Security deposits are often part of leases. Rental leases require at least one month’s rent to be deposited a security amount to the landlord. Tenants may claim a refund of the security deposit at the time of contract maturity.
Some trade contracts or leases of equipment may also require security deposits. Security deposits cannot be treated as income until forfeited. Similarly, receivers of security deposits do not make any interest payments on them.
Let us analyze different aspects regarding security deposits.
What is a Security Deposit?
A security deposit is an amount paid by one party to another in a contract as collateral. The first party in the contract receives the deposit and holds it for the period of the contract.
The deposit amount is refundable at the time of contract maturity. However, the first party holds the right to deduct any damages or losses from the security deposit.
The right to a deduction for losses or any unpaid lease amounts must be included in the contract between both parties.
Security Deposit Paid and Received
In lease contracts for rental property, equipment, or machinery; the first party is the receiver of the security deposit. The second party in these contracts is the payer of the deposit amount.
Both parties can recognize the deposit amount in their balance sheets provided it meets certain criteria. The deposit amount can be either recorded as asset/liability or income/expense by both parties under specific conditions.
Recognition of Security Deposit – IAS 39 or IAS 32
The security deposit amount can be recognized under the IAS 32 rule for financial instruments; recognition or under the IAS 39 rule, financial instruments; recognition and measurement.
Both of these IAS rules deal with financial assets and liabilities. However, a security deposit must meet the criteria of a financial asset or financial liability to be recognized under IAS 32 or IAS 39.
In most lease contracts, a security deposit results in the exchange of cash (through check or cash payment) between both parties. The deposit amount then leads to an exchange of one financial instrument (cash for security deposit) and one non-financial instrument (property leased).
The transaction of security deposit exchange falls under the scope of IAS 39.
Paragraph 49 of IAS 39 states that ‘the fair value of a financial liability with a demand feature (demand deposit) is not less than the amount payable on demand, discounted from the first date that the amount could be required to be paid.’
Accounting for Security Deposit
If the lease contract between both parties is for one year or less, then both parties will recognize the security deposit amount as a short-term asset/liability respectively.
If the lease contract is for more than one year, then both parties will recognize the amount as a long-term asset/liability.
Since the deposit received by the first is refundable in part or full later, the party will create a new contra account of “security deposit liability” to offset the cash amount received. Similarly, the second party will create a contra account for “security deposit receivable” under the assets section.
The journal entry for the first party in the lease contract receiving cash for security deposit can be:
|Security Deposit Liability||$ XXX|
Since the first party receives cash, it must reflect in the balance sheet of the party. Also, since the amount is refundable at a later date, it generates a liability. Thus, there is no element of equity in this transaction as the first party does not own the amount as income unless it meets certain conditions.
Is Security Deposit an Income?
Under normal circumstances, a security deposit cannot be accounted for as income. The amount is refundable to the second party at a later date depending on the contract terms. Thus, the receiver cannot recognize the deposit amount as income.
Accounting for Security Deposit Forfeited – Transfer to Income Statement
The amount deposited for security cannot be recognized as ordinary income by the receiver. However, in special circumstances, the deposit can be forfeited partially or fully.
Importantly, the advance rent payment should be considered separately from the security deposit amount. The advance rent should be considered as income when received.
The first-party or the landlord in the lease contract may deduct some amount from the refundable deposit. Such deductions can only be used for damages and repairs.
However, if the tenant or the second party breaks a law and does not complete the contract term, the security deposit can be forfeited. In this case, the amount should be recognized as income by the receiver.
Suppose two parties ABC company and XYZ enter into a rental property agreement. The monthly rental amount and the security deposit are $1,000. The lease contract is for one year.
ABC will receive the cash for $1,000 as a security deposit and will record the journal entry as:
|Security Deposit Liability||$1,000|
If the contract completes, ABC company will reverse the journal entry by crediting cash and debiting the security deposit liability for the same amount.
If XYZ does not complete the contract and ABC company forfeits the deposit, it will be recognized as ordinary income in the income statement of AB company.
Interest on Security Deposits
Usually, the security deposits do not earn interest for the payer. However, laws differ from state to state on the provision of interest earned on security deposits received by landlords.
If the first party earns interest on deposit, it is offset by the inflation rate. In other words, in absence of interest income, the second party in the lease contract may have to deposit more funds.
For accounting purposes, the security deposit can be converted to the present value of the future cash outflow. The first party can calculate the required amount of deposit by discounting the future cash outflow in present value terms.
IRS Tax Guidance of Refundable Security Deposits
Since the first party in a lease contract cannot recognize the security deposit amount as ordinary income, it does not incur a tax liability.
The IRS provides clear instructions on dealing with security deposits.
- The security deposit must not be included in the taxable income if it is refundable.
- If there is partial deduction, it must be spent on damages or maintenance expenses.
- If the security deposit is against one month’s rent or lease payment, it must be recorded as income when received immediately rather than at the time of contract maturity.
- Any forfeited amount due to break of lease contract can be included in the taxable income by the first party.
Any deductions from the security deposit for expenses of repairs must be reimbursed accordingly. The first party should include the amount as either income or deduct the expenses to avoid the double-dip in tax deductions.
The amount for the security deposit is refundable in most cases. It can be accounted for as a short-term asset/liability or long-term asset/liability by both parties in the contract. It cannot be accounted for as income unless it meets the forfeited amount criteria. The amount will not incur a tax liability for the receiver unless it is recognized as forfeited income.
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