New Lease Standard – Part 7: Initial Direct Costs

By November 7th, 2022 November 19th, 2022 Audit

 

In this article, we will look at initial direct cost from the perspective of the lessee. (Note that initial direct cost also occurs from the perspective of the lessor, but we will not discuss that here.) ASC 842 defines initial direct cost as follows:

Incremental costs of a lease that would not have been incurred if the lease had not been obtained (842-20-20). It is somewhat difficult to understand that at this point, but ASC 842 gives the following example.

Applicable (ASC 842-10-30-9)

  1. Commission (to real estate brokers, etc.)
  2.  Eviction payments to existing tenants

On the other hand, those not applicable (ASC 842-10-30-10 simplified)

  1. General overhead costs
  2. Costs related to publicity done by Lessor, seeking lessees, etc. (this is from the perspective of the lessor)
  3. Costs related to activities prior to entering into the lease (e.g., obtaining tax and legal advice, negotiating lease terms, etc.)

I personally think that the above example is easier to understand if we think of initial direct costs from the perspective of LESSEE as “costs to outsiders other than lessor that are incurred only after the lease agreement is signed”.

Initial direct cost and ROU asset, lease liability

ASC 842 requires lessees to add the initial direct cost when calculating the ROU asset (ASC 842-20-30-5). In fact, ASC 842 states that a ROU asset consists of the following three components.

  1. Discounted lease liability
  2. Lease payments paid to lessor prior to or at the inception of the lease, less any lease incentives received
  3. Initial direct cost

The above b. is a phrase that looks familiar. This phrase is the same as the “lease payment” explained in Part 5 of this series. Simply put, the lease liability is the amount of the lease payment discounted as explained in Part 5. In addition, adding the lease payment (minus the release incentive) to the calculation of the ROU asset in b. above would appear to result in double counting.

In this regard, ASC 842-20-30-1 has the following provisions regarding release liability.

It states that the lease liability and ROU asset must be measured at the commencement date of the lease, with the lease liability at the present value of the lease payments not yet paid, discounted using the discount rate for the lease at lease commencement.
Therefore, the ROU asset measured at the commencement date of the lease consists of:

(present value of lease payment not yet paid = lease liability) + (lease payment already paid) + (initial direct cost)

and will not be in the double-counting situation described above.
The following is an example to illustrate this point.

[Example]

Contents of the Lease Agreement
・The lease agreement was signed on January 1, and the Commencement date is March 1.
・The lease is for 3 years with 36 monthly payments of $10,000, with the first $10,000 due at signing.
・The remaining 35 payments are due monthly in arrears, with a present value of $300,000.
・Lessor will pay a $5,000 release incentive on February 1.
・An initial direct cost (broker commission) of $2,000 was incurred by lessee on January 1 upon signing of the contract.

 

 

 

 

 

In this case, the ROU asset is:

Lease liability $300,000
Lease payment before or on commencement date 10,000
Lease incentive  (5,000)
Initial direct cost   2,000
Total   ROU asset   $307,000

 

 

 

 

By the way, ASC 842 states that lessee recognizes ROU asset and release liability at the commitment date in ASC 842-20-25-1. If so, how will this transaction be recorded until the commitment date?
The names of the accounts may differ slightly, but generally they are as follows.

January 1 (at the time of contract signing)  
    (Dr.) Prepaid rent $10,000
        (Cr.) Cash      $10,000
  (Lease payments prior to Commencement date)  
   
    (Dr.) Initial direct cost $2,000
       (Cr.) Accrued expense      $2,000
(Initial direct cost incurred)  

 

February 1  
    (Dr.) Cash  $5,000
        (Cr.) Lease incentive       $5,000
  (Lease incentive received)  

 

 

 

 

 

 

March 1 (commencement date)  
    (Dr.) ROU asset  $300,000
       (Cr.) Lease liability       $300,000
  (Lease liability and ROU asset recognition)  
   
    (Dr.) ROU asset  $7,000
    (Dr.) Lease incentive $5,000
       (Cr.) Prepaid rent       $10,000
       (Cr.)Initial direct cost       $2,000
  (Transfer of prepaid rent, lease incentive, and initial direct cost to ROU asset)

 

 

 

 

 

 

 

 

 

As can be seen from the components of the ROU asset described above, it should be noted that the initial amount of the lease liability and the ROU asset do not necessarily coincide

Initial direct cost in ASC 840

The previous standard also included the concept of initial direct costs, but it defined the treatment of costs incurred on the lessor’s side. The scope of the old standard was slightly broader than ASC 842 and included not only incremental costs but also costs would not have been incurred had that leasing transaction not occurred.) and  included: 1) the evaluation of Lessee’s financial condition; 2) the evaluation and registration of guarantees, collateral, and other claims protection arrangements; 3) the negotiation of lease terms; 4) the preparation and processing of lease documents; and 5) the costs of closing the lease. In addition, internal personnel costs directly related to these activities were included.

In the next article, we will present a comprehensive example of an operating lease that summarizes the issues discussed so far.