Initial direct costs under ASC 842 are incremental costs of a lease that would not have been incurred if the lease had not been obtained, such as a broker commission paid at signing. Lessees add them to the right-of-use asset, never to the lease liability. Lessors account for them based on how the lease is classified.
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 capitalized, 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.
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 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 initial direct costs as part of the transition to ASC 842.
Items that are included in the initial direct costs of a lease are:
| Included in initial direct costs | Excluded from initial direct costs |
|---|---|
| Commissions paid because the lease was signed | Fixed salaries paid whether or not a lease is signed |
| Payments made to an existing tenant to incentivize that tenant to terminate its lease | General overhead: depreciation, occupancy, equipment, idle time |
| Advertising, soliciting leases, servicing existing leases | |
| Tax or legal advice, negotiating terms, evaluating a lessee's credit | |
| Legal fees to negotiate or draft the lease (FASB Example 27) |
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.
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:
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
deferred and recognized as expense over the lease term on the same basis as 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:
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 expensed as incurred. Only the $20,000 payment is added to the ROU asset, and none of these costs affect the lease liability.
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.
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.
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.
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.
The capitalized cost of a lease is the amount recognized as the right-of-use asset at commencement: the lease liability, plus initial direct costs and lease payments made at or before commencement, less lease incentives received.
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Initial direct costs are incremental costs of a lease that would not have been incurred if the lease had not been obtained. Common examples are broker commissions paid when the lease is signed and payments made to an existing tenant to incentivize that tenant to terminate its lease.
Usually not. The FASB's own example treats attorney fees to negotiate and draft a lease as expensed, because they are owed whether or not the lease is signed. A fee that is truly owed only if the lease is signed may be incremental, so confirm the treatment with your auditor.
No. A lessee adds initial direct costs to the right-of-use asset at commencement. The lease liability is measured from the lease payments only, so initial direct costs never change it.
It depends on classification. For an operating lease, the lessor defers initial direct costs and expenses them over the lease term on the same basis as lease income. For a sales-type lease where fair value differs from carrying amount, they are expensed at commencement. Otherwise they are included in the net investment in the lease.
Yes, when the commission is paid only because the lease was signed. A commission owed regardless of the outcome, or a fixed salary for the leasing team, is not an initial direct cost.
Not if the entity elected the package of practical expedients at transition. That package let entities carry forward initial direct costs capitalized under ASC 840 without reassessing them under the narrower ASC 842 definition.
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