Overview of Initial Direct Costs
Initial direct costs are the incremental costs of obtaining a lease that would not have been incurred if the lease had not been obtained. Although often relatively small compared to lease payments, these costs directly affect the measurement of right-of-use assets and lease investments, and therefore influence depreciation, interest income, and expense recognition over the lease term for both lessees and lessors.
This article forms part of our full IFRS 16 guide.
Practical insight
When assessing initial direct costs, focus on whether the cost would exist at all if the lease had not been signed — this single question often resolves most judgement areas.
Definition and Scope
Initial direct costs are defined as incremental costs of obtaining a lease that an entity would not have incurred if the lease had not been obtained.
This definition represents a deliberate narrowing compared to IAS 17, which referred more broadly to costs directly attributable to negotiating and arranging a lease. Under IFRS 16, the emphasis is placed firmly on incremental costs, aligning the concept with IFRS 15 on revenue.
Examples of costs that typically qualify include:
- sales commissions payable only upon execution of the lease;
- legal fees that are contingent on successfully concluding the lease; and
- payments made to existing tenants to secure a new lease.
Costs that do not qualify include:
- general overheads;
- internal staff costs that are not contingent on lease execution; and
- advisory or legal costs incurred regardless of whether the lease is obtained.
This narrower scope reduces subjectivity and improves consistency in application.
Lessee Accounting for Initial Direct Costs
For a lessee, initial direct costs are included in the cost of the right-of-use asset at the commencement date.
The cost of a right-of-use asset comprises:
- the initial measurement of the lease liability;
- lease payments made at or before commencement, less lease incentives received;
- initial direct costs incurred by the lessee; and
- estimates of dismantling or restoration obligations.
By including initial direct costs in the right-of-use asset, IFRS 16 ensures that these costs are depreciated over the lease term, reflecting the pattern in which the lessee derives economic benefits from the lease.
Run these numbers yourself in our free lease liability and right-of-use asset calculator.
Lessor Accounting for Initial Direct Costs
While the definition of initial direct costs is consistent for lessors, the accounting treatment depends on lease classification.
Finance Leases
For finance leases, lessors — other than manufacturer or dealer lessors — include initial direct costs in the initial measurement of the net investment in the lease. These costs are effectively spread over the lease term through a reduction in interest income.
Manufacturer or dealer lessors exclude initial direct costs from the net investment in the lease. Instead, these costs are recognised as an expense when the selling profit or loss is recognised at lease commencement.
Operating Leases
For operating leases, initial direct costs are added to the carrying amount of the underlying asset and recognised as an expense over the lease term on the same basis as lease income. This matching ensures that costs are recognised systematically as income is earned.
Example: Initial Direct Costs for Lessee and Lessor
The same lease is shown from both sides, since the treatment differs.
A lessor leases equipment with a fair value of 200,000 under a five-year lease. Annual payments of 48,000 are receivable in arrears, and the asset is expected to be worth 20,000 at the end of the term, none of it guaranteed. The lessor pays a broker commission of 3,000, payable only because the lease was signed. The lessee pays its own legal fees of 2,000 on the same contingent basis.
Lessee
The lessee's 2,000 is an incremental cost of obtaining the lease, so it is capitalised into the right-of-use asset. Assuming a lease liability of 180,000 at commencement:
| Component of the right-of-use asset | Amount |
|---|---|
| Initial measurement of the lease liability | 180,000 |
| Initial direct costs | 2,000 |
| Cost of the right-of-use asset | 182,000 |
The 2,000 is not expensed on signature. It is depreciated over the lease term along with the rest of the asset, adding 400 a year to the depreciation charge over five years.
| Account | Debit | Credit |
|---|---|---|
| Right-of-use asset | 182,000 | |
| Lease liability | 180,000 | |
| Bank — legal fees | 2,000 |
Lessor
If the lease is a finance lease and the lessor is not a manufacturer or dealer, the 3,000 commission is capitalised into the net investment in the lease. It is not a separate asset: it forms part of the amount the implicit rate is solved against, and is therefore recovered through finance income across the term rather than expensed at commencement.
Had the same lessor been a manufacturer or dealer lessor, the 3,000 would instead be expensed at commencement, alongside recognition of the selling profit.
If the lease were an operating lease, the 3,000 would be added to the carrying amount of the equipment and expensed over the lease term on the same basis as the lease income — typically straight line, giving 600 a year.
| Party and classification | Treatment of initial direct costs |
|---|---|
| Lessee, any lease | Added to the right-of-use asset; depreciated over the lease term |
| Lessor, finance lease | Included in the net investment; recovered through finance income |
| Manufacturer or dealer lessor | Expensed at commencement, with the selling profit |
| Lessor, operating lease | Added to the underlying asset; expensed on the same basis as lease income |
Effect on the Interest Rate Implicit in the Lease
A lessor's initial direct costs do more than sit on the balance sheet. They form part of the amount the interest rate implicit in the lease is calculated against, because that rate equates the present value of the lease payments and the unguaranteed residual value to the fair value of the asset plus the lessor's initial direct costs.
The consequence is straightforward: for a given set of lease payments, capitalising initial direct costs increases the amount invested and therefore reduces the implicit rate. The lessor recovers the cost through a slightly lower yield spread across the term rather than through a charge at commencement.
Whose costs count
Only the lessor's initial direct costs enter the implicit rate. The lessee's own costs are added to the right-of-use asset and never affect the lease liability or the discount rate applied to it — a distinction that matters whenever a lessee attempts to derive the rate from the contract.
Because a manufacturer or dealer lessor expenses these costs rather than capitalising them, they are excluded from that lessor's rate calculation entirely.
Alignment With Other IFRS Standards
A key objective of the IFRS 16 deliberations was to align the treatment of initial direct costs with broader IFRS principles, particularly those in IFRS 15. Both standards focus on incremental costs that would not have been incurred without the contract.
This alignment enhances comparability across different types of transactions and reduces complexity by applying a consistent conceptual framework to contract-related costs.
Practical Application Considerations
In practice, entities applying IFRS 16 should do the following when dealing with initial direct costs:
- clearly identify which costs are truly incremental;
- avoid capitalising internal overheads or non-contingent advisory fees;
- apply consistent judgements across leases and other contracts; and
- ensure that initial direct costs are allocated appropriately based on lease classification.
Careful documentation of judgments is particularly important, given the narrower scope of qualifying costs under IFRS 16.
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Conclusion
The IFRS 16 model for initial direct costs represents a clear, principle-based approach centred on incremental costs of obtaining a lease. By embedding these costs in the measurement of right-of-use assets or lease investments and aligning recognition with lease income patterns, IFRS 16 enhances transparency and comparability in lease accounting, while reducing ambiguity around cost inclusion. Entities should exercise careful judgement in identifying qualifying costs to ensure compliance and meaningful financial reporting.
For clarification, guidance, or feedback on our article, please reach out to us at insight@leash.co.za.