Are Patents Amortized? – 7 Steps in the Process

Are patents amortized? In the intricate world of accounting and finance, the treatment of intangible assets like patents often sparks a blend of curiosity and confusion.

Among the nuanced topics in this realm stands the question: “Are patents amortized?”

This inquiry not only touches on the practical aspects of accounting practices but also delves into the strategic considerations companies must navigate to manage their intellectual property effectively. 

Whether you’re a financial professional, a business owner, or simply an intellectual property enthusiast, understanding the intricacies of patent amortization is key to grasping the broader picture of intangible asset management and its impact on the financial health and innovation trajectory of businesses.

What are Patents?

Patents are a form of intellectual property (IP) protection that grant inventors exclusive rights to their inventions.

These legal protections are designed to encourage innovation by providing inventors with a temporary monopoly on the use, production, and sale of their invention.

A patent essentially allows its holder to prevent others from making, using, selling, or distributing the patented invention without permission for a certain period, typically 20 years from the filing date of the patent application.

The purpose of patents is twofold: to reward inventors for their ingenuity and investment in developing new technologies and to share detailed information about the invention with the public to advance knowledge and spur further innovation.

To be granted a patent, an invention must meet several criteria:

• Novelty: The invention must be new, meaning it has not been previously made public in any way, anywhere in the world.
• Inventiveness (Non-Obviousness): The invention must represent a non-obvious improvement over existing knowledge or products, meaning it cannot be an obvious solution to someone with knowledge and experience in the subject area.
• Utility: The invention must be useful, meaning it has a practical application and functions as described.

Patents cover a wide range of inventions, including industrial processes, machines, chemical compositions, manufactured goods, and even software algorithms in some jurisdictions.

However, not everything can be patented. Examples of non-patentable items typically include abstract principles, natural phenomena, and purely theoretical concepts.

Further Reading: Importance of Patent Copyright and Trademark

Are Patents Amortized?

In accounting terms, amortization refers to the systematic allocation of the cost of an intangible asset over its useful life.

Patents, as intangible assets with a finite useful life, are subject to amortization under accounting principles such as those outlined by the International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP) in the United States.

When a company acquires a patent, either through direct development costs or through purchase, the initial cost of obtaining the patent is capitalized, meaning it is recorded as an asset on the company’s balance sheet.

The cost includes not only the price of acquiring the patent but also other related expenses, such as legal fees to secure the patent rights. The company then amortizes this cost over the patent’s useful life, reflecting the consumption of the economic benefits the patent provides.

The useful life of a patent is typically the legal life granted by the patent office, which is usually 20 years from the filing date, but the amortization period could be shorter if the economic life of the patent is expected to be less due to technological changes or market obsolescence.

The amortization expense is recognized in the company’s income statement and reduces the carrying value of the patent on the balance sheet over time.

It’s important to note that the method of amortization for patents should reflect the pattern in which the economic benefits of the patent are consumed by the entity. If such a pattern cannot be reliably determined, a straight-line method of amortization is used, dividing the patent’s initial cost evenly over its useful life.

The process of amortizing patents is crucial for companies to accurately represent their financial position and performance, ensuring that the costs associated with acquiring and holding patents are matched with the revenues they generate over time.

Further Reading: Are Patents and Copyrights Fixed Assets?

What is the Process of Amortizing Patents?

The process of amortizing patents involves systematically allocating the cost of the patent over its useful life to accurately reflect its consumption and the benefits it brings to the company.

Amortization of patents is a critical aspect of accounting for intangible assets, ensuring that financial statements present a true and fair view of the company’s financial health. Here’s a step-by-step look at the process:

1. Identify the Amortizable Amount

The first step is to determine the initial cost of the patent, which includes the purchase price and any other direct costs associated with securing the patent, such as legal fees, filing fees, and other related expenses.

If the company has developed the patent internally, the costs to be amortized include those expenses directly attributable to the development of the patent, such as research and development costs, that were incurred after the patent’s feasibility and commercial viability were established.

2. Determine the Patent’s Useful Life

Next, establish the useful life of the patent, which is the period over which the patent is expected to generate economic benefits for the company.

While the legal life of a patent is typically 20 years from the filing date, the economic useful life might be shorter due to factors like technological advancements, changes in market demand, or competition. The useful life assessment should be revisited annually, as changes in circumstances could adjust the expected duration of benefits.

3. Choose an Amortization Method

The amortization method should reflect the pattern in which the economic benefits of the patent are expected to be consumed.

If this pattern can be reliably determined, an amortization method aligning with this pattern should be used. However, if the pattern cannot be reliably determined, a straight-line amortization method is commonly applied, distributing the patent’s cost evenly over its useful life.

4. Calculate the Amortization Expense

Using the chosen amortization method, calculate the annual amortization expense. For the straight-line method, divide the amortizable amount by the useful life of the patent to determine the annual expense.

For example, if a patent costs $100,000 and has a useful life of 10 years, the annual straight-line amortization expense would be $10,000.

5. Record the Amortization Expense

Each accounting period, record the amortization expense in the income statement as a reduction in profits.

This expense reduces the carrying value of the patent on the balance sheet. Concurrently, decrease the patent’s book value on the balance sheet by the same amount to reflect its reduced value over time.

6. Review and Adjust as Necessary

The useful life of a patent and its residual value should be reviewed at least annually. If expectations significantly change regarding the future benefits to be derived from the patent, adjust the amortization schedule accordingly to reflect the new useful life or residual value.

7. Report in Financial Statements

The amortization of patents and the carrying amount of intangible assets should be clearly reported in the company’s financial statements, including notes that describe the method of amortization and any significant adjustments made to the useful life or amortization schedule.

Further Reading: How to Get a Trademark for Amazon

Conclusion

In conclusion, patents are indeed amortized, which is a fundamental accounting practice for managing the costs associated with intangible assets over their useful life.

Amortization allows businesses to spread out the expense of a patent, reflecting its consumption and the gradual decrease in economic value as the patent ages.

This process ensures that the financial statements accurately represent the company’s financial position by matching the patent’s cost with the revenues it generates over time.

By determining the patent’s initial cost, establishing its useful life, choosing an appropriate amortization method, and regularly reviewing these parameters, companies can navigate the complexities of patent amortization.

This not only complies with accounting standards but also provides valuable insights into the true value of a company’s intellectual property portfolio. Understanding and implementing the amortization of patents is crucial for any business seeking to maximize its innovation investments and maintain a clear picture of its financial health.

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