might be suggested that the life of an asset can be extended indefinitely if there is unlimited expenditure on repairs and maintenance. However, the law requires us to assume that an asset will be maintained only in reasonably good order and condition. So an asset’s effective life is generally limited by the period it is economic to maintain the asset, even though it is still possible to continue repairs and maintenance to keep it operational.
An asset can be subject to such a level of repair and maintenance that it has been wholly or substantially physically replaced. In those circumstances, the effective life of the asset is considered to have ended and a new asset to have come into place.
Retention period
The effective life of an asset is the total period it can be used by any entity for a specified purpose. The retention period is the time a particular taxpayer expects to hold a depreciating asset for any purpose.
For example, it is common practice in some businesses to dispose of a car after it has been driven a pre-determined number of kilometres. That would be the retention period for that taxpayer. The effective life of the car, however, would end only when the car can't be used by any taxpayer for a specified purpose.
Obsolescence
An asset may become obsolete because of commercial or technological reasons.
Commercial obsolescence may occur if demand for the goods produced by the asset stops because consumers choose not to buy them, or government regulation affects market demand. It may also occur if the raw material the asset processes becomes unavailable.
Technological obsolescence may occur when technology advances and another asset becomes better suited for the relevant purpose for which an existing asset is used. Even so, an asset’s effective life does not necessarily end with each technological advance. A taxpayer can still use an asset for a specified purpose even though a newer model exists.
There are 2 types of commercial and technological obsolescence – one can be predicted at the time the asset is first used and one is unpredictable and emerges later.
Predicted obsolescence would only be taken into account if it is expected with a high level of certainty across a majority of users. If predicted obsolescence arises because of the particular use of the asset, taxpayers may choose to work out the effective life of the asset themselves, rather than adopt the effective life determined by us.
Unpredictable obsolescence can't be taken into account when estimating effective life.
Scrapping or abandonment practices
Once a taxpayer has scrapped or abandoned an asset, it is presumed it can no longer be used by anyone for a specified purpose. The scrapping of an asset can demonstrate that the asset is either physically exhausted or obsolete. The abandonment of an asset can demonstrate that it is too difficult or costly to remove it from its place of operation.
This factor is only relevant if a general scrapping or abandonment practice can be established across users of the asset.
Lease periods
Effective life is the period a depreciating asset can be used by any entity for a specified purpose. So it is unlikely that an asset would be leased for a period greater than its effective life. This generally suggests that the effective life of an asset is no shorter than the period it is leased. In fact, the effective life of an asset would usually be longer than a lease term unless the asset is expected to be scrapped or abandoned at the end of that lease.
Financial analysis
As with lease periods, economic or financial analysis indicating the period over which an asset is intended for use suggests the effective life is no shorter than that period. In many instances, the analysis may only reflect the capital cost recovery period or the term of a contract, when the asset may in fact be used for a specified purpose by any entity for a much longer time.
Market value
The defining character of a depreciating asset is that its value falls, or is expected to fall, over time. So analysing the decline of market value of an asset class is important in determining the asset’s effective life.