To account for share-based payment forfeitures under ASC 718, you reverse the compensation expense previously recognized for the unvested portion of the award, debiting additional paid-in capital and crediting stock-based compensation expense. When you record that reversal depends on a policy election: you can either estimate expected forfeitures upfront and true up each period, or ignore forfeitures until they actually happen and reverse the full amount in the period of departure. The election applies only to service-condition forfeitures, and misapplying it to a missed stock-price target is one of the most common errors in this area.
The Policy Election Under ASU 2016-09
ASU 2016-09 gave companies a choice that ASC 718 previously did not allow. You can either estimate expected forfeitures and reduce compensation expense upfront, or record full expense for all outstanding awards and reverse only when someone actually forfeits. The election is entity-wide, applies to all share-based payment arrangements, and must be disclosed in your significant accounting policies.
The election is not irrevocable, but changing it later is not simple. A switch is a voluntary change in accounting principle under ASC 250, and you must demonstrate that the new method is preferable because it improves financial reporting, not because it produces a better income number or matches what peers do. SEC registrants also need a preferability letter from their independent auditor, filed as an exhibit to the first Form 10-Q or 10-K after the change. Most companies pick a method and stay with it.
One further nuance: the policy election for non-employee awards under ASU 2018-07 is independent of your election for employee awards. A company can estimate forfeitures for employee stock options while recognizing consultant forfeitures as they occur, or vice versa.
Estimating Expected Forfeitures
Under the estimation method, you reduce compensation expense each period by the percentage of awards you expect employees to forfeit before vesting. The forfeiture rate typically comes from historical turnover data, segmented by employee group if different populations have meaningfully different retention patterns. A company that historically sees 10% annual turnover among rank-and-file employees might apply a 10% rate to that group’s awards while using a lower rate for senior executives.
You revisit the estimate every reporting period. When actual forfeitures diverge from the estimate, you record a cumulative catch-up adjustment in the current period. Assume you granted awards to 100 employees and estimated 10 would forfeit. One employee leaves and forfeits. If that departure was part of your original estimate and you still expect 10 total forfeitures, adjust the rate to roughly 9% of the remaining 99 employees. If the departure was unexpected and you still anticipate 10 forfeitures from the original group, the 10% rate continues to apply to the remaining pool. The point is that you recalibrate every period so that by the time the vesting period ends, total recognized expense equals the fair value of the awards that actually vested.
Estimation produces smoother earnings because you absorb expected forfeitures gradually rather than in sudden bursts. The tradeoff is complexity: you need reliable historical data, a defensible segmentation methodology, and systems that track individual award status across multiple vesting tranches and periods.
Recognizing Forfeitures as They Occur
The alternative is straightforward. Record compensation expense as though every employee will vest, then reverse the expense in the period someone actually forfeits. No forecasting, no rate adjustments, no cumulative catch-ups driven by changing estimates.
This approach simplifies the accounting considerably, which is why smaller companies with predictable turnover tend to favor it. But it introduces volatility. During stable periods, reported compensation expense runs higher than under the estimation method because you are not discounting for expected departures. When forfeitures cluster, the reversals create noticeable one-time reductions in expense. A senior executive departure that triggers forfeiture of a large award can produce a material boost to net income in a single quarter that has nothing to do with business performance. Companies with high or unpredictable turnover may find the swings large enough to warrant management discussion in their earnings releases.
The Journal Entry
Regardless of which policy you elected, the mechanics of the forfeiture entry itself are the same. When an award is forfeited, you reverse the compensation expense previously recognized for the unvested portion:
- Debit additional paid-in capital (APIC) for the cumulative expense recognized on the forfeited awards.
- Credit stock-based compensation expense for the same amount.
The debit removes the equity that was building in APIC as you recognized expense each period. The credit reduces current-period compensation expense, unwinding the cost recorded for an award the employee never earned. Under the estimation method, this entry occurs as part of your periodic true-up when actual forfeitures differ from estimates. Under the recognize-as-occurred method, the full reversal hits the period in which the employee departs.
For awards with graded vesting, each tranche is treated as a separate award for expense recognition purposes, and a forfeiture reversal applies only to the unvested tranches. If an employee vested in the first two tranches of a four-tranche award before leaving, you reverse expense only for tranches three and four.
Which Vesting Conditions Actually Trigger a Reversal
Your forfeiture policy governs service conditions. Other vesting conditions follow different rules, and confusing them is where restatements come from.
Service Conditions
Service conditions require the employee to stay for a specified period, either graded (for example, 25% each year over four years) or cliff (the entire award at the end of a set period). If the employee resigns, retires, or is terminated before completing the required service, the unvested portion is forfeited and the previously recognized expense reverses. Some grant agreements go further, clawing back vested portions on termination for cause. Service-condition forfeitures are the most common type and the ones your policy election directly governs.
Performance Conditions
Performance conditions tie vesting to internal business targets such as revenue thresholds, earnings goals, or operational milestones. If the target is no longer probable of being achieved, you stop recognizing expense and reverse any expense recorded to date. If conditions later improve and the target becomes probable again, expense recognition resumes with a cumulative catch-up. Your forfeiture policy election does not apply here. You assess probability every reporting period regardless of which method you chose.
Market Conditions Are Different
A market condition ties the award to a stock price target, total shareholder return, or a similar metric indexed to the company’s shares. Under ASC 718, a market condition is not treated as a vesting condition. Its effect is baked into the grant-date fair value using an option-pricing model. The practical consequence: you never reverse compensation expense solely because a market condition goes unmet. If the employee completes the derived service period but the stock price target is never reached, the award expires worthless and the full compensation cost stays on the books. You only reverse expense on a market-condition award if the employee fails the requisite service. Treating a missed stock-price target like a missed performance target, and reversing expense accordingly, is a common error that leads to restatements.
Income Tax Effects
As you recognize compensation expense for an unvested award, you also build a deferred tax asset representing the future tax deduction expected when the award vests or is exercised. When the award is forfeited, that future deduction disappears. You reverse the deferred tax asset through income tax expense in the period of forfeiture. Following ASU 2016-09, any shortfall between the tax benefit previously recorded and the actual tax benefit realized (zero, in a forfeiture) flows through the income statement rather than through APIC.
The boundary on the employee side is worth flagging because employees ask about it. An employee who filed a Section 83(b) election on restricted stock, paying tax on the grant-date value, gets no deduction if the stock is later forfeited before vesting. The tax already paid is lost. No capital loss, no other offset for the amount previously included in income.
Changing the Policy After the Fact
Companies sometimes conclude that the initial election no longer fits. A company that elected estimation might find its workforce has stabilized to the point where the estimation process adds complexity without meaningful accuracy. A fast-growing company that recognized forfeitures as they occurred might find the resulting volatility hard for investors to read.
The change must meet the preferability standard under ASC 250. Valid justifications include meaningful changes in workforce composition, turnover patterns, or the types of awards being granted. Invalid justifications include reducing your effective tax rate, matching peer practice, or anticipating a FASB proposal that has not been finalized.
The transition uses a modified retrospective method. You record a cumulative-effect adjustment to retained earnings as of the beginning of the period in which you adopt the change; prior periods are not restated. SEC registrants file the auditor’s preferability letter with the next quarterly or annual report.
Required Disclosures
Your summary of significant accounting policies must state whether you estimate forfeitures or recognize them as they occur. If you changed your policy at any point, describe the transition impact on retained earnings and net income. Vague language here invites questions from both auditors and investors.
The footnotes must include a rollforward of award activity for the most recent year presented, showing awards granted, vested, exercised, and forfeited, along with weighted-average grant-date fair value. Forfeitures appear as a separate line, giving readers a direct view of how many awards were cancelled and the associated fair value that left the table.
You also disclose total compensation cost recognized in income for share-based payment arrangements, along with the related tax benefit. If you use the estimation method, describe the significant assumptions underlying your forfeiture rate, including the historical data and methodology used to develop the estimate. Companies that estimate should also reflect expected forfeitures when disclosing total unrecognized compensation cost related to unvested awards and the weighted-average period over which that cost will be recognized.