Initial Direct Cost Incurred in a Lease Transaction

The lessor usually incurs the initial direct costs. Under ASC 842, the lessor treats the initial direct costs differently depending on the lease classification:

Lease Type	Profit Recognition	Initial Direct Costs
Direct Sales Type Lease	Gross profit recognized at lease inception. Interest income recognized over lease term using the effective rate method.	Initial Direct Costs are recognized as an expense at lease inception.
Direct Financing Lease*	Profit recognized over the lease term using the effective rate method. *	Recognized as part of Net Investment in the Lease (an asset), effectively reducing the profit recognized over the lease term.*
Operating Lease	Rental Revenue recognized each period. Depreciation expense recognized each period.	Recognized as a prepaid asset and amortized as an expense over the lease term.

Question: Explain the theoretical rationale for treating Initial Direct Costs differently based on whether the lessor has a Direct Sales Type Lease or an Operating Lease. References to the FASB Statement of Financial Accounting Concepts, ASC Topic 842, and related Accounting Standard Updates and any other source you deem necessary should be included in your response. You may ignore the treatment of Initial Direct Cost when the lessor has a direct financing lease.

Guidance: The issues that need addressing are:

• When should a cost be treated as an asset?
• When should a cost be treated as an expense?
• If a cost is initially treated as an asset, when, if ever, is a related expense recognized through depreciation, amortization, allocation, impairment, etc.?

In answering these questions, referring to Concepts Statement No. 6 Elements of Financial Statements is essential.