Initial Direct Costs Explained – IFRS 16

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.

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:

1. the initial measurement of the lease liability;
2. lease payments made at or before commencement, less lease incentives received;
3. initial direct costs incurred by the lessee; and
4. 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.

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.

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.

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.