Be Aware of Changes to Accounting for Forfeitures of Share-Based Payments

The Financial Accounting Standards Board (FASB) has simplified the rules on accounting for share-based payment awards through the issuance of ASU 2016-09. Through this update, companies are no longer required to estimate share-based payment forfeitures when calculating share-based compensation expense.

The current guidance requires entities to estimate forfeitures and reduce share-based compensation expense based on projected forfeitures. The FASB acknowledged that these estimates can be time consuming and do not always produce accurate results. As a result, they have updated the guidance allowing entities to make an election between two methods of accounting for forfeitures, including:

• Method 1: Entities may choose to continue to account for forfeitures according to the current rules, whereby an estimate is made and share-based compensation expense in the current period is reduced for options expected to forfeit in future years.
• Method 2: Entities may choose to record forfeitures as they actually occur.

Let’s consider an example and walk through each option. An entity has awarded 100,000 stock options to an employee. The fair value of each option is $3, making the fair value of the total grant $300,000. The options vest 25% each year on the anniversary date, over a four year period. The entity estimates a 10% forfeiture rate. An employee leaves the company and forfeits their options after two and half years of the vesting period.

• Method 1: At the beginning of the option vesting period, the entity calculates annual share-based compensation related to this award to be $67,500 ($300,000 total value / 4 years * 90%). This amount is recorded monthly, so at the time of the employee’s termination, the cumulative expense recorded is $168,750 ($67,500 *2.5). When the employee leaves, only two anniversaries have been reached so only 50% of the award has actually vested. As such, total cumulative expense that should be recorded is $150,000 ($300,000 * 50%) and an entry to true-up share-based compensation expense will be recorded as follows: $18,750 decrease to share-based compensation expense in the current period ($150,000 cumulative amount that should be recorded – $168,750 cumulative amount that was actually recorded).
• Method 2: At the beginning of the option vesting period, the entity calculates annual stock-based compensation related to this award to be $75,000 ($300,000 / 4 years). After two and half years, total cumulative expense recorded is $187,500 ($75,000 *2.5). As discussed above, total cumulative expense should be $150,000 as of the time of the employee’s termination. As such, an entry to true-up stock-based compensation expense will be required as follows: $37,500 decrease to share-based compensation expense in the current period ($150,000 cumulative amount that should be recorded – $187,500 cumulative expense that was actually recorded).

While each method requires an adjustment to be recorded in the year of forfeiture, the second method requires less initial work by forgoing the forfeiture rate estimation process. As a result, this update will likely save time and money for entities that choose to use the second method. Once the method is chosen, the entity should consistently follow the same method.

These changes apply only to arrangements with service conditions and do not change the rules for awards with performance conditions. Awards with performance conditions should continue to be evaluated on an annual basis based on if it’s probable that the performance condition will be met.

ASU 2016-09 must be adopted for annual periods beginning after December 15, 2016 for public companies and for annual periods beginning after December 15, 2017 for non-public entities. Early adoption is permitted for all entities. The update should be applied using a modified retrospective transition, meaning the cumulative effect of the change should be applied to the opening equity balance in the period of adoption.

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