A patent is a form of intellectual property (IP) relating to innovations or advances in technology. The patent cost is the costs incurred by a startup business in obtaining a patent on its product or on the process of manufacturing the product.
The patent gives the business the legal right to exclusively manufacture, use and sell its product or process for a period of 20 years.
Accounting for Patent Costs
A patent can either be purchased or developed internally by the business.
When the patent is purchased from its current owner then the patent cost is the purchase price together will ancillary fees such as legal costs. In such circumstances the patent cost is capitalized and shown on the balance sheet of the business under long term intangible assets.
When a product is developed internally the research and development costs incurred in developing a subsequently patented product cannot be treated as part of the patent cost, and are normally treated as an expense in the income statement in the year in which they were incurred. The costs of actually obtaining the patent itself such as legal fees, can be capitalized if significant.
How to Calculate Amortization Expense
Like any long term asset the cost of a patent needs to be amortized (written off) over the shorter of its remaining legal life or its useful life. So for example a patent might have a legal life of 20 years but the business expects that the benefits from having the patent will only exist for 10 years. In this case the patent would be amortized over 10 years.
In general the patent cost amortization expense is calculated using the following formula.
Patent Cost Amortization Example
A patent is purchased from a third party including associated fees for 24,000. The patent has 18 years of its legal life left but the business estimates it will have only a 12 year useful life over which it will accrue the benefits of the patent
The amortization expense is given by the formula above and is calculated as follows:
Amortization expense = Patent Cost / Useful life Amortization expense = 24,000 / 12 = 2,000
The patent cost amortization expense will be included in the income statement at the rate of 2,000 for the next twelve years.
Financial Projections and Patent Costs
The cost of any purchased patents can be included in the cash flow statement under the heading of amount paid for long-term assets (line 53). Any amount not being capitalized should be included in the income statement under operating expenses as incurred.
For the purposes of this financial projection the amortization expense can be included as part of the depreciation expense by adjusting the depreciation rate used.
The net book value of the capitalized patent cost will form part of long term assets (line 26) shown in the balance sheet.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.