Initial Direct Costs: What Qualifies Under ASC 842?

The Financial Accounting Standards Board (FASB) introduced Accounting Standards Codification (ASC) 842, Leases, establishing the primary guidance for lease accounting in the United States. A significant element of this standard involves the proper identification and accounting for initial direct costs, referred to as IDCs. The transition to ASC 842 has brought a more precise definition to these costs, changing how both lessees and lessors account for the expenses incurred to put a lease in place.

Defining Initial Direct Costs

Under ASC 842, the definition of initial direct costs is narrow and specific. The standard defines them as incremental costs of a lease that would not have been incurred if the lease had not been successfully executed. If the cost would have been avoided had the lease not been signed, it likely qualifies.

Certain costs meet this definition. The most common example is a commission paid to a real estate agent or broker for successfully arranging the lease, as this payment is contingent upon the lease’s execution. Another qualifying expense includes specific legal fees incurred for drafting and executing the final lease contract. Payments made to an existing tenant to persuade them to terminate their lease early also qualify as an initial direct cost.

Many expenses associated with leasing activities do not qualify because they are incurred regardless of whether a specific lease is signed. These non-qualifying costs include:

• General overhead, advertising, and marketing costs
• Costs related to negotiating lease terms before an agreement is reached
• Salaries of a company’s in-house legal or real estate departments, unless structured as a direct commission

Accounting Treatment for Lessees

For a lessee, the accounting for initial direct costs is straightforward once they are correctly identified. These qualifying costs are capitalized as part of the Right-of-Use (ROU) asset, which is recorded on the balance sheet at the commencement of the lease. This capitalization directly increases the asset’s carrying amount on the balance sheet from day one.

The total value of the ROU asset, which includes these initial direct costs, is amortized over the lease term. This amortization is typically done on a straight-line basis, blending the cost into the single lease expense recognized each period. This aligns the expense recognition with the period over which the lessee benefits from using the leased asset.

Accounting Treatment for Lessors

The accounting for initial direct costs from the lessor’s perspective is more nuanced and depends entirely on the classification of the lease. The treatment differs for operating leases, sales-type leases, and direct financing leases, reflecting the different economic substance of these arrangements.

For an operating lease, the lessor defers any initial direct costs and recognizes them as an expense over the lease term. This is typically done on a straight-line basis, matching the cost recognition with the lease income received over the same period.

In a sales-type lease, the treatment of initial direct costs depends on whether a selling profit is recognized. If the lease results in a selling profit for the lessor, the initial direct costs are expensed at the commencement of the lease. However, if there is no selling profit, the initial direct costs are deferred and added to the net investment in the lease to be recognized over the lease term.

For a direct financing lease, the initial direct costs become part of the net investment in the lease. These costs are then effectively recognized over the lease term as an adjustment to the interest income earned from the lease, reducing the rate of return on the investment.

Comparison with Previous Guidance

The guidance under ASC 842 represents a significant change from its predecessor, ASC 840. The primary difference lies in the definition of what constitutes an initial direct cost. Under the older ASC 840 standard, the definition was broader and permitted the capitalization of certain internal costs related to originating a lease.

ASC 842 introduced a much narrower definition, restricting IDCs almost exclusively to incremental, external costs. As a result of this stricter definition, many costs that were previously capitalized under ASC 840 are now required to be expensed as they are incurred under ASC 842.

This shift means that companies generally capitalize fewer costs as IDCs today than they did in the past. The focus on costs that would not have been incurred “if the lease had not been obtained” has removed much of the judgment previously involved.