Expand
Resize
Add to favorites
Companies should make an accounting policy election to either estimate forfeitures or to account for them when they occur.
For purposes of this guide, “pre-vesting forfeiture” describes the circumstance when an award is forfeited prior to vesting, for example due to termination or failure to satisfy a performance condition. A “post-vesting cancellation” describes the circumstance when an employee terminates after vesting and does not exercise their vested award or if a vested award expires unexercised at the end of its contractual term. This distinction is important because a pre-vesting forfeiture results in reversal of compensation cost whereas a post-vesting cancellation would not. Additionally, as discussed in SC 9.3, the development of the expected term assumption does not consider pre-vesting forfeitures but does consider post-vesting cancellations.

2.7.1 Estimating forfeitures

Companies may make a company-wide accounting policy election to estimate forfeitures of employee awards based upon providing the requisite service. Under ASC 718, if a company has a policy to estimate forfeitures, then it is required to develop an assumption regarding the pre-vesting forfeiture rate beginning on the grant date. The forfeiture estimate impacts the estimated amount of compensation expense to be recorded over the requisite service period. Companies are required to true-up forfeiture estimates for all awards with performance and service conditions through the vesting date so that compensation cost is recognized only for awards that vest (ASC 718-10-35-3). For awards with market conditions, a forfeiture rate assumption is applied to adjust compensation cost for those employees that do not complete the requisite service period. However, compensation cost is not reversed if the company fails to satisfy the market condition.
Under ASC 718-10-35-3, companies that estimate forfeitures will (1) estimate the number of awards for which it is probable that the requisite service will be rendered and (2) update that estimate as new information becomes available through the vesting date. A company should also review its forfeiture-rate assumption for reasonableness at least annually and potentially on a quarterly basis, considering both forfeiture experience to date and a best estimate of future forfeitures of currently outstanding unvested awards. It should also review its forfeiture-rate assumption when significant events occur which could affect the likelihood of employees vesting in outstanding awards, such as planned restructuring actions.
Under ASC 718-10-35-8, the amount of compensation cost that is recognized on any date should at least equal the grant-date fair value of the vested portion of the award on that date. If a company applies a forfeiture-rate assumption that assumes more forfeitures than actually occur, the company may not be recognizing enough compensation cost to meet this requirement. Accordingly, for awards that vest in separate tranches, companies should assess, as each tranche vests, whether the compensation cost recognized for the award at least equals the vested portion of that award.

2.7.1.1 Election to account for forfeitures as they occur

Companies may also make a company-wide accounting policy election to account for forfeitures of employee awards as they occur. The policy election only relates to the service condition aspects of awards; entities will still need to assess the likelihood of achieving performance conditions each reporting period.
A company that elects to account for forfeitures as they occur will record compensation cost assuming all option holders will complete the requisite service period. If an employee forfeits an award because they fail to complete the requisite service period, the company will reverse compensation cost previously recognized in the period the award is forfeited. Thus, the total cumulative amount of compensation cost recognized for an award will be the same regardless of whether the company elects to estimate forfeitures or account for forfeitures as they occur.
There are certain circumstances where it will still be necessary to estimate forfeitures:
  • If an award is modified, the company should assess whether the performance or service conditions of the original award are expected to be satisfied when measuring the effects of the modification (refer to SC 4). The company should apply its accounting policy to account for forfeitures when they occur upon subsequent accounting for the modified award.
  • If an award is exchanged or replaced in connection with a business combination, forfeitures must be estimated to attribute the acquisition date fair value of the replacement awards between pre-combination service (which is included as part of the consideration exchanged in a business combination), and the amount attributable to postcombination service (which is recorded as compensation cost). The amount attributed to precombination service is reduced for awards that are expected to be forfeited. See BCG 3.4.1 for further discussion of the fair value attributable to pre- and post-combination service in the exchange of share-based awards in a business combination.
Example SC 2-15 illustrates the recognition of forfeitures as they occur.
EXAMPLE SC 2-15
Recognition of forfeitures as they occur
On January 1, 20X1, SC Corporation grants a restricted stock award to its CEO that vests on December 31, 20X3 based on providing continued service over that period. SC Corporation has elected a policy to account for forfeitures as they occur.
On December 1, 20X2, the CEO informs the board of directors of her intent to voluntarily terminate her employment effective January 31, 20X3.
When should SC Corporation reverse previously recognized compensation cost for the award?
Analysis
SC Corporation should reverse previously-recognized compensation cost in the period the award is forfeited, which is January 20X3. Although as of December 31, 20X2 it is expected the award will be forfeited, SC Corporation has elected to account for forfeitures as they occur. Therefore, SC Corporation should not adjust compensation cost in its 20X2 financial statements. Further, compensation cost should continue to be recognized through the date of actual forfeiture. SC Corporation should consider whether disclosure of the anticipated termination and the related financial statement impact is warranted in the 20X2 financial statements.

2.7.2 Forfeitures and liability-classified awards

For companies that elect to estimate forfeitures, a forfeiture assumption (considering forfeiture experience to date and estimating future forfeitures) should be applied to awards that are classified as liabilities as well. Liability awards are remeasured at fair value each reporting period, and any impact of forfeitures or updates to the forfeiture estimate, although not affecting the fair value measurement of the awards, should be reflected at that time as well. 

2.7.3 Applying a forfeiture-rate assumption

For companies that elect to estimate forfeitures, the forfeiture-rate assumption is typically expressed as the estimated annual rate at which unvested awards will be forfeited during the next year, which may or may not differ significantly by employee group. Some companies estimate the total forfeitures for the entire grant or for each vesting tranche. The forfeiture-rate assumption can be based on a company’s historical forfeiture rate if known. However, management should assess whether it is necessary to adjust the historical rate to reflect its expectations. For example, adjustments may be needed if, historically, forfeitures were affected mainly by turnover that resulted from business restructurings that are not expected to recur.
Companies could use separate pre-vesting forfeiture assumptions for different employee groups when they believe those groups will exhibit different behaviors. For example, based on its history and expectations, a company may develop a 5% annual forfeiture estimate for senior executives and a 10% annual forfeiture estimate for all other employees.
Example SC 2-16 illustrates how a company could apply its estimated annual forfeiture rate to an option grant.
EXAMPLE SC 2-16
Estimated annual forfeiture rate applied to an option grant
SC Corporation grants to its employees a total of 400 stock options that (1) vest upon the employees’ completion of a service condition and (2) have a four-year graded vesting schedule (25% or 100 awards per year). SC Corporation estimates a 5% annual forfeiture rate, based on its historical forfeitures. SC Corporation uses the following calculations to determine the number of options that are expected to vest:
Year
Number of options eligible for vesting
Number of options expected to vest
Calculation
1
100
95
= 100 × .95
2
100
90
= 100 × .95 × .95
3
100
86
= 100 × .95 × .95 × .95
4
100
81
= 100 × .95 × .95 × .95 × .95
Totals
400
352
How much compensation expense should SC Corporation recognize in year 1?
Analysis
In this example, 88% of the options are expected to vest (352 options expected to vest/400 options granted). As discussed in SC 2.8, for awards with graded vesting features, companies will use either a graded vesting (accelerated) or straight-line attribution approach to recognize compensation cost over the vesting period. If a company uses an annual forfeiture rate for awards with graded vesting, as illustrated above, and the straight-line attribution approach to recognize compensation cost, there could still be some compensation cost that needs to be front-loaded to the earlier portions of the requisite service period. In this case, SC Corporation would begin expensing 95 options in year 1 under the straight-line attribution approach, rather than 88 options, because of the requirement to expense at a minimum the number of awards actually vested at each vesting date.
As each tranche vests, a company should assess the actual number of awards vested in order to comply with the requirement that the amount of compensation cost that is recognized on any date should at least equal the grant-date fair value of the vested portion of the award. For example, if all 100 options vest in the first year in the above scenario (i.e., no awards are forfeited in the first year), the company should recognize compensation cost for those 100 awards. Additionally, the company will need to re-evaluate the number of unvested options remaining and the reasonableness of the forfeiture-rate assumption used for the remaining requisite service period.
Other approaches for determining and applying a forfeiture rate in the above scenario may be acceptable; however, a company should comply with the requirement that the amount of compensation cost recognized on any date equals at least the compensation cost associated with the vested portion of the award.

2.7.4 Segregating and analyzing pre-vesting forfeitures

For companies that elect to estimate forfeitures, the forfeiture estimate should generally start with an analysis of the company's historical data covering several years. The group of the employee and terms of an award could affect the likelihood of the award being forfeited; therefore, companies should evaluate the pre-vesting forfeiture rate of awards by employee group and grouping awards with similar terms and using a specific forfeiture rate for each group of similar awards. For each grant, actual forfeitures should be compiled by period (e.g., one year from the grant date, two years from the grant date, etc.), and the percentage of the remaining outstanding unvested award forfeited each year should be computed. The company should then average those forfeiture rates to compute an average historical annual forfeiture rate.
When analyzing forfeitures, companies should segregate forfeitures into two categories: (1) pre-vesting forfeitures and (2) post-vesting cancellations, as defined earlier. Assume, for example, that a company grants 500 options and that 100 of the options vest each year, over a five-year requisite service period. The employee terminates employment after two years. His vested options are underwater, and thus, are not exercised. Accordingly, the 200 vested options are not pre-vesting forfeitures but, instead, post-vesting cancellations; the 300 unvested options are pre-vesting forfeitures.
Some software packages used to track stock option activity do not differentiate between pre-vesting forfeitures and post-vesting cancellations and, therefore, this data in some cases may be difficult to obtain. Additionally, startups and other companies that do not have a sufficient history to estimate the expected pre-vesting forfeiture rate might have to rely on surveys of, or disclosures by, other similar companies. However, ASC 718 does not require disclosure of the forfeiture-rate assumption; therefore, the ability to obtain public information on forfeiture rates may be limited.
Another factor that may be considered in developing a forfeiture assumption, or in adjusting historical forfeiture rates, is current human resources or industry near-term forecasts of anticipated employee turnover by employee group. An annual employee turnover rate and an annual forfeiture rate assumption may be comparable for this purpose.
Without proper recordkeeping, it will be difficult to accurately compute a historical pre-vesting forfeiture rate. Making accurate true-up adjustments to recognize actual forfeitures may also be difficult. Companies should review their recordkeeping systems to assess whether pre-vesting forfeitures can be separated from post-vesting cancellations; separating the two will ensure that companies sort the appropriate data to develop an accurate estimate regarding the pre-vesting forfeitures.

2.7.5 Examples of the impact of forfeiture policies

Example SC 2-17 illustrates how estimated forfeitures and actual forfeitures interrelate with different vesting conditions.
EXAMPLE SC 2-17
Accounting for actual and estimated forfeitures for each type of vesting condition
Assumptions for all four scenarios:
SC Corporation grants its employees 5,000 stock options on January 1, 20X1. The grant-date fair value is $8 per option.
Scenario 1: Service condition
All of the options cliff vest after three years of service. The company has elected a policy to estimate forfeitures. In 20X1 and 20X2, SC Corporation estimates that 95% of the options will vest. In 20X3, SC Corporation completes a significant restructuring, which results in only 45% of the options vesting because 55% of the options are forfeited prior to vesting. Because the actual pre-vesting forfeiture rate differs dramatically from management’s prior expectations, the company will recognize a credit to compensation cost in 20X3 as shown below.
20X1
20X2
20X3
Number of options
5,000
5,000
5,000
Fair value per option
$8.00
$8.00
$8.00
Fair value of total options
$40,000
$40,000
$40,000
Percentage expected to vest
95%
95%
45%
Total expected compensation cost
$38,000
$38,000
$18,000
Portion of service period completed at year-end
33%
67%
100%
Cumulative compensation cost recognized at year-end
$12,540
$25,460
$18,000
Cumulative compensation cost previously recognized
$—
$12,540
$25,460
Current-period expense/ (income)
(pre-tax)
$12,540
$12,920
$(7,460)
Scenario 2: Performance and service condition
The options are subject to a three-year service condition and a performance condition based on each employee achieving a specific cumulative sales target over the period from 20X1 through 20X3. In 20X1, SC Corporation estimates that 90% of its employees will achieve their targets and remain employed through 20X3 (i.e., 90% of the options will vest). At the end of year 2, however, SC Corporation reassesses the likelihood that the targets will be achieved and determines that 95% of the employees will achieve their targets by the end of 20X2 and remain employed through 20X3. Due to a new competitor’s product that is launched in 20X3, only 75% of employees actually achieve the cumulative sales targets.
20X1
20X2
20X3
Number of options
5,000
5,000
5,000
Fair value per option
$8.00
$8.00
$8.00
Fair value of total options
$40,000
$40,000
$40,000
Percentage expected to vest
90%
95%
75%
Total expected compensation cost
$36,000
$38,000
$30,000
Portion of service period completed at year-end
33%
67%
100%
Cumulative compensation cost recognized at year-end
$11,880
$25,460
$30,000
Cumulative compensation cost previously recognized
$—
$11,880
$25,460
Current-period expense (pre-tax)
$11,880
$13,580
$4,540
Scenario 3: Market and service conditions
The options become exercisable only if the employee remains employed by SC Corporation for three years and SC Corporation’s stock price outperforms the S&P 500 Index by 10% during that three-year vesting period. The requisite service period is three years because that is the explicit period for the market condition and the date that the employee must be employed in order to vest in the award. As a result of the market condition, the fair value of these options is $4.50. Ninety-five percent of the employees are expected to complete the requisite service period at the end of both 20X1 and 20X2.
At the end of the three-year period, SC Corporation's stock price has outperformed the S&P 500 Index by only 3%. Therefore, no awards are exercisable. Additionally, 10% of employees did not complete the three-year requisite service period as compared to the estimated forfeiture rate of 5%. In this scenario, the compensation cost should be adjusted to reflect actual forfeitures; however, compensation cost should not be reversed for the 90% of the employees who fulfilled the requisite service period of three years, even though the market condition was not met.
20X1
20X2
20X3
Number of options
5,000
5,000
5,000
Fair value per option
$4.50
$4.50
$4.50
Fair value of total options
$22,500
$22,500
$22,500
Percentage expected to complete requisite service period
95%
95%
90%
Total expected compensation cost
$21,375
$21,375
$20,250
Portion of service period completed at year-end
33%
67%
100%
Cumulative compensation cost recognized at year-end
$7,054
$14,321
$20,250
Cumulative compensation cost previously recognized
$—
$7,054
$14,321
Current-period expense (pre-tax)
$7,054
$7,267
$5,929
Scenario 4: Accounting for forfeitures as they occur
Assume the same facts as in Scenario 1, except that the company has elected to account for forfeitures as they occur. In 20X1, 20X2, and 20X3, actual forfeitures are 0, 750, and 500, respectively.
20X1
20X2
20X3
Number of options not yet forfeited - beginning of year
5,000
5,000
4,250
Number of options forfeited during the year
0
750
500
Number of options not yet forfeited - end of year
5,000
4,250
3,750
Fair value per option
$8.00
$8.00
$8.00
Fair value of unforfeited options
$40,000
$34,000
$30,000
Portion of service period completed at year end
33%
67%
100%
Cumulative compensation cost recognized at year end
$13,200
$22,780
$30,000
Cumulative compensation cost previously recognized
0
13,200
22,780
Current period expense
$13,200
$9,580
$7,220

2.7.6 “Last man standing” arrangements

A “last man standing” arrangement is an agreement with more than one employee whereby if the employment of one of the employees is terminated prior to the end of a defined vesting period, the stock-based compensation awards granted to that employee will be reallocated among the remaining employees who continue employment. Because each employee has a service requirement, each individual grant of stock-based compensation awards should be accounted for separately. Generally, the accounting for a reallocation under a “last man standing” arrangement is effectively treated as a forfeiture of an award by one employee and regrant of options to the other employees. Therefore, if and when an employee terminates his or her employment and options are reallocated to the other employees, the reallocated options should be treated as a forfeiture of the terminated employee’s options and a new option grant to the other employees.
Expand

Welcome to Viewpoint, the new platform that replaces Inform. Once you have viewed this piece of content, to ensure you can access the content most relevant to you, please confirm your territory.

Your session has expired

Please use the button below to sign in again.
If this problem persists please contact support.

signin option menu option suggested option contentmouse option displaycontent option contentpage option relatedlink option prevandafter option trending option searchicon option search option feedback option end slide