Interest

Question: A company buys a patent from an inventor on January 1, Year One, for $1 million to be paid

immediately. The accounting is straightforward; the patent is recognized as an intangible asset and reported at

Don't use plagiarized sources. Get Your Custom Essay on
Interest
Just from $13/Page
Order Essay

the historical cost of $1 million. Accounting rules are clear on the handling of such acquisitions.

Assume, instead, that the company offers to pay this $1 million but not until five years have passed. The seller

agrees to that proposal. The purchase is made now but payment is delayed. Is the $1 million still being paid

solely for the patent? Does the entire $1 million reflect the historical cost of this intangible? What reporting is

appropriate if an asset such as a patent, building, or land is bought but payment will not take place for several

years? How is historical cost determined?

Answer: Approximately forty years ago, the authoritative accounting body at the time ruled that when cash is

paid for a purchase1 over an extended period of time in the future, there are always two distinct reasons for the

payments2.

• The first is obviously the acquisition of the property such as the patent in this example.

• The second is interest. Interest is the charge for the use of money over time.

It was held to be unreasonable to believe that cash payments could be spread over several years without some

interest charge being factored into the negotiated amounts. The accounting here is based on that assertion.

In many purchases, interest is explicitly stated. For example, the contract to buy this patent could have required

payment of $1 million after five years plus interest at a 7 percent rate to be paid each year. Once again, the

accounting is not complicated. The $1 million is the historical cost of the patent while the annual $70,000

payments ($1 million × 7 percent) are recorded each year by the buyer as interest expense. The two amounts are

clearly differentiated in the terms of the agreement.