Accounting for Initial Direct Costs Under ASC 842
Accounting for Initial Direct Costs Under ASC 842

Accounting for Initial Direct Costs Under ASC 842

ASC 842 Leases is effective this year for public companies. While the largest impact of the new standard is that all leases are recorded on the balance sheet, there are other nuances to consider. One of those is the accounting for initial direct costs of obtaining a lease. In this blog post, we’ll take a look at how the initial direct costs of obtaining a lease are accounted for under ASC 842.

Before we get to the actual accounting, it is important to understand the definition of initial direct costs as ASC 842 changed the definition from ASC 840. Initial direct costs are defined in ASC 842 as “incremental costs of a lease that would not have been incurred if the lease had not been obtained.”

Under legacy ASC 840, initial direct costs included costs incurred by the lessor that had both of the following characteristics:

  1. They are costs to originate a lease incurred in transactions with independent third parties that meet both of the following conditions:
    1. The costs result directly from and are essential to acquire that lease.
    2. The costs would not have been incurred had that leasing transaction not occurred.
  2. They are costs directly related to only the following activities performed by the lessor for that lease:
    • Evaluating the prospective lessee's financial condition
    • Evaluating and recording guarantees, collateral, and other security arrangements
    • Negotiating lease terms
    • Preparing and processing lease documents
    • Closing the transaction.

ASC 842 narrows the definition of what constitutes initial direct costs from ASC 840. As such, fewer lease origination costs are expected to be capitalized under ASC 842 as compared to legacy ASC 840.

Examples of typical initial direct costs under ASC 842 include commissions and payments made to an existing tenant to incentivize that tenant to terminate its lease as these costs would only be incurred as a result of execution of the lease. Costs that typically would not be considered initial direct costs are legal fees, costs of negotiating lease terms, lease underwriting or general overhead expenses such as depreciation, occupancy, and equipment costs, as these costs would be incurred regardless of whether the lease is ultimately executed.

Accounting for initial direct costs

For lessors, the accounting for initial direct costs by the lessor depends on the lease classification as follows.

Initial direct costs

Sales-type lease

Direct financing lease

  • If the fair value of the underlying asset does not equal its carrying amount:
    • Expense at least commencement
    • Exclude from determination of the rate implicit in the lease
  • If the fair value of the underlying asset equals its carrying amount:
    • Defer and include in the net investment in the lease
    • Include in determination of the rate implicit in the lease
  • Defer and include in the net investment in the lease
  • Include in determination of the rate implicit in the lease

 

For lessees, initial direct costs should be capitalized as part of the right of use asset when a lease is recorded. The lessee would then amortize those costs ratably over the lease term as part of its total lease cost.

ASC 842 became effective for public companies in 2019, but private copmanies were granted additional time. For these entities, the ASC 842 is effective in 2022.

If you would like more training on lease accounting under ASC 842, take a look at our eLearning modules on the Revolution, our online learning platform. For additional resources, check out our Leases topic page.

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Comments (1)

  1. Mohan:
    Sep 17, 2019 at 01:19 PM

    Can a lessee have negative initial direct cost? For eg : If the broker shares the commission they received from the lessor for entering the lease with the lessee.


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