Initial Direct Costs in Lease Accounting – Definition, Treatment, and Examples

Initial direct costs (IDCs) are incremental costs directly attributable to negotiating and executing a lease. They are incurred only if the lease is obtained and are treated differently by lessees and lessors under U.S. GAAP (ASC 842) and IFRS (IFRS 16).

This article explains what qualifies as an initial direct cost, how these costs are recognized and amortized, and how they affect the accounting treatment of leases for both lessees and lessors.

1. What Are Initial Direct Costs?

Initial direct costs are:

✦ Incremental – would not have been incurred if the lease had not been executed

✦ Directly attributable – related specifically to that lease transaction

Examples include:

✦ Commissions to brokers or salespeople

✦ Legal fees to draft or review a lease agreement

✦ Payments to external advisors contingent on lease execution

Do not qualify:

✦ General overhead

✦ Internal legal salaries

✦ Advertising or marketing

✦ Lease proposal development costs

2. Lessee Accounting for Initial Direct Costs

Under ASC 842 and IFRS 16, lessees:

✦ Add initial direct costs to the right-of-use (ROU) asset

✦ Do not include them in the lease liability

✦ Amortize the costs as part of the total ROU asset over the lease term

Example:

✦ Lease liability = $500,000

✦ Initial direct costs = $10,000

Initial recognition:Dr. ROU Asset – $510,000 / Cr. Lease Liability – $500,000 / Cr. Cash – $10,000.

Subsequent amortization:ROU asset is depreciated based on the full capitalized amount, including IDCs.

3. Lessor Accounting for Initial Direct Costs

Operating Leases

For operating leases, lessors:

✦ Capitalize IDCs as deferred costs

✦ Amortize them as expense over the lease term in proportion to lease income

Initial entry: Dr. Deferred Lease Costs – $5,000 / Cr. Cash – $5,000.

Amortization entry (monthly over 5-year lease): Dr. Lease Expense – $83 / Cr. Deferred Lease Costs – $83.

Finance Leases

For sales-type or direct financing leases, lessors:

✦ Include IDCs in the net investment in the lease

✦ Adjust interest income over the lease term to reflect effective yield

Dr. Net Investment in Lease – $7,000 / Cr. Cash – $7,000.

The result is a lower initial gain (if any) and smoother recognition of income over the lease term.

4. Differences Between GAAP and IFRS

While both standards treat IDCs similarly, IFRS 16 requires:

✦ More emphasis on whether costs are incremental and contingent

✦ Slightly stricter criteria for capitalization

✦ Same treatment across all lessee leases (no classification difference)

5. Disclosure Requirements

Required disclosures include:

✦ Lessee: Amounts capitalized into ROU assets

✦ Lessor: Total IDCs by lease type and related amortization

✦ Any judgments regarding which costs qualify

✦ Methods used to allocate and amortize deferred costs

Disclosure example – lessee: “Right-of-use assets include $35,000 in capitalized initial direct costs related to real estate leases.”

Disclosure example – lessor: “Initial direct costs totaling $120,000 were deferred and amortized over the lease term for operating leases.”