What is the accounting treatment for finance leases?

The accounting treatment for finance leases requires recognizing future lease payments as both a liability and an asset on the balance sheet. This treatment reflects the economic reality of the lease transaction, where the lessee effectively gains control over the leased asset and assumes the obligation to make lease payments.

In a finance lease, the lessee records the leased asset at its present value, which reflects the cost of the asset to be used over the lease term. Simultaneously, the lessee recognizes a liability for the future lease payments, indicating the obligation to pay those amounts. This dual recognition underscores the fundamental principles of accounting by showing both the asset being controlled by the lessee and the responsibility for the future cash outflows.

Other choices fall short of this requirement. Recording only cash outflows limits the impact on the balance sheet, ignoring the asset and corresponding liability. Similarly, not recognizing lease payments at all or classifying all lease payments as operating expenses would misrepresent the financial position of the company, as it wouldn't reflect the substance of finance leases that are akin to borrowing. Thus, recognizing the asset and liability provides a comprehensive view of the financial implications of finance leases.