By LeaseCrunch® on August 17, 2022 at 2:33 PM
Properly identifying Initial direct costs is an important part of lease accounting. Keep reading to avoid accounting mishaps by familiarizing yourself with the definition of initial direct costs, complete with examples of how to determine whether a cost is an initial direct cost.
What are the Initial Direct Costs of a Lease?
The initial direct costs of a lease are incremental costs that are only incurred if a lease is executed. In other words, they are costs contingent on a lease being successfully signed. This definition of initial direct costs is the same for lessors and lessees.
When initial direct costs are incurred as part of signing a lease, they must be capitalized, or added to the right of use asset recorded on the balance sheet.
The definition of an initial direct cost changed with the advent of the new lease standard, ASC 842. For example, under the previous lease standard, ASC 840, the cost of an attorney reviewing a lease contract was considered an initial direct cost. Now under ASC 842, because you must pay your attorney regardless of whether the lease is actually signed, these costs must be expensed, not capitalized.
On the other hand, a commission paid upon signing a lease is considered an initial direct cost. As a result, it must be capitalized and included in the right of use asset on the balance sheet for that lease.
Changing the definition of initial direct costs could also change what is capitalized for transition leases, which are leases that started before the new lease standard is effective. It could be cost- and time-prohibitive to go back years - and sometimes decades - to re-analyze the costs incurred to execute a lease contract. Happily, the FASB recognized this and included a practical expedient so initial direct costs previously capitalized under ASC 840 do not need to be re-examined. FASB allows you to simply carry forward the ASC 840 indirect costs.
Items that are included in the initial direct costs of a lease are:
- Any lease documentation preparation costs incurred after the execution of the lease
- Legal fees that are contingent on the successful execution of a lease
- Payments to existing tenants to incentivize them to terminate their lease
- Consideration paid for a guarantee of a residual asset by an unrelated third party
Items that are excluded from the initial direct costs of a lease are:
- Fixed employee salaries that are paid regardless of successfully signing a lease agreement.
- General overheads, such as depreciation, occupancy and equipment costs, unsuccessful origination efforts, and idle time
- Costs related to activity performed by the lessor for advertising, soliciting potential leases, servicing existing leases, or any other ancillary activities
- Any costs related to activities that occur before the lease is obtained, such as costs of obtaining tax or legal advice, negotiating lease terms and conditions, or evaluating a potential lessee's financial situation
What is the Accounting Treatment for Initial Direct Costs?
Initial direct costs for a lease should be recorded as an increase in a lessee’s right of use asset, but not recorded as a part of the lease liability. Because of this, lease accounting for initial direct costs can differ for lessors and lessees.
How are the Incurred Initial Direct Costs Accounted for by the Lessor in an Operating Lease?
Accounting for incurred initial direct costs is best shown in this example from ASC 842:
A lessee and a lessor enter into an operating lease. The following costs are incurred by the lessor in connection with the lease:
- $7,000 in travel costs related to the lease proposal
- $22,000 in external legal fees
- $6,000 in employee costs for time negotiating lease terms and conditions
- $10,000 in commissions to brokers
For a total of $45,000 incurred by the lessor. In this particular situation, only the $10,000 in commissions to brokers are considered an initial direct cost and rolled into the right of use asset. All other costs are paid regardless of whether the lease was signed and expensed when they are incurred.
For the same lease, the following costs are incurred instead by the lessee in connection with the lease:
- $15,000 in external legal fees
- $7,000 in allocation of employee costs for time negotiating lease terms and conditions
- $20,000 in payments made to existing tenants to obtain the lease
For a total of $42,000 in costs incurred by the lessee. However, only the $20,000 payment made to the existing tenant is considered an initial direct cost because all other costs are paid even if the lease is not signed. These other costs are expensed when they are incurred.
What is Included in Acquisition Cost?
Lease acquisition costs are similar to initial direct costs; they are the costs of “acquiring” a lease. It is important to note that, when leasing, one is not buying the underlying asset/s in question; instead, leasing is temporarily acquiring the right to use an asset.
From the lessee standpoint, acquisition costs are what they have to pay to obtain a right of use asset. From a lessor standpoint, they have their own initial direct costs, such as an incentive to get someone to rent their asset.
What Does Lease Acquisition Mean?
Lease acquisition is when a lessor and a lessee have successfully entered into a lease, which means that any initial direct costs incurred must be documented and capitalized per the standards set forth in ASC 842.
How are Lease Acquisition Fees Calculated?
Any expense of acquiring a leased asset must be assessed as to whether it is an initial direct cost that needs to be capitalized as a part of the lease.
Are Lease Acquisition Costs Intangible Assets?
If lease acquisition costs fall under the definition of initial direct costs, then they are capitalized as parts of the right of use asset. If the contract itself is for an intangible asset, it likely does not even qualify as a lease under ASC 842, which covers leases of physical assets.
Read more about software leases, or leases for non physical assets, here.