There is the classic college textbook definition. It is straight forward, but it doesn’t really begin to get involved in the gray area definitions. Then there is the more extended definition as used in accounting and customarily in the traditional business setting. Really getting into higher thinking and use of the terms comes into play when discussing value. Finally, there is the relationship to each other with regards to economics and the evolving concept of wealth. They are similar to the theory of the Yin and the Yang of life itself.
The following sections describe these various levels of use. For most readers, they’ll be satisfied with the textbook answer. For those of you desiring to reach a higher level of understanding of these two terms and their respective relationship with each other – continue reading. When you have finished, you’ll appreciate the proper use of tangible and intangible especially in the proper context and how sophisticated business people express themselves using tangible and intangible.
Tangible and Intangible – Textbook Definition
The college textbook answer is relatively straight forward. The following is what college teaches the business student in regards to tangible and intangible:
The most widely accepted definition is ‘a three dimensional physical item’; something you can touch. Extended definitions include ‘affected by the law of gravity’ and so on. In the world of business we refer to these as physical assets and they include your traditional fixed assets found on the balance sheet:Real Estate and Improvements
- Furniture and Fixtures
At the other extreme, the best answer is that ‘none of the five human senses can detect the item’. Makes sense, because in business, you can’t see or touch the intangible items. The traditional intangible assets include:
- Patents and Copyrights
- Closing Costs
- Research and Development Expenditures
Most of these assets are located in the ‘Other Assets’ section of the balance sheet.
Simply defined as the difference in physical and non-physical, business students are taught the classic definition of tangible and intangible. But in accounting, we broaden the definitions and take into consideration some historical issues related to the terms.
Tangible and Intangible – Accounting Definition and Use
What is interesting is that in accounting, the national standards setting board uses a modified definition of these two terms. A great example of this is the asset ‘Software’. Now the classic definition would have this asset fall into the intangible group. The reality is that in accounting, we actually class this asset as a tangible asset. This relates to one of the tenets of accounting which refers to consistency. If we have always called it a tangible asset, well then, let’s be consistent and continue to call it tangible. How on earth did it start out as a tangible asset? Well, it relates to technology. Back in the 50’s, 60’s and 70’s, the software was built into the equipment. In those days, there really was no way of transferring information between computers. Computers were physically entire rooms of banks of tubes and then transistors. The earliest form of transporting data was the use of the 12” floppy disk. Even then, you didn’t and couldn’t transfer software, you could only transfer data. Effectively, software was in a physical state and nontransferable.
Well, in the late 80’s, software was developed, most notably operating systems that you could load onto computers. In those days, computers were huge machines the size of several volumes of encyclopedias. You could purchase software on 5 ½” floppies and load what you needed onto your 286k ram device. But still, the larger corporations purchased the entire package for their companies. So the world of accounting finally adapted the rules but still stuck with its concept of transferability. If the software is purchased off the shelf and is regularly updated, it should be expensed to the books or recorded as intangible asset. If the software is essentially custom designed and a function of your property plant and equipment (PP&E), then it is considered a part of the PP&E, nontransferable and is recorded as a fixed asset on the books of record. The profession generally uses the $100,000 point as the minimum value before consideration as a component of PP&E.
On the flip side of this are physical assets that are documented as intangible. Goodwill is a prime example. In general, goodwill is the excess price paid for a business (group of assets). The current accounting standards require the physical assets purchased in this deal to be recorded as tangible assets and the excess price paid as an intangible asset. But unlike a patent or other intellectual property that can be sold separately, goodwill cannot be sold unless you sell the entire group of assets as originally purchased. So many accountants argue that the goodwill purchased should be allocated to the fixed assets whereas others argue it is still intangible. Because of the complexity involved, our profession as reevaluated this asset and now no longer amortizes its costs but requires an annual evaluation of the value of goodwill. If the value has decreased, then accounting requires a mark-down of this value by expensing the change to the income statement. So much for being consistent, huh?
Now I’m going to end with another odd aspect of tangible and intangible. In accounting, this term is only used with non-monetary assets. So some financial assets which can exist as physical in nature such as inventory and work in process are not considered tangible for accounting purposes. On the other side, financial assets such as receivables, investments and cash are not considered intangible either. Don’t be confused, they are not tangible. The profession has figuratively excluded current assets from the definitions of tangible and intangible.
So as we explore this gray area of the definition of tangible and intangible, accounting excludes current assets from the example list for these two terms. In addition, it has adapted the terms to fit some odd situations as illustrated with software and goodwill above. So now we are really exploring the gray territory of tangible and intangible and this is where we get involved in using these terms in regards to qualify value.
Tangible and Intangible – Advanced Business Issues
Now that you understand the textbook answer and the accounting use of the terms tangible and intangible, it is time to reveal how the terms are used in more advance business conversations. As our society changed over the last 50 years, more emphasis has been placed on intellectual property. You can see it with the balance sheets of many companies. The Other Assets section is now beginning to expand and increase in value due to the shifting of our economic dynamics. We are no longer an agricultural or manufacturing country. We are headed towards the age of information exchange. Some industries have gained ground in the calculation of the gross domestic product (GDP) including health care, entertainment and technology. All of these industries have utilized more intellectual property recently to provide value to our society and therefore gained a greater share of our GDP.
As further proof, the most recent history of IPO’s for many organizations such as Facebook and Twitter have sold at amounts well beyond their fixed asset values. This means the excess value is intangible in nature. As a business entrepreneur, you need to fully understand how to value intangibles.
There are some more differences in the attributes related to tangible and intangible. Tangible assets are depreciated over functions of time or utility. Intangible assets are amortized over their EXPECTED benefit period. So evaluating intangibles is more subjective than tangible assets. To further complicate this subjective requirement, accounting requires the enterprise to demonstrate separability from other assets. This is easy for certificate based intangibles such as patents or copyrights. But identifying separation from the physical assets is much more difficult when valuing research and development costs, contractual rights and some legal rights.
Furthermore, measuring their economic value is different between these two types of assets. Tangible assets can be easily and very accurately measured using the net present value formula applied against future cash flows. Whereas, intangibles can best be measured using an active market for similar intangibles. A good example is mineral rights. The underlying physical asset giving rise to the rights have a known market and therefore the business can accurately value the rights. So as a businessman, you need to remember one important attribute related to intangibles, they are more subjective in nature as it relates to their book value.
Tangible and Intangible – Economic Relationships
Surprisingly, both types of assets need each other in order to capture their value in cash. In a typical business enterprise, the tangible assets are operated using intangible assets, mostly acquired knowledge, to produce the final product or deliver service to the customer. To acquire cash from an intangible asset, tangible assets must be applied to create the product for the consumer. Think of Coke, their formula and brand require the application of equipment and distribution to put a product on a shelf for ultimate purchase. There is a Yin and Yang effect going on here.
In addition, as our economic foundations move towards intangible assets, many investments in the market still utilize traditional accounting formulas which are tangible based to value their worth. Understanding the valuation principles of intangibles moves you towards being a more sophisticated business entrepreneur. If you use this understanding well, you can garner more wealth. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you.