In a direct finance lease, how is the debt accounted for by the lessor?

• A. Debt incurred to acquire the equipment remains on the balance sheet as a long-term liability.
• B. Debt is expensed as incurred.
• C. The debt is reclassified to current assets.
• D. The debt is recognized as income.

Answer: (A)

In a direct financing lease, the lessor is essentially financing the asset for the lessee. Instead of keeping the asset on the books, the lessor derecognizes the asset and records a net investment in the lease (a financial asset) that represents the amount to be recovered through lease payments. The debt used to acquire the equipment remains on the balance sheet as a long‑term liability, reflecting the financing of the asset. Lease payments flow to repay that debt over time, with the interest portion recognized as income and the principal portion reducing the net investment in the lease. This is why the correct approach is to keep the debt on the balance sheet as a long-term liability rather than expensing it, reclassifying it, or treating it as income.