Go Dynamic! A Forfeiture Rate Comparison


When companies issue stock awards, they’re required to recognize the expense for each grant. In doing so, they must take into account the number of forfeitures they anticipate. This estimate is based on historical forfeiture activity analysis and is expected to change over time as continued analysis is done. Expense is accrued according to a schedule that takes this estimate into account, with the additional requirement that expense accrued at any given point in time must at least be equal to expense associated with shares vested at that time.The dynamic method is one of many ways to calculate the estimated forfeiture rate. It’s based on the concept that as the vesting date (or more specifically the service period end-date of an award’s tranche) draws near, the chance of those shares forfeiting decreases. Therefore, companies following this approach will gradually decrease the estimated forfeiture rate when calculating the expense at every reporting period, until the service period end-date is reached and 100% of the expense is realized.Your forfeiture rate serves as the starting point of the dynamic forfeiture rate calculation.

Ideally, your software will update your forfeiture rate as your reporting periods progress. The expense realized in each period is based on this new rate. The new expense also takes into account the necessary retroactive adjustments that must be done, due to the changed forfeiture rate.The graphs on the right show a comparison between the flat-rate and dynamic models. The dotted black line represents the shares that would be accrued in each period based on the total shares granted. The colored sections show what would actually be expensed due to an estimated forfeiture rate reduction.A flat rate forces a company to take a bulk positive expense adjustment in the period when shares become vested to ensure the expense is equal to the number of shares vested. Depending on the forfeiture rate in use, this could represent a material increase to the company’s expense. In the dynamic model, where this rate is adjusted to gradually decrease over time, that adjustment is instead spread throughout the service period.

Forfeiture rate comparison

Grant date: 01 January 2011
Vest date: 30 June 2011
Shares vesting: 60
Forfeiture rate: 10%
Note that graphs are approximated in order to demonstrate conceptual differences.

Static forfeiture rate expense recognition
Dynamic forfeiture rate expense recognition

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