Accounting theory and practice, Volume 2 (of 3) : a textbook for colleges and…

obsolescence. Obsolescence is particularly operative in cases where the patent covers a product the life of which depends on the whims of fashion. Obviously, when the market for the product ceases, the value of the patent is gone. From the above it is seen that the three elements of depreciation are usually operative concurrently and the rate of depreciation must take cognizance of them all. Service Life of Patents While the vast majority of patents become valueless before their expiration, some few may have a value beyond their protected term. It may happen that the concern using the patent has built up such an organization that competitors cannot with profit enter the field after the patent has expired; or it may have acquired the good-will of the purchasing public to such a degree that buyers come to it rather than to a competitor. In these and other ways the value of the patent may extend beyond its life. This is exceptional, however, and cannot with conservatism form the basis for estimating the service life of the average patent. 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 Related to this problem of patent costs is the effect on manufacturing costs of the rate of depreciation of the patent. It is evident that a too rapid depreciation will result in an inequitable loading of the product made during the early years of the life of the patent as compared with that of its later life. A product made under a patent still valuable after all value has been written off the books, bears none of the burden though enjoying the benefit accruing from its being a patented article. On the other hand, if the rate of depreciation is not rapid enough, the product is then underburdened. It should constantly be borne in mind that depreciation is always an estimate. It should be the best estimate possible and subject to periodic revision where accurate results are desired. Slight inaccuracies and inequities are bound to occur and must be absorbed by the future product; the record of the past is a closed book and cannot usually be reopened. Sale Price of Patents The sale price of a patent, as distinguished from the value at which the owner may carry it in his accounts, frequently is based on the estimated savings in royalties which could be made by a purchaser. When a new concern is organized and patents are owned by some of the incorporators, and purchased from them, the value at which they are carried is almost always speculative and arbitrary. A valuation based on the saving in royalties has no place on the books of a concern unless that price were paid in purchase. Similarly, licenses to use patents should not be carried as an asset unless purchased by a lump sum payment even though they grant a virtual monopoly in the product. Copyrights Copyrights are similar to patents in that they secure to the author or publisher the exclusive right for a term of years to make and sell copies of literary or artistic productions. They are thus in nature a monopoly grant. The term for a copyright is 28 years, with a renewal privilege of 28 years if application is made within one year prior to expiration of original copyright. A more rigid application of the principles of valuation enunciated for patents must be made for copyrights. On the books of the original grantee they should be carried at full cost which may be only the fees required in securing the copyright. For a subsequent purchaser they should be set up at full cost to him. A much smaller proportion of copyrights than of patents continue valuable for their granted term. Periodic valuations, then, require a very liberal and rapid depreciation from original value. In the accounts of publishers who make outright purchases of copyrights, extreme care is needed in keeping track of and valuing this asset, else a too optimistic outlook will result in carrying false and misleading values. Oftentimes the only satisfactory and reliable method of valuation will require an examination of each copyright owned and an independent appraisal of its worth. Trade Secrets Akin to copyrights are formulas for manufacture, receipts, and other trade secrets. These may constitute very valuable holdings, perhaps the most valuable of all the assets, but they are not usually carried on the books as assets under this title. A baker with a secret economical process of making yeast may have a marked advantage over competitors. An oil refiner with a process which secures a larger return of gasoline has a similar advantage over competitors without such means of refining. If costs are incurred in developing or acquiring these formulas or processes, the same reason exists for treating them as assets as in the case of patents or copyrights. If not protected in any way by the government, greater need of rapid depreciation is apparent as the discovery of the secret by others might greatly reduce its value. Trade-Marks A trade-mark is an earmark of ownership for advertising and selling purposes. Thus a firm may adopt a label for their products or a manner of marking or displaying them which wherever used is evidence of the make, brand, and quality of the goods. A concern enjoying a trade built up by educating the public to recognize its trade-marks and what they represent may possess therein a very valuable property. The courts of the country guarantee the rightful owner in the exclusive enjoyment of any benefits arising from the use of his trade-mark. Priority of continuous use is the factor determining rightful ownership. Such priority is most easily established through registration of the trade-mark with the government. Registration is not necessary but is offered by the government as a convenient and certain means of establishing rightful ownership. Continuous use is necessary to retain unquestioned ownership of the right. Trade-marks must be valued at cost. Cost to develop, cost of purchase, cost to defend—all are legitimate charges to the asset. At times even some portion of the advertising expense may be capitalized under the caption “Trade-Marks.” This question and that of periodic revaluation follow so closely the principles of revaluation of good-will and the treatment of depreciation in relation thereto, that its consideration is deferred for combined treatment in later pages of this chapter. Franchises—Definition and Kinds A franchise is an intangible asset of considerable value in most cases. Its appearance on a balance sheet is usually limited to those of public, or quasi-public, utility companies. There it is included as an asset of value from the standpoint of rate-making rather than for ordinary commercial purposes. Such companies are usually under the close supervision and regulation of public service commissions. The latter prescribe the manner of showing the utility company’s accounts and the basis for the valuation of its assets, chiefly from the point of view of an adequate protection of the interests of the public. It is neither the purpose nor within the scope of the present volume to raise the question of the valuation of public utility companies, part of which problem would be concerned with the valuation of franchises. An attempt will be made, however, to lay down some principles of valuation from the commercial standpoint as distinguished from the rate-making standpoint, applicable to a very limited number of concerns which are not subject to state regulation, and to indicate briefly the tendency of the rulings of the best public service commissions with regard to franchises. A franchise is defined by H. A. Foster[45] as “a privilege given by the community to a private person—or corporation—for use of the public property for the benefit of the public, and only incidentally is it the intention of the community in granting such a right, to allow the person accepting the same enough profit to insure his willingness to take advantage of it by investing in plant to make use of the grant.” To the same effect is the statement of the Federal Court in the case of the Consolidated Gas Co. of New York, 157 Fed. 373: “The franchise is but a part of the power or privilege of sovereignty allotted to a private person for the benefit of all, and only incidentally given for private emoluments.” [45] In “Engineering Valuation of Public Utilities and Factories.” Franchises may be perpetual, where the grant is without time limit; limited, where the term is definitely stated; and indeterminate where the privilege granted is good “during good behavior and may be terminated by the authorities at any time by paying the fair value of the property exclusive of the franchise.” It may be noted that in Massachusetts no provision is made for buying the property of the utility company in case of revocation of the franchise. Manifestly the contract entered into with the state will influence very largely the manner of handling and the valuation of all the assets. Without regard to such contract and on the general principles of valuation as laid down for fixed assets, a franchise should be taken onto the books at full cost to acquire. Proper charges to the account would cover: