IAS 17 classifies leases as finance leases or operating leases, but this is mere words. Finance leases correspond to the Financial Accounting Standards Board's capital leases. There are five criteria for determining whether a lease is a finance lease; they are:

• The lease transfers ownership to the lessee;
• The lease contains a bargain purchase option to purchase that is expected to be exercised;
• The lease is for the major part of the economic life of the asset;
• The present value of the minimum lease payments amounts to substantially all of the fair value of the leased asset;
• Only the lessee can use the leased asset.

The first four criteria correspond strongly with those of FASB; the last one is also contained in FAS 13 even though it is not specifically included as one of the criterion to determine whether a lease is a capital lease.

Critics are correct inasmuch as FASB included bright lines in criteria 3 and 4 (the 75 percent and the 90 percent thresholds), whereas IASB did not. One wonders, however, whether that change eliminates or enhances arbitrariness in financial reporting. True, FASB chose thresholds that cannot be defended while IASB does not contain them. The upshot might be to move the threshold from the standard-setter to the preparer and the auditor, without the investor's being privy to the debate. For example, the preparer might have a lease in which the present value of the minimum lease payments amounts to (say) 95 percent of the fair value of the asset and argues for operating lease treatment. What power and authority does an auditor have to challenge that assertion?

Yes, FAS 13 contains bright lines that are inherently arbitrary, as no economic theory supports the 75 percent or the 90 percent thresholds. But, the lack of bright lines does not solve the issue at all -- it merely shifts the decision about the threshold from the standard-setter to the preparer and to the auditor. This adds subjectivity to the determination of an appropriate cutoff point between what is a capital or an operating lease. Unfortunately, this reality places the decision in the hands of the one being evaluated by the investment community, and the last decade has shown us what happens when we entrust accounting policy making to managers.

To my way of thinking, the arbitrariness in FAS 13 is significantly less than the arbitrariness inherent in IAS 17. To say it another way, the transparency of FASB's arbitrariness to the investment community trumps the opaqueness of IASB's rule.

The present value of the lease is calculated with the interest rate implicit in the lease, if practicable; otherwise, the present value is determined with the business enterprise's incremental borrowing rate. Notice that IASB thereby allows financial engineering by the managers of the entity. Managers can argue that they do not know and cannot find out the implicit rate, obtain a lower present value of the leased item, and then be in a better position to argue that the lease is an operating lease. IASB's position conceptually is no better than FASB's on this point.

IASB defines assets and liabilities as follow:

An asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity.

A liability is a present obligation of the entity arising from past events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits.

These definitions are not substantially different from FASB's definitions. Most importantly, notice that if one is truly principled, he or she must conclude that leased items are assets and lease obligations are liabilities. There is no room for operating leases if managers or auditors are adhering to the principles imbedded in the definitions that IASB gives assets and liabilities.

Both FASB and IASB have ignored their own conceptual frameworks in FAS 13 and IAS 17. Under both sets of definitions, leased items are assets and lease obligations are liabilities. The only logical conclusion for FASB and IASB is to require capitalization of all leases.

When American corporations are allowed to employ international rules, as seems highly probably, then U.S. managers will have a field day in hiding their lease obligations, assuming IASB doesn't have the courage to amend IAS 17. Justice will come when class action suits will be filed against the managers and directors of such companies and perhaps their auditors as well. When the plaintiffs' attorneys read these IASB definitions and note that the managers did not follow the principles in these definitions, they will go a long way in proving the defendants' intent to deceive. Europeans may quash legal redresses on their continent, but American courts are not so easy to intimidate.

FAS 13 is one of the most deficient standards ever issued by FASB. Yet, IAS 17 contains most of the same errors and shortcomings. Its only improvement -- removal of the bright lines -- is actually a detriment because it assists managers in their efforts to obfuscate meaningful communications with investors and creditors. If that's the best example of principles-based accounting, give me rules any day.

This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.