Question

Kust Company acquired a patent on a manufacturing process on January 1, 2012 for $5,100,000. It was expected to have a 12 year life and no residual value. Kust uses straight-line amortization for patents. On December 31, 2013, the expected future cash flows from the patent are $387,500 per year for the next ten years. The present value of these cash flows, discounted at Kust's market interest rate, is $3,050,000. At what amount should the patent be carried on the December 31, 2013 balance sheet?

Answer 1

The patent should be carried at its recoverable amount of $3,050,000 on the December 31, 2013 balance sheet, after recognizing an impairment loss of $1,200,000.

Step-by-step explanation:

On December 31, 2013, Kust Company must assess the carrying amount of the patent on its balance sheet. The company initially recorded the patent at the acquisition cost of $5,100,000 with a 12-year life, implying straight-line amortization. The amortization expense for each full year would be $425,000 ($5,100,000 / 12 years). By the end of 2013, two years of amortization would have been recognized, totaling $850,000 ($425,000 per year x 2 years). Therefore, the book value of the patent prior to any impairment test at the end of 2013 is $5,100,000 - $850,000 = $4,250,000.

However, the expected future cash flows have fallen to $3,050,000, which is below the patent's book value. According to accounting principles, if the recoverable amount (present value of future cash flows) of an asset is less than its carrying amount, an impairment loss should be recognized. Therefore, the patent should be carried at its recoverable amount of $3,050,000 on the December 31, 2013 balance sheet. An impairment loss of $1,200,000 ($4,250,000 - $3,050,000) would be recognized.