A lease is an agreement in which a lessor allows a lessee to use their assets. In this process, the lessor owns the asset and grants a right to use the underlying asset. The lessee, in exchange, pays them for this right. Some several other terms and conditions dictate these contracts. In essence, however, most lease contracts are the same due to the same features.
Some lease contracts provide the lessee with the right to get the asset after they end. In these contracts, the lessee essentially pays for it in installments while the lessor owns it. However, other lease agreements do not include the transfer of the underlying asset. In these circumstances, the asset’s condition before and after the lease period becomes crucial to investigate.
What is a Security Deposit?
Some lessees may damage a leased asset during the period of their use. In these cases, it becomes crucial for the lessor to have some certainty about compensation. Therefore, lessors charge a security deposit before they physically transfer the asset to the lessee. Usually, this security deposit is a refundable amount that the lessee agrees to place with the lessor before taking possession of the asset.
In some cases, the security deposit may also be refundable. However, in most circumstances, the lessor will pay the lessee back for the amount. Before that, though, the lessor will evaluate the condition of the underlying asset. Usually, it involves looking at the difference between how it was before and after the lease period. Once the lessor does so, they may find some damages to the underlying asset.
In case of damages, the lessor will hold off on reimbursing the lessee. Instead, they will use the security deposit to repair the underlying asset. Once done, they can repay the residual amount to the lessee. This way, the lessor gets better protection against any damages to their assets. In some cases, these lease contracts may require the lessee to pay this amount. Therefore, the lessee cannot enter a lease agreement without payment.
Overall, a security deposit is an upfront payment made by a lessee to a lessor. It protects the lessor from any financial losses in case of damages to the underlying asset. The lessor can also use this amount as compensation if the lessee falls short on rent payments. Security deposits are most common in the housing market, where tenants must pay the landlord before renting a house.
What is the Accounting for Security Deposit?
The accounting for security deposit will differ from lessors to lessees. In both circumstances, this deposit will represent a financial instrument. For the lessee, it will be a financial asset. However, for the lessor, it will fall under financial liabilities. Similarly, there are two processes included in accounting for a security deposit. The first involves the payment of the deposit, while the second concerns its return.
For the lessor, the security deposit is a refundable amount. Consequently, they will record it as a financial liability. In some jurisdictions, the lessor must also pay interest for keeping this deposit. Therefore, they must also account for any interest in it. However, these situations are rare. Lessors must also record the repayment when they return the underlying payment.
For the lessee, the security deposit is an asset. In accounting terms, this deposit is similar to accounts receivables. Lessees usually record this amount when they pay it to the lessor. Once they return the underlying asset, they will receive their payment back. Therefore, they will substitute their receivables for cash in exchange.
However, there is one other critical stage to account for security deposits. This stage involves when the lessor returns the amount. As mentioned, in some cases, the lessor will not refund the amount in full due to compensation for damages. Therefore, it reduces assets for the lessee and an addition for the lessor. Both parties have to account for it accordingly.
Lastly, security deposits are usually refundable. Therefore, all the above steps in the process will apply. In some cases, however, the underlying payment will not be refundable. Both parties cannot use the same treatment if these cases apply. For the lessee, this deposit will be an expense. But for the lessor, it will be income. However, non-refundable security deposits are rare.
What are the Journal Entries for Security Deposits?
As mentioned, the accounting treatment of security deposits varies based on the party accounting for them. Similarly, there are two stages in the process, both of which will require the opposite treatment. The accounting for security deposits for lessees and lessors are as below.
For Lessee
As mentioned, for the lessee, the security deposit is an asset. When the lessee pays this amount, they are basically giving it to the lessor for a future refund. Therefore, for the lessee, this process involves the transfer of assets between different classes. Usually, lessees pay this amount in cash. In some situations, it may also include a bank payment.
The initial security deposit payment is when the lessee obtains the asset or signs the lease contract. In some circumstances, this payment will also include a month’s rent in advance. Therefore, the lessee must separate this amount from the security deposit. Once done, they can record the security deposit using the following journal entries.
| Account | Debit | Credit |
| Security Deposit | XXXX | |
| Cash / Bank | XXXX |
The refund transaction is also straightforward. The process involves reversing the above entry. In most circumstances, however, the lessor will charge some amount for repairs. Therefore, the lessee must also recognize a related expense. The journal entries for the refund of a security deposit are as follows, assuming damages exist.
| Account | Debit | Credit |
| Cash / Bank | XXXX | |
| Expense | XXXX | |
| Security Deposit | XXXX |
For Lessor
For the lessor, all of the above conditions will also apply. When the lessor receives a security deposit from the lessee, they must create a financial liability. The accounting treatment will be the reverse of that done by the lessee. Overall, the journal entries for the receipt of the security deposit will be as follows.
| Account | Debit | Credit |
| Cash / Bank | XXXX | |
| Security Deposit | XXXX |
When the lessor returns the amount to the lessee, they must reverse the above entries. However, the lessor may also deduct an amount for repairs from it. However, it does not constitute an income for the lessor. This amount stays in the security deposit account until the lessor uses it to repair the underlying asset. However, the accounting treatment for the return will be as follows.
| Account | Debit | Credit |
| Security Deposit | XXXX | |
| Cash / Bank | XXXX |
Example
A company, ABC Co., rents out a property from a landlord. The company enters into a lease agreement that requires a monthly payment of $10,000. For the initial transaction, the lease contract also requires ABC Co. to pay a security deposit of $50,000. Similarly, the company must pay three months’ rent in advance at the commencement of the contract.
When ABC Co. enters the contract, it pays $80,000 to the landlord through the bank. This payment includes a $50,000 security deposit and the reset as advance rent. Therefore, the company must recognize both payments. The journal entries for this transaction are as follows.
| Account | Debit | Credit |
| Prepaid Rent | $30,000 | |
| Security Deposit | $50,000 | |
| Bank | $80,000 |
After a year, ABC Co. leaves the property for another location. However, the landlord does not return the full security deposit after inspecting the property. The landlord holds back $10,000 as damages and returns only $40,000 through the bank. Therefore, ABC Co. must expense out the $10,000. The company uses its Miscellaneous expenses account for it.
The journal entries for the refund of the security deposit to ABC Co. are as follows.
| Account | Debit | Credit |
| Bank | $40,000 | |
| Misc. Expenses | $10,000 | |
| Security Deposit | $50,000 |
Conclusion
Lease contracts involve transferring the rights to use of an asset from a lessor to a lessee. These contracts may also require the lessee to submit a security deposit. Usually, this deposit is refundable and acts as protection for the lessor against damages to the asset. The accounting for security deposits may differ based on various factors discussed above.
