Late lung development comprises the formation of the terminal sac followed by the subdivision of the terminal sac by septa into alveoli and results in the formation of the gas‐exchange surface of the lung. This developmentally regulated process involves a complex epithelium–mesenchyme interaction via evolutionarily conserved molecular signaling pathways. In addition, there is a continuous process of vascular growth and development. Currently there are large gaps in our understanding of the molecular mechanisms involved in the formation of the gas‐exchange surface. In this review, we attempt to integrate and reconcile the morphologic features in late lung development with what is known about the molecular basis for these processes. We describe the formation of the terminal sac and the subsequent formation of the septa, which divide the terminal sac into alveoli, in terms of the classically described developmental stages of induction, morphogenesis and differentiation. We believe that evolutionarily conserved pathways regulate this process and that morphogen gradients are likely to be a central mechanism. In addition, we highlight the importance of the molecular mechanisms involved in the simultaneous development of the vascular bed and its importance in the late development of the lungs. BioEssays 24:1052–1059, 2002. © 2002 Wiley‐Periodicals, Inc.