During the year-end audit of Shere Khan Corporation\'s financial statements for
ID: 2466067 • Letter: D
Question
During the year-end audit of Shere Khan Corporation's financial statements for 2016, you discover the following items: Shere Khan capitalized $57,000 to the Patent account at the beginning of 2015 for the cost of the patent. This amount included $50,000 in R&D; costs. The patent was amortized over a straight line 20 year life in 2015 and 2016. At the beginning of 2016, Shere Khan paid its lawyers $8,000 to successfully defend a patent infringement suit related to the patent in Item 1. Shere Khan debited this cost to Legal Fees Expense. At the beginning of 2016, Shere Khan purchased a patent for $30,000 from Mogli Company. It recorded the cost in the Patent account and had amortized the cost over the 20 years. However, the purchased patent was protected for only 7 more years as of the beginning of 2016. Required: For each transaction, determine the impact on total assets, liabilities and shareholders' equity for any errors noted in Shere Khan's accounting as of December 31, 2016. In other words, are total assets, total liabilities, or total shareholders' equity overstated/not affected/understated, and if yes, by how much? Remember to consider effects from 2015.Explanation / Answer
1. The initial asset cost i.e the cost to acquire the patent will be recorded as patent cost in the Balance Sheet. This cost will include registration, documentation and other legal fees associated with the patent.
In the given question,$57000 is recorded as patent cost but this amount is inclusive of $50000 as R&D cost incurred on the patent. But this R&D cost required to develop the idea being patented cannot be capitalised and thus cannot be included in the capitalised cost of a plant. These R&D costs are charged to the expenses account incurred. The amortiastion done is valid because the patent cost is required to be expensed over the useful life of the asset.
Thus, patent cost must be shown in the Balance Sheet at assets side under the head Intangible assets at the cost of $7000. Therefore, the assets are overstated by $50000 and profits in return will also be overstated by the same amount because less expenses are shown as compared to the actual expenses incurred, thus overstating the shareholder's equity.
2. The legal fees paid to the lawyers for defending a patent infringement suit related to the above patent is required to be charged and are deductible business expenses in the year they were incurred. Thus, the action taken by Shere Khan of debiting this expense to Legal Fees Expense is valid.
note: if the charges would have occurred for the defense or protection of title to the patent then they were required to be capitalised and thus amortised over the life of the asset.
3.The purchase of another patent costing $30000 and capitalisation of the same is perfectly valid. The same cost is amortised over 20 years though the useful life was just 7 years. in such a case, the life of the asset is being reduced from 20 years to just 7 years.
The accounting treatment will be such that the value to be amortised will be 30000/20*7=10500 i.e $10500 will be amortised and the remaining unamortised value of $19500 ($30000-$10500) will be expensed and the patent at the end of 7 years is written down to the value of zero.
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