Properly identifying Initial direct costs is an important part of lease accounting under ASC 842. Keep reading to avoid accounting mishaps by familiarizing yourself with the definition of initial direct costs, complete with examples of how to determine what qualifies as an initial direct cost and how they should be handled.

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 by all parties. 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 capitalize or added to the right of use asset on the balance sheet.

The definition of an initial direct cost evolved with the advent of the new lease standard, ASC 842, narrowing the definition as compared to ASC 840. Note that lessors and lessees apply the same definition of initial direct costs. 

The new guidance is consistent with the concept of the incremental costs of obtaining a contract. Costs that may qualify as initial direct costs are commissions paid to a broker when a lease agreement is signed or payments are made to existing tenants to incentivize them to terminate their lease. Initial direct costs do not affect the lease liability; however, they are included in the ROU Asset. 

Transition Leases

The new definition of initial direct costs could also change what is capitalized for transition leases, which are leases that started before the new lease standard went into effect. It may be cost- and time-prohibitive to go back years—and sometimes decades—to re-analyze the costs incurred to execute a lease contract. 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 as part of the transition to ASC 842.

Items that are included in the initial direct costs of a lease are:

1. Commissions
2. Any lease documentation preparation costs incurred after the execution of the lease
3. Legal fees that are contingent on the successful execution of a lease
4. Payments to existing tenants to incentivize them to terminate their lease
5. 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:

1. Fixed employee salaries that are paid regardless of successfully signing a lease agreement.
2. General overheads, such as depreciation, occupancy and equipment costs, unsuccessful origination efforts, and idle time
3. Costs related to activity performed by the lessor for advertising, soliciting potential leases, servicing existing leases, or any other ancillary activities
4. 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. For a lessor, the initial direct costs are recorded based on lease classification. For operating leases, they are expenses over the lease term on the same basis as lease income. For sales-type leases where the fair value of the asset differs from its carrying amount at lease commencement, initial direct costs are expensed at lease commencement. For sales-type leases where the fair value equals the carrying value at lease commencement and direct financing leases, initial direct costs are included in the initial and subsequent measurement of the net investment in the lease.

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 for an operating lease under ASC 842:

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

This leaves a total of $45,000 worth of costs incurred by the lessor. In this particular situation, only the $10,000 in commissions to brokers are considered initial direct costs that are capitalized over the lease term consistent with their recognition of lease income. 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

This is a total of $42,000 of costs incurred by the lessee. 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 capitalized as part of the ROU Asset and do not affect the lease liability.

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 assets 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 related to acquiring a leased asset must be assessed to determine 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 for the lessee. If the contract itself is for an intangible asset, it likely does not qualify as a lease under ASC 842, which covers leases of physical assets.

What is Capitalized Cost in a Lease?

A capitalized lease cost is representative of the total ROU Asset straight-lined over the term of the lease.

Conclusion on Initial Direct Costs Under ASC 843

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