When a lease is classified as a financial lease, what is the typical impact on financial statements?

• A. It is recorded as an operating expense with no balance sheet impact.
• B. It reduces liabilities immediately.
• C. It is recognized as an asset and liability, increasing leverage.
• D. It has no effect on reported debt.

Answer: (C)

When a lease is classified as a finance lease, the lessee records a right-of-use asset and a corresponding lease liability on the balance sheet, reflecting the financed purchase of the asset. This increases both assets and liabilities, i.e., it raises leverage. Over the life of the lease, the asset is depreciated and the liability accrues interest, so the income statement shows depreciation expense plus interest expense rather than a simple lease payment. The other statements don’t fit because there is a balance sheet impact (not just an operating expense with no balance sheet effect), liabilities are not reduced immediately (they are established and then amortized), and debt levels are indeed affected (so there is an effect on reported debt).