Patent Valuation from the CPA's Viewpoint
By Grover Rutter CPA/ABV, CVA, BVAL
If you can't see it, then it doesn't exist. Suppose science successfully perpetrated that medieval philosophy and we never accepted the existence of neutrons, protons, electrons, germs, bacteria, viruses or DNA. Today's science would not exist and we would still be living in the dark ages. Just as with physical science, economic science and theories have evolved as the world in which we live continues to change.
Much like the physical sciences, economic science possesses certain elements that are invisible to the human eye. However, there are specific rules one must follow when dealing with certain economic issues. Take patents for instance. Patents are considered "intangible" assets. Accountants often refer to and record these intangible "assets" with a certain measurement of value. Yet, investors looking at a set of financial statements may or may not see a value assigned to patents owned by a particular company. In some instances the financial statements reflect values associated with patents, and sometimes not. Sometimes financial statements will expense or amortize the value of patents, and sometimes they don't. And, anyone looking at the patent amortization expenses reported on a company's tax return will not find a similar amount of expense on the financial statements of the company. Very befuddling indeed!
The valuation of patents is essential in many circumstances. Just as important are the accounting, tax and reporting treatments associated with patents. While volumes could be written on the subject, I will provide a simple overview of the financial and tax reporting treatments of patents and their values. Here are two common scenarios involving patents:
Self Created Patents (when the patent has been developed within an organization or company).
Purchased Patents (when a company purchases the patent, either independently or as part of a group of assets acquired in the purchase of another company).
Self Created Patents
|Reflected as Asset on Financial Statements?||Often a company will develop the patent and the associated costs are deducted as current operating expenses. This is common for companies reporting on the cash basis of accounting or another consistent basis of accounting other than the GAAP (Generally Accepted Accounting Principles). When this cash basis situation occurs, the development cost of the patent is not reflected as an asset on the balance sheet of the company. However, the legal fees and filing costs associated with the patent are carried as an intangible asset on the financial statements of the company. If legal costs are incurred to defend the patent rights, those costs are capitalized as an asset if the defense of the patent is successful. If defense of the patent is unsuccessful, legal costs of defense are expensed. If the company prepares its financial statements according to Generally Accepted Accounting Principles, then costs associated with the development of the patent may be carried as an asset on the balance sheet of the company. However, the carrying costs of developing the patent may not have any correlation to the actual economic value of the patent.|
|Treatment as Expense on Financial Statements?||In the "cash basis" method of accounting, the development costs have been expensed, and no asset is carried on the balance sheet of the books. Accordingly, the cost has offset current period income in the period the costs were incurred. There is, however amortization of legal and filing fee costs over the useful life of the patent. If the company reports on the GAAP basis, then certain costs of developing the patent may be carried as an asset, along with the legal and filing costs associated with the patent. The cost of the asset is written off ratably (expensed) over the expected useful technological or economic life of the patent. The legal life of a patent typically is about 17 years.|
|Treatment as Expense on Tax Returns?||The cash basis taxpayer has deducted costs associated with patent development as the costs are incurred. The legal and filing costs associated with the patent are carried as an intangible asset and are expensed ratably over 15 years. An accrual basis taxpayer is also allowed to amortize (expense) the costs of the patent ratably over a 15 year period. Again, it is important to note that the tax return treatment of the patent costs and deductions are different from GAAP reporting treatment on the financial statements.|
|When is Valuation Required?||Valuing the patent is not necessary for income tax purposes when the cash basis or another consistent basis of accounting is used. HOWEVER, there may still be the need for patent valuations: Potential sale of the business, potential purchase of another business with self-developed patents, actual sale or purchase of a self-developed patent, divorce actions, estate taxation, gifting, bankruptcy actions, and tort actions are such examples.|
|Reflected as Asset on Financial Statements?||The purchase price (cost allocation to the patent) is recorded as an intangible asset on the balance sheet of the purchasing company.|
|Treatment as Expense on Financial Statements?||In the case of GAAP and non-GAAP financial reporting, the patent is expensed (amortized) ratably over the determined useful technical and economic life of the patent.|
|Treatment as Expense on Tax Returns?||Amortized ratably over 15 years and expensed on tax returns. Financial reporting has no impact on income tax reporting.|
|When is Valuation Required?||GAAP and non-GAAP financial reporting of patents may require a valuation of the patent for certain purposes. Potential sale of the business, potential purchase of another business with purchased patents, actual sale or purchase of a previously purchased patent, divorce actions, estate taxation, gifting, bankruptcy actions, and tort actions are such examples.|
The Financial Accounting Standards Board issued SFAS 142 in 2001. Effective for all years beginning after December 15, 2001, certain intangible assets without determinable useful lives are no longer amortized (expensed for GAAP reporting) over their useful lives. Rather, annual expensing of the intangible asset is done only in the years that the fair value of the intangible asset becomes less than the carrying value of the intangible asset. This application does not generally apply to the financial treatment of patents. The reason being, that patents usually have a determinable life, whereas assets such as goodwill, customer lists, etc. do not have determinable useful lives.
I hope this brief overview of financial and tax reporting issues associated with the valuation and treatment of patents provides you with some basic concepts to be remembered when dealing with patents.