Initial direct costs play an important role in lease accounting under ASC 842. These costs can affect the initial measurement of a lease, the right-of-use asset and how lease-related expenses are recognized over time.
Under ASC 842, however, the definition of initial direct costs is much narrower than it was under ASC 840. Not every cost related to finding, negotiating or preparing a lease can be capitalized. In many cases, costs that were previously included as initial direct costs must now be expensed as incurred.
For accounting teams, this makes it important to understand what qualifies, what does not qualify and how initial direct costs should be recorded.
What Are Initial Direct Costs Under ASC 842?
Under ASC 842, initial direct costs are incremental costs of a lease that would not have been incurred if the lease had not been obtained.
In simpler terms, a cost generally needs to pass two tests:
- The cost must be incremental: This means the cost was caused by obtaining the lease.
- The cost would not have been incurred if the lease had not been obtained: If the company would have paid the cost whether or not the lease was signed, it usually does not qualify as an initial direct cost.
This definition is important because it limits which lease-related costs can be capitalized. Costs that do not meet the ASC 842 criteria are typically expensed as incurred.
Evolution from ASC 840 to ASC 842
Under ASC 840, the treatment of costs associated with lease acquisition was more liberal. It allowed for the capitalization of certain costs like legal fees and even labor costs associated with lease acquisition. However, ASC 842 introduces stricter criteria for what qualifies as an IDC. Now, IDCs are defined as costs directly attributable to negotiating and executing a lease agreement, which are incremental and would not have been incurred otherwise.
Common Costs That May Have Been Treated Differently Under ASC 840
Under ASC 840, companies may have capitalized costs such as:
- Internal salaries for employees working on lease negotiations
- Legal fees related to reviewing or negotiating lease terms
- Costs to prepare lease documents
- General costs related to arranging the lease
- Commissions paid to brokers or selling agents
Under ASC 842, some of these costs no longer qualify because they may have been incurred whether or not the lease was ultimately obtained.
What Qualifies as an Initial Direct Cost?
The most common qualifying initial direct costs are costs directly tied to obtaining the lease and only paid because the lease was completed.
Leasing Commissions
These are perhaps the most straightforward example of IDCs. If there is no lease agreement, there would be no leasing commission paid, making it an incremental cost directly tied to the lease execution.
Payments to Existing Tenants
In some cases, a lessor may pay an existing tenant to terminate a lease early so a new lease can be signed with another tenant.
When these payments are made to obtain a new lease and would not have been incurred otherwise, they may qualify as initial direct costs.
Other Costs
Other lease-related costs should be reviewed based on whether they are incremental and directly tied to obtaining the lease. If the cost would have been incurred even if the lease was not signed, it generally should be expensed as incurred rather than treated as an initial direct cost.
What Does Not Qualify as an Initial Direct Cost Under ASC 842?
ASC 842 excludes many costs that may feel connected to a lease but are not directly caused by the lease being obtained.
Internal Salaries and Payroll Costs
Internal salaries generally do not qualify as initial direct costs under ASC 842.
For example, if employees in the real estate, finance, legal or accounting department spend time evaluating leases, preparing documents or negotiating lease terms, their salaries are usually expensed as incurred.
This is because the company would likely pay those employees regardless of whether a specific lease was obtained.
General Overhead
General overhead costs do not qualify as initial direct costs. These may include:
- Office expenses
- Administrative support
- Internal software costs
- General lease management costs
- Standard operating expenses
These costs are not incremental to obtaining one specific lease.
Legal, Tax and Professional Fees
Legal and professional fees need to be reviewed carefully.
Under ASC 842, many legal, tax and advisory costs do not qualify as initial direct costs if they would have been incurred regardless of whether the lease was obtained.
For example, legal fees paid to review lease terms, provide tax advice or support negotiations are often expensed as incurred. These costs may support the leasing process, but they are not always dependent on the final lease being obtained.
A professional fee may only qualify if it is truly incremental and would not have been incurred unless the lease was obtained.
Site Search and Property Evaluation Costs
Costs related to searching for a property, evaluating lease options or comparing potential locations usually do not qualify.
For example, if a company pays a consultant to help identify possible office locations, that cost is typically incurred before the lease is obtained. The cost would still exist even if the company chose not to sign the lease.
Because of this, site selection and property evaluation costs are usually expensed as incurred.
Impact on Lessees
For lessees, initial direct costs are included in the initial measurement of the right-of-use asset.
The right-of-use asset generally starts with the lease liability and is adjusted for items such as:
- Lease payments made at or before the commencement date
- Lease incentives received
- Qualifying initial direct costs
This means initial direct costs increase the ROU asset when they qualify under ASC 842.
Instead of being recognized as an immediate expense, those costs are recognized over the lease term through the accounting treatment of the ROU asset.
Example of Lessee Treatment
If a lessee signs a lease and pays a $20,000 broker commission that is only due because the lease was executed, the $20,000 would generally be included in the ROU asset.
If the lessee also pays $5,000 in legal review fees that would have been incurred whether or not the lease was signed, those legal fees would generally be expensed as incurred.
Impact on Lessors
Initial direct costs are also important for lessors, but the accounting treatment depends on the lease classification.
Operating Leases
For operating leases, lessors generally defer qualifying initial direct costs and recognize them over the lease term, usually on the same basis as lease income.
Direct Financing Leases
For direct financing leases, qualifying initial direct costs are generally included in the lessor’s net investment in the lease and recognized over time.
Sales-Type Leases
For sales-type leases, the treatment depends on whether the lessor recognizes selling profit at lease commencement.
If selling profit is recognized at commencement, initial direct costs are generally expensed at that time. If no selling profit is recognized, the costs may be deferred and included in the net investment in the lease.
Because lessor accounting can vary based on lease classification, lessors should carefully review how initial direct costs are treated for each lease type.
Accounting Treatment under ASC 842
Under ASC 842, qualifying initial direct costs are capitalized as part of the right-of-use asset, while costs that do not qualify are expensed as incurred. For lessees, qualifying IDCs increase the initial measurement of the ROU asset and are recognized over the lease term, helping align the cost with the period benefiting from the leased asset.
For lessees, the basic concept is:
ROU Asset = Lease Liability + Qualifying Initial Direct Costs + Lease Payments Made at or Before Commencement – Lease Incentives Received
Differentiating Lease Acquisition Costs Vs. Lease Initial Direct Costs
It’s important to differentiate IDCs from lease acquisition costs that do not qualify as IDCs under ASC 842. Lease acquisition costs include expenses necessary to acquire the lease but do not meet the incremental and direct criteria required for IDCs. These costs are expensed in the period incurred and do not impact the ROU asset.
Practical Implementation
Because ASC 842 has a narrower definition, companies should have a clear process for reviewing lease-related costs.
1. Create Clear Cost Categories
Separate lease-related costs into categories such as:
- Broker commissions
- Legal fees
- Internal labor
- Site search costs
- Lease negotiation costs
- Tenant termination payments
- Other professional fees
This makes it easier to review each cost and determine whether it qualifies.
2. Document Why a Cost Qualifies
For any cost treated as an initial direct cost, accounting teams should document why it meets the ASC 842 criteria.
Helpful questions include:
- Was this cost incremental?
- Would this cost have been incurred if the lease had not been obtained?
- Is the cost directly tied to one specific lease?
- Is the cost supported by an invoice, contract or agreement?
3. Review Legal and Professional Fees Carefully
Legal and professional fees are often where confusion happens.
Even if a legal fee is related to a lease, that does not automatically make it an initial direct cost. The company should review whether the fee was truly dependent on the lease being obtained.
Managing Initial Direct Costs Under ASC 842
Lease accounting software can help companies track lease costs, identify qualifying initial direct costs and apply consistent accounting treatment across a lease portfolio. Platforms like Visual Lease facilitate proper accounting entries for IDCs, ensuring they are correctly capitalized and amortized over the lease term. This involves moving qualifying costs out of the immediate expense category and increasing the ROU asset, allowing those costs to be recognized over time.
As ASC 842 narrows the definition of initial direct costs, companies need to be more careful when reviewing lease-related expenses. The key question is whether the cost is incremental and would not have been incurred if the lease had not been obtained. By documenting cost treatment clearly and using lease accounting software to support consistent entries, organizations can improve accuracy, reduce manual work and maintain stronger compliance across their lease portfolio.
