An invention is protected by a patent, which is an unique right awarded to the inventor. In other terms, a patent is an exclusive right to a product or a process that offers a novel technical solution to a problem or a new way of doing something.
These patent rights are of tremendous value to company if the design of the product is dependent on the patent right. This prevents the competition to legally produce, sell and distribute the patented products without the permission of the owner.
Know more about Patents
What is amortization
Amortization is defined as the reduction in value of intangible asset over a period of time.
Just like how any other asset like machinery, tends to depreciates over a period of time. Similarly, the value of the patent tends to depreciate too. Thus, the depreciation of the intangible assets is coined as amortization.
Intangible assets, particularly patent rights have a limited duration for the owner to claim rights. Due to this reason, as the patent gets older, it loses its original value.
This is done by the companies to arrive at the fair value of net profits.
Why is it booked into accounts
Just like tangible assets, intangible assets too have a limited duration of time. Patents for example have an authority of about 20 years.
When a company invests its money in a patent, or acquires a right from an independent owner, they tend to spend tremendous money on their acquisition.
During the course of 20 years, when the company owns the patent rights, they tend to take the best advantage to enhance the product with their patent.
As the patent tends to get older, it nears to the point where it will be open to general public, thus losing its original value.
This loss in value is a financial burden for the company. In order to compensate for this loss and recover the initially added investment on the patent rights, a portion of the profits are deducted in the name of amortization of patent rights.
How to calculate amortization of a patent
Step 1: Identify the duration of the patent right
Every patent right comes with a set of duration for the owner of the patent to use for a defined duration. The duration is usually 20 years. During this period, the owner has full control of the use of the product and take the best advantage of the ownership.
Step 2: Determine the cost of acquiring the patent
This is the cost at actual that was incurred to buy / acquire the rights. This must include the cost of purchasing the patent / research invention, as well as the costs of naming the patent, such as lawyer expenses, report preparation, and so on.
Step 3: Factor the cost of patent to determine the patent value
It will not be fair to value a patent right with the initial cost of the asset. There can be times where the patent right can be of such great value that it can save millions of dollars for a company. In this case the value of the patent will be high.
The value of the patent will also depend on the intensity of the problem it solves. The bigger the problem solver, the higher will be the factor of valuation.
Step 4: Calculate the value of amortization for each year
Thus, by having these data values, the amortization for each year can be calculated using the following formula:
Amortization = (Cost of patent * Valuation factor) / Duration
This value that will be lead to with this formula is the amortization value per year. This value can be deducted from your profits before paying the taxes. Thus, giving a realistic and a more practical form of net profit.
The method used in this blog is straight line method. In this calculation, it is assumed that the value of the patent right tends to decrease linearly over the period of 20 years.
Thus, if the value of asset tends to decrease at a constant rate, this method of calculation can be used.