The prevailing practice authorizes writing off the value of a patent quite rapidly during the early years of its life when its earning capacity should be at a maximum, leaving only a small part of the value to be spread over its later years. This policy applies to the possession of single or separate patents. An effective method used for extending the life of a patent is the securing of auxiliary patents every few years. Thus an improvement of some part may be patented, without which the use of the original or basic patent would not be worth while. The basic patent may thus have its effective life—though not its legal life—extended almost indefinitely.
Where an additional cost, such as infringement costs, is incurred some time after the grant is made, strict accuracy would demand that these costs be spread over the remaining life of the patent. Where, however, the above policy of securing periodic improvements is in force, sufficiently accurate results are secured by wanting off at the end of each year—in the case of mechanical patents—one-seventeenth of the total values to date. In this way, by the end of the original 17-year term, there will be values left in the account which may be looked upon as applicable to the patented improvements. There is in these cases a constant overlapping of the grant periods and no serious inequity results as between fiscal periods by writing off each year one-seventeenth of the total value in the Patents account. In the case of the one original patent or an occasional improvement, the more accurate method is desirable because here the life of the patent is rather definitely limited.
If the estimated life on which the depreciation estimate is based, should prove longer than the real life, the value remaining in the asset at the end of its real life must be absorbed by the profits; i.e., charged against surplus. The Federal Income Tax Law allows this remaining value to be charged against the profits of the period in which it is written off.
Booking Depreciation on Patents
In booking the depreciation of patents, the periodic charge is to the expense account, Depreciation—or Depletion—and the credit is made either direct to the asset account or to the corresponding Depreciation Reserve account. It is sometimes argued that since the life of the patent is for a definite term, its depreciation is equally definite and the value of the asset should be written down rather than carry the estimated amount of the periodic depreciation in a reserve account. Because of the elements of supersession and obsolescence on which in the majority of cases the service life of the patent depends more than on its time grant, it is evident that determination of the amount of periodic depreciation is just as much a speculative estimate as is the case with any other asset. Either method of showing the periodic value of the patent may be used with equal propriety. If an easy determination of “total value to date” is sought, as under the policy referred to above, the information is better secured by carrying the offsetting estimate of depreciation in a reserve account. When no such purpose is to be served, it is a needless multiplication of accounts to use the reserve account.
Accounting Classification of Depreciation on Patents
A problem closely related to the valuation of patents has to do with the classification or incidence of the periodic depreciation of the patent. According to some theorists it is stated that if the patent applies to the process of manufacture—i.e., to any part of the manufacturing equipment used—the periodic depreciation is a cost of manufacturing and should be allocated to the product at that point. But if the patent covers the article itself, its periodic depreciation expense should be treated as a selling expense. Perhaps the point is well taken but the distinction is rather finely drawn. Another view requires the showing of depreciation on patents among the general administrative items, on the several grounds that there is no logical basis or method for distributing it directly to the product; that there is no direct connection between the product and this expense; and that it is a general overhead item which must be cared for out of gross earnings but cannot be applied definitely to manufacturing or selling. Failure to establish a suitable basis on which to apply the cost in practice cannot, of course, be allowed to militate against the determination of its theoretical incidence.
Royalties
An analogous problem arises in the treatment of royalties where such cover the cost of renting the patented devices of others for the purpose of manufacture. Although the general practice is to treat this expense as a cost of manufacture, it is sometimes handled as a general management expense on the ground that it represents a policy of management which has adopted the royalty method of production in preference to the outright purchase or development of the patents. The point seems not well taken, however. The value of a patent may be looked upon as a prepaid expense item which is the equivalent of royalties expense and should therefore usually be treated as a manufacturing cost. There may be instances, however, where such treatment would not be advisable on practical and perhaps theoretical grounds.
Relation of Depreciation Rate to Cost of Manufacture