Free Wheelers is a bike shop located near the campus of Alabama State University. The shop rents bikes on a nine-month basis. When a bike is rented, the student pays a security deposit equal to 50 percent of the bike’s value. Typically, a bike is returned damaged in some way, causing some portion of the security deposit to be for feited. Should Damage to the bike be so excessive as to eliminate the security deposit, students are required to pay the difference in cash. When a security deposit is received, the company’s bookkeeper debits Cash and credits Miscellaneous Revenue. If a bike is returned damaged, the book keeper debits Repairs Expense and credits Cash (or Inventory, if parts are used to repair the bike). Any portion of the deposit that is not required to repair the bike is returned to the student. Deposit amounts returned to students are recorded with a debit to Miscellaneous Expense and a credit to Cash.
Required:
Write a brief memo to Free Wheelers’ bookkeeper regarding the accounting treatment given security deposits on bike rentals. Explain why the current accounting treatment is incorrect and how it may introduce errors in to the business’s financial statements. Also recommend a more appropriate method of accounting for security deposits.