Financial Accounting and Reporting CPA Practice Exam - Prep, Practice Test & Study Guide

When accounting for a capital lease, the lessee must recognize both an asset and a liability on their balance sheet at the commencement of the lease. This recognition occurs because a capital lease is essentially treated as a purchase of the asset financed through a loan.

The asset is recorded at the lesser of the fair value of the asset at the lease's inception or the present value of the minimum lease payments. This reflects the economic substance of the lease agreement, where the lessee gains control over the use of an asset while also incurring a corresponding obligation to make lease payments. The associated liability represents the future lease payments that the lessee is committed to paying.

The other choices do not accurately capture the accounting treatment for a capital lease. Recording only the lease payments does not acknowledge the underlying asset and liability that should appear on the balance sheet. Not making any entries until the end of the lease ignores the ongoing financial obligations and the control of the leased asset throughout the lease term. Finally, only recording the economic life of the asset fails to address the need to recognize the asset and liability on the balance sheet as required by accounting standards.