Lease acquisition cost

What Is Lease Acquisition Cost?

Lease acquisition cost refers to the incremental costs incurred by a company to obtain a lease that would not have been incurred if the lease had not been obtained. These costs are a crucial component within lease accounting, a specialized area of financial accounting. For a lease to be executed, various expenses may arise, and how these are treated on a company’s balance sheet and income statement is dictated by prevailing accounting standards.

Under modern accounting frameworks, such as ASC 842 in the United States and IFRS 16 internationally, these costs are typically capitalized rather than expensed immediately. Specifically, these costs increase the value of the right-of-use asset recognized by the lessee, reflecting the incremental expense directly tied to securing the lease agreement itself. They represent the direct, unavoidable costs of bringing a lease into existence.

History and Origin

The concept of lease acquisition costs, and more broadly, the accounting for leases, has undergone significant evolution, particularly with the introduction of new standards designed to enhance transparency. Historically, under previous standards like FASB ASC 840 (in the U.S.) and IAS 17 (internationally), many leases were treated as "operating leases" and remained largely off-balance sheet, meaning the associated assets and liabilities were not fully recognized. This practice led to concerns about "off-balance sheet financing," which could obscure a company's true financial leverage and obligations.

In response to these concerns, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) initiated a joint project to revise lease accounting standards. While the boards ultimately diverged on some key aspects, both aimed to bring lease obligations onto the balance sheet. ¹⁴The IASB issued IFRS 16 in January 2016, effective for annual periods beginning on or after January 1, 2019. ¹³Shortly after, the FASB issued ASC 842 in February 2016, with similar effective dates for public companies. ¹²These new standards fundamentally changed how lessees account for leases by requiring them to recognize a right-of-use asset and a corresponding lease liability for nearly all leases, regardless of their classification as operating lease or finance lease (under ASC 842).
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A key part of these new standards was a more stringent definition of the costs that could be considered "initial direct costs" (or lease acquisition costs) and capitalized. Under ASC 842, these are defined as "incremental costs of a lease that would not have been incurred if the lease had not been obtained". ¹⁰This narrow definition ensures that only costs directly attributable to securing the lease are capitalized, excluding internal costs that would have been incurred regardless of lease execution, such as allocated overhead or general legal and administrative fees.
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Key Takeaways

• Lease acquisition costs are incremental expenses directly attributable to obtaining a lease.
• Under ASC 842 and IFRS 16, these costs are capitalized and added to the right-of-use asset on the balance sheet.
• Examples include leasing commissions and legal fees specifically for lease finalization.
• Costs that would have been incurred even if the lease were not executed (e.g., general overhead) are not considered lease acquisition costs.
• Their recognition impacts a company's reported assets and liabilities, providing greater transparency into lease obligations.

Formula and Calculation

Lease acquisition costs themselves are not calculated using a specific formula, but rather are identified as discrete, incremental expenses. Once identified, these costs are incorporated into the initial measurement of the right-of-use asset at the commencement date of the lease.

Under both ASC 842 and IFRS 16, the initial measurement of the right-of-use asset generally includes:

1. The initial measurement of the lease liability.
2. Any lease payments made to the lessor at or before the commencement date, less any lease incentives received.
3. Any initial direct costs (lease acquisition costs) incurred by the lessee.
4. An estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset and restoring the site.

The portion related to lease acquisition costs is simply the sum of these qualifying incremental costs.
For example, if a company incurs $10,000 in leasing commissions and $5,000 in specific legal fees for lease execution, the lease acquisition cost component added to the right-of-use asset would be $15,000.

The lease liability itself is typically measured as the present value of the future lease payments. The lease acquisition costs are then added to this initial lease liability amount (plus any other relevant adjustments) to arrive at the total initial cost of the right-of-use asset. The right-of-use asset is then subject to amortization over the shorter of the lease term or the useful economic life of the underlying asset.

Interpreting the Lease Acquisition Cost

The interpretation of lease acquisition cost is rooted in its impact on a company's financial statements and its role in reflecting the true cost of obtaining a leased asset. By recognizing these costs as part of the right-of-use asset, they are not immediately expensed, but rather spread over the lease term through amortization. This approach aligns the recognition of the cost with the period over which the company benefits from the leased asset.

For financial analysts, understanding the capitalized lease acquisition cost helps in assessing the total investment a company makes in its leased assets. It provides a more complete picture of the economic resources committed to gaining access to and using those assets. This is particularly relevant when comparing companies that lease assets versus those that purchase them, as the new accounting standards aim to reduce the previous disparity in balance sheet presentation. The inclusion of these costs ensures that the initial value of the right-of-use asset more accurately reflects all directly attributable costs to make the asset available for use.

Hypothetical Example

Consider a hypothetical scenario for a company, "Tech Innovators Inc.," entering into a five-year operating lease for new office space. The annual lease payments are $120,000, payable at the beginning of each year. Tech Innovators Inc. also incurs the following costs directly related to obtaining this lease:

• Leasing commission paid to the real estate broker: $10,000
• Legal fees for drafting and reviewing the specific lease agreement: $3,000
• Internal administrative costs (salaries of internal staff who processed paperwork): $2,000
• Credit check fees: $500

Under ASC 842, only the incremental costs that would not have been incurred had the lease not been obtained qualify as lease acquisition costs (initial direct costs).

1. Leasing commission ($10,000): This is an incremental cost directly tied to securing the lease. It would not have been paid if the lease wasn't executed. This qualifies as a lease acquisition cost.
2. Legal fees for specific lease agreement ($3,000): These fees are specific to the negotiation and finalization of this particular lease. They would not have been incurred otherwise. This qualifies.
3. Internal administrative costs ($2,000): Under ASC 842, general internal costs are not considered lease acquisition costs because they would likely be incurred irrespective of whether a specific lease was executed. These are expensed as incurred.
4. Credit check fees ($500): Similar to internal administrative costs, these are typically part of a broader business process and would likely be incurred even if the lease ultimately fell through, or as a general part of vetting counterparties. These are expensed as incurred.

Therefore, for Tech Innovators Inc., the total lease acquisition cost (initial direct costs) that will be capitalized is $10,000 + $3,000 = $13,000.

This $13,000 will be added to the present value of the future lease payments to determine the initial measurement of the right-of-use asset. This asset will then be amortized over the five-year lease term, impacting the company's income statement annually.

Practical Applications

Lease acquisition costs are a critical consideration in several areas of financial accounting and reporting, particularly given the widespread adoption of ASC 842 and IFRS 16.

• Financial Statement Presentation: For both lessees and lessors, properly identifying and accounting for these costs is essential for accurate financial statement presentation. Under ASC 842, a lessee’s right-of-use asset (and corresponding lease liability) is adjusted by the initial direct costs. Th⁷is capitalization of costs ensures that the balance sheet reflects a more comprehensive view of assets obtained through leasing.
• Compliance and Auditing: Companies must adhere strictly to the definitions provided¹²³⁴⁵⁶