Economic Life

Definition

The term economic life is defined as the timespan over which the annual cost of owning and operating an asset is minimized.  The economic life of an asset can be a function of factors such as physical wear and tear, as well as technological obsolescence.

Explanation

The concept of economic life is important to both accountants as well as the operators of the asset.  For example, Generally Accepted Accounting Principles would suggest the book depreciation of an asset occurs over the same timespan as its economic, or useful, life.  In the same way, the operator of an asset should plan for the purchase of a replacement when the asset has reached the end of its economic life.

The economic life of an asset may be determined in a number of ways.  For example, the physical wear and tear that occurs in a machine over time may limit its economic life.  Minor repairs are no longer sufficient to keep the machine in service, and a replacement lowers the company's overall operating costs.

Economic life may also be a function of technological obsolescence.  For example, a company's information technology group may be able to keep a computer system running for many years; however, the processing speed of the computer may no longer be adequate to meet the demands of modern-day software programs.  In this second example, the physical life of the equipment is much longer than its economic life.

Note:  To foster investment, tax law oftentimes allows companies to accelerate the depreciation of an asset, thereby providing the owner with a near-term tax savings benefit.  For this reason, a tax depreciation schedule may be compressed relative to the book depreciation that appears on the company's balance sheet.

Related Terms

operating lease, capital lease, bargain-purchase option test, transfer of ownership test, economic life test, economic life, recovery of investment test, economic life test, executory costs, minimum lease payment, guaranteed residual valueunguaranteed residual value