6.11 Initial Direct Costs

ASC 842-10 — Glossary

Initial Direct Costs

Incremental costs of a lease that would not have been incurred if the lease had not been obtained.

ASC 842-10

30-9 Initial direct costs for a lessee or a lessor may include, for example, either of the following:

Commissions
Payments made to an existing tenant to incentivize that tenant to terminate its lease.

30-10 Costs to negotiate or arrange a lease that would have been incurred regardless of whether the lease was obtained, such as fixed employee salaries, are not initial direct costs. The following items are examples of costs that are not initial direct costs:

General overheads, including, for example, depreciation, occupancy and equipment costs, unsuccessful origination efforts, and idle time
Costs related to activities performed by the lessor for advertising, soliciting potential lessees, servicing existing leases, or other ancillary activities
Costs related to activities that occur before the lease is obtained, such as costs of obtaining tax or legal advice, negotiating lease terms and conditions, or evaluating a prospective lessee’s financial condition.

Connecting the Dots

Definition of Initial Direct Costs Consistent With ASC 606

In a manner consistent with ASC 606, initial direct costs for both lessees and lessors include only those costs that are incremental to the arrangement and that would not have been incurred if the lease had not been obtained. Paragraph BC307 of ASU 2016-02 explains the FASB’s decision for aligning the definition of initial direct costs under ASC 842 with that in ASC 606:

The Board [FASB] concluded that a lessor and a seller of the same good, including an entity that both sells and leases assets, should account for similar costs in the same way. In addition, the Board noted that the guidance on initial direct costs in previous GAAP was aligned with one of the two acceptable methods for accounting for costs to obtain a contract in previous revenue recognition guidance, and, therefore, the Board’s decision on initial direct costs in Topic 842 maintains alignment between the leases and revenue recognition guidance for these types of costs.

Changing Lanes

Fewer Costs Qualify as Initial Direct Costs Under ASC 842

The definition of initial direct costs under ASC 842 is considerably more restrictive than the definition under ASC 840. For example, under ASC 842, commissions paid and payments made to existing tenants to obtain the lease are considered initial direct costs, whereas allocated internal costs and costs to negotiate and arrange the lease agreement that would have been incurred regardless of lease execution (e.g., professional fees such as those paid for legal and tax advice) no longer qualify as initial direct costs.

The FASB included Example 27 in ASC 842 to illustrate the types of costs that qualify as initial direct costs under ASC 842.

ASC 842-10

Illustration of Initial Direct Costs

55-239 Example 27 illustrates initial direct costs.

Example 27 — Initial Direct Costs

55-240 Lessee and Lessor enter into an operating lease. The following costs are incurred in connection with the lease:

55-241 Lessor capitalizes initial direct costs of $10,000, which it recognizes ratably over the lease term, consistent with its recognition of lease income. The $10,000 in broker commissions is an initial direct cost because that cost was incurred only as a direct result of obtaining the lease (that is, only as a direct result of the lease being executed). None of the other costs incurred by Lessor meet the definition of initial direct costs because they would have been incurred even if the lease had not been executed. For example, the employee salaries are paid regardless of whether the lease is obtained, and Lessor would be required to pay its attorneys for negotiating and drafting the lease even if Lessee did not execute the lease.

55-242 Lessee includes $20,000 of initial direct costs in the initial measurement of the right-of-use asset. Lessee amortizes those costs ratably over the lease term as part of its total lease cost. Throughout the lease term, any unamortized amounts from the original $20,000 are included in the measurement of the right-of-use asset. The $20,000 payment to the existing tenant is an initial direct cost because that cost is only incurred upon obtaining the lease; it would not have been owed if the lease had not been executed. None of the other costs incurred by Lessee meet the definition of initial direct costs because they would have been incurred even if the lease had not been executed (for example, the employee salaries are paid regardless of whether the lease is obtained, and Lessee would be required to pay its attorneys for negotiating and drafting the lease even if the lease was not executed).

Connecting the Dots

Initial Direct Costs May Be an Allocated Amount

As discussed in Section 6.1, when nonlease components are present in a contract, the consideration in the contract must be allocated to the lease and nonlease components. In a manner consistent with this requirement, ASC 842-10-15-38 requires that lessors allocate capitalized costs (including initial direct costs) to the separate components in the contract. As a general rule, we believe that lessors should allocate these costs on the same basis as the consideration in the contract (i.e., on the basis of stand-alone selling price). However, when the capitalized costs (e.g., commissions) are entirely related to the lease component(s) in the contract rather than to the overall contract (which contains both lease and nonlease components), we believe that it is acceptable to allocate these costs entirely to the lease component(s) in the contract.

On the other hand, ASC 842-10-15-33 requires that lessees allocate initial direct costs to the separate lease components in the contract on the same basis as lease payments (i.e., on the basis of stand-alone price).

Example 6-20

Company L (the lessee) enters into an arrangement to lease a building for 10 years. As part of the arrangement, the lessor is required to provide CAM services for the 10-year lease term. In exchange for the right to use the building and obtain the CAM services, L will make fixed monthly payments of $5,000. The stand-alone price of the monthly building lease and CAM is $4,750 and $500, respectively. As compensation for executing the contract, the lessor pays a one-time commission of $1,000 to its employee.

The following table illustrates the allocation of the $1,000 commission between the lease and nonlease components in the contract:

The $905 commission allocated to the lease component in the contract should be accounted for in accordance with the guidance on initial direct costs in ASC 842. The $95 commission allocated to the nonlease component in the contract should be accounted for in accordance with the guidance on incremental costs to obtain a contract in ASC 606 (see Section 13.2 of Deloitte’s Roadmap Revenue Recognition). The accounting treatment of the $905 commission under ASC 842 may not be aligned with that of the $95 commission under ASC 606.

See Chapters 8 and 9 for a discussion of the recognition and subsequent measurement of initial direct costs for lessees and lessors, respectively.

6.11.1 Payment Made by a Lessor to a Lessee to Induce Early Termination of a Lease

A lessor may make a payment (or payments) to a lessee to induce the lessee to terminate the lease before the end of the lease term. Such a situation may arise, for instance, when the rental rate is unfavorable from the lessor’s perspective (i.e., below the prevailing market rate) or the lessor has an opportunity to lease the space to a more attractive tenant. Generally, at the time the payment is made, the lessor either will have secured a replacement lessee for the space (perhaps with eviction of the current tenant being the only unresolved matter) or, at a minimum, will have identified a replacement lessee and will be in the process of negotiating the lease.

A payment made by a lessor to a lessee to induce the lessee to terminate the lease before the end of the lease term generally qualifies as an initial direct cost of the lessor in obtaining the new lease. (Similarly, such a payment received by the lessee generally qualifies as a lease incentive in the lessee’s accounting for its new lease, as discussed in Section 6.2.2.1.)

Provided that, at the time of the payment, the lessor has identified a replacement lessee for the space and entering into the new lease with that identified replacement lessee is reasonably certain, the payment made to induce the current lessee to terminate the lease qualifies as an initial direct cost of obtaining the new lease. The lessor should defer the payment as an initial direct cost of obtaining the new lease and recognize it into income over the term of the new lease.

However, deferral of the payment would not be appropriate in situations in which, at the time the payment is made, either (1) a specific replacement lessee has not been identified or (2) a replacement lessee has been identified but entering into the new lease with that replacement lessee is not reasonably certain. In these situations, the payment would not constitute an initial direct cost and instead should be expensed as incurred.

6.11.2 “Key Money” Payment Made to an Existing Lessee to Assume a Lease

In certain jurisdictions, lessees are able to renew leases at below-market rates because of the regulatory restrictions placed on lessors. Therefore, an entity is economically incentivized to assume a below-market lease from an existing lessee rather than negotiate a new lease at market rates. The entity will often pay the existing lessee to assume the lease; this payment is commonly referred to as a “key money” payment.

We believe that key money payments typically should be accounted for as initial direct costs. ASC 842-10-20 defines initial direct costs as “[i]ncremental costs of a lease that would not have been incurred if the lease had not been obtained.” Further, ASC 842-10-30-9 gives examples of two types of initial direct costs:

Initial direct costs for a lessee or a lessor may include, for example, either of the following:

Commissions
Payments made to an existing tenant to incentivize that tenant to terminate its lease. [Emphasis added]

Although key money payments are made to assume an existing lease with favorable market terms rather than simply to induce an existing tenant to terminate its lease, both represent costs incurred to obtain the right to use the underlying asset over the lease term and would not have been incurred if the lease had not been obtained. We therefore believe that key money payments typically meet the definition of initial direct costs.

Likewise, under the new leasing standard, lessees no longer record separate intangible assets for below-market lease payments upon acquiring an operating lease in a business combination; rather, such amounts are capitalized as part of the ROU asset in accordance with ASC 805-20-25-12. Therefore, we believe that entities should generally capitalize the entire key money payment as an initial direct cost — and thus as part of the ROU asset — and amortize this cost over the life of the ROU asset (i.e., over the lease term unless the lease transfers ownership or contains a purchase option that the lessee is reasonably certain to exercise).

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.