A company holds a patent with a remaining carrying amount of $150,000. A competitor infringes on the patent, and the company incurs $40,000 in legal fees successfully defending its right to the patent in court, with the favorable ruling clearly establishing an increase in the patent's future economic benefit. In a separate, unrelated matter the same year, the company incurs $25,000 in legal fees unsuccessfully defending a different patent against an invalidity challenge, and that other patent is cancelled as a result. Under US GAAP, how should the company account for these two sets of legal costs?
- Capitalize the $40,000 of successful-defense legal costs, added to the first patent's carrying amount to the extent the defense evidently increased its value, and expense the $25,000 of unsuccessful-defense legal costs immediately, writing off the remaining carrying amount of the cancelled patent as a loss at the same time
- Expense both sets of legal costs immediately as incurred, because costs to defend intangible assets, win or lose, are always treated as period costs rather than added to an asset's carrying amount
- Capitalize both sets of legal costs, because litigation costs incurred to protect a recognized intangible asset are always added to that asset's carrying amount regardless of the outcome of the litigation
- Capitalize the $25,000 of unsuccessful-defense legal costs, since the effort was made to preserve an asset, and expense the $40,000 of successful-defense legal costs immediately, since a favorable outcome merely confirms a right the company already owned rather than representing a new cost of that right
Why A? And why not the others?
Correct answer: A. Capitalize the $40,000 of successful-defense legal costs, added to the first patent's carrying amount to the extent the defense evidently increased its value, and expense the $25,000 of unsuccessful-defense legal costs immediately, writing off the remaining carrying amount of the cancelled patent as a loss at the same time
Under ASC 350-30, the accounting treatment of costs to legally defend an intangible asset turns on the outcome of the litigation. A successful defense that clearly establishes an increase in the asset's future economic benefit supports capitalizing the associated legal costs, added to the patent's carrying amount, to the extent that increase in value is evident, since the defense preserved and confirmed a benefit the company can now be confident of realizing. An unsuccessful defense, by contrast, signals that the asset's value is impaired or that the right no longer exists as believed, so the related legal costs are expensed immediately, and here the remaining carrying amount of the cancelled patent must also be written off as a loss since the patent itself no longer has enforceable value. Expensing both outcomes identically ignores the outcome-dependent distinction the standard draws and treats a value-confirming successful defense the same as a value-destroying loss. Capitalizing both regardless of outcome wrongly assumes litigation cost capitalization is automatic rather than contingent on a favorable, value-increasing result. Reversing the treatment — capitalizing the losing case's costs while expensing the winning case's costs — inverts the rule entirely, since it is the successful outcome that evidences increased value worth capitalizing, not the unsuccessful one.
Source: FASB ASC 350-30-25 (costs incurred to defend an intangible asset: capitalized to the extent of an evident value increase if the defense is successful; expensed, along with any impaired carrying amount, if unsuccessful)