What is an Initial Direct Cost?

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.”

In order to classify as an Initial Direct Cost, the expenditure must be direct and incremental in nature. In short, the lessee would not have incurred the cost had they not entered into the leasing arrangement.

Common examples of Initial Direct Costs are as follows:

Payments made to a current tenant by a lessee to incentivize them to terminate their lease so that a lessee can enter that space.
Commissions paid to a broker upon execution of a lease.

Costs that are often mistaken for Initial Direct Costs are legal fees and other costs incurred during the negotiation process. These are not considered to be direct and incremental in nature (and therefore do not qualify as Initial Direct Costs) due to the fact that they would have been incurred regardless of whether the lease was ultimately executed. On the other hand, broker commissions for example are only paid if and when the lease is executed.

Why are Initial Direct Costs important?

Initial Direct Costs are important in the context of ASC 842/IFRS 16 as they directly impact the calculation of the ROU asset upon transition to the new standard(s) and/or at inception of a lease.

Upon transition to the new standard(s) and/or inception of a new lease, your balance of Initial Direct Costs increases the ROU asset.