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Q12-2CA

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Intermediate Accounting (Kieso)
Found in: Page 647

Short Answer

Question: (Accounting for Patents) On June 30, 2017, your client, Ferry Company, was granted two patents covering plastic cartons that it had been producing and marketing profitably for the past 3 years. One patent covers the manufacturing process, and the other covers the related products.

Ferry executives tell you that these patents represent the most significant breakthrough in the industry in the past 30 years. The products have been marketed under the registered trademarks Evertight, Duratainer, and Sealrite. Licenses under the patents have already been granted by your client to other manufacturers in the United States and abroad, and are producing substantial royalties.

On July 1, Ferry commenced patent infringement actions against several companies whose names you recognize as those of substantial and prominent competitors. Ferry’s management is optimistic that these suits will result in a permanent injunction against the manufacture and sale of the infringing products as well as collection of damages for loss of profits caused by the alleged infringement.

The financial vice president has suggested that the patents be recorded at the discounted value of expected net royalty receipts.

Instructions

  1. What is the meaning of “discounted value of expected net receipts”? Explain.
  2. How would such a value be calculated for net royalty receipts?
  3. What basis of valuation for Ferry’s patents would be generally accepted in accounting? Give supporting reasons for this basis.
  4. Assuming no practical problems of implementation and ignoring generally accepted accounting principles, what is the preferable basis of valuation for patents? Explain.
  5. What would be the preferable theoretical basis of amortization? Explain.
  6. What recognition, if any, should be made of the infringement litigation in the financial statements for the year ending September 30, 2017? Discuss.

Answer

As a result, a patent's accounting is similar to any other intangible asset, including initial recordation, amortization, impairment, and derecognition.

See the step by step solution

Step by Step Solution

Step 1: Meaning of Patents                                                                                                                        

The company's most valuable and intangible assets are patents, which offer unique legal rights to utilize a technique or manufacture and sell a product. The value of patents grows and decreases in tandem with the performance of the firm.

Step 2: Explaining the meaning of the discounted value of expected net receipts (a)                                                                                                                                                                         

A dollar obtained in the future is less valuable than a dollar received now due to the time value of money. In this case, the patent is worth a lesser percentage of predicted net royalty revenue, so think of it as the present value of an annuity or the entire present value of $1 (annuity).

Step 3: Explaining the calculation of net royalty receipts (b)                                         

The deferred value of royalty revenues may be computed by multiplying the value of royalty receipts by the present value of an annuity of $1 for the number of periods the royalty receipts are projected to be received.

For example, if $10,000 in receipts are projected every six months for the next ten years, and an annual interest rate of 8% is chosen, the present value of the twenty $10,000 payments is equal to $10,000 times the present value of a 1 for 20 periods at 4%. Because the payments are expected at semiannual intervals, twice as many periods and half the annual interest rate of 8% are applied. As a result, the current (discounted) value of these receipts is $135,903 ($10,00013.5903).

Step 3: Explaining the basis of valuation for Ferry’s patents would be generally accepted in accounting (c)                                                                                                                 

Under widely accepted accounting principles, the acquisition cost is used to value a patent. The Client Corporation obtains the patent rights to cartons directly in this case, and Company F clearly has the rights to create and develop the cartons.

As a result, the patent acquisition cost solely reflects the actual expenditures connected with securing patent rights. The patent's research and development expenditures would be expensed as they were incurred.

Costs associated with obtaining a patent should be capitalized. If the infringement litigation fails, the patent’s worth should be assessed to determine if carrying forward the patent expense is appropriate. If the lawsuit is successful, the attorney's fees and other patent-protection costs should be capitalized and amortized throughout the patent's remaining useful or legal life, whichever is shorter.

Step 4: Explaining the preferable basis of valuation for patents (d)       

Intangible assets are rights to rewards in the future. The discounted present value of intangible assets' future benefits is the optimum measure of their worth. The discounted value of projected net receipts from royalties, as proposed by the finance vice-president, as well as the discounted value of expected net receipts to be received from Ferry Company's output, would be included for Ferry Company. Current cash equivalent or fair market value has also been presented as an alternative valuation basis.

Step 5: Explaining the preferable theoretical basis of amortization (e) 

Intangible assets are defined as rights to future rewards, which imply an amortization scheme. To ensure that revenues and costs are properly matched, the cost or other value of the benefits should be charged to expense or inventory when they are received.

The periodic amortization in the discounted value method is the decrease in the present value of projected net revenues over the course of the year. Straight-line amortization is commonly utilized in practice because it is straightforward and provides a consistent amortization strategy. The units-of-production technique is a different approach.

Step 6: Explaining the recognition that should be made of the infringement litigation in the financial statements for the year ending September 30, 2017 (f) 

The litigation can and should be highlighted in the notes to the financial statements. The statements should be accompanied by some indication of the legal counsel's predictions for the result. A contingent asset representing the projected losses to be recovered would be incorrect.

Costs incurred in connection with the litigation up to September 30, 2017, should be carried forward and charged to expense (or loss if the cases are lost) as royalties (or damages) are collected from the parties against whom the litigation has been filed; however, the standard treatment would be to charge these costs as ordinary legal expenses. If the lawsuit's eventual result is favorable, the costs of litigation should be capitalized.

Similarly, if the client were the successful defendant in a patent infringement dispute involving these patents, the legal defense costs would be added to the Patents account.

Post-balance sheet (or later events) information would be correctly recorded in notes to the statements between the balance sheet date and the date the financial statements are issued.

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