As some of you may have heard, FASB issued ASU 2016-09, new guidance that will have some positive effects on companies that calculate stock-based compensation expense. While the guidance covered a few provisions, the focus of this post will be on the provision that relates to accounting for forfeitures within compensation expense.
As those of you who calculate stock compensation expense can understand, determining a good estimate of stock award forfeitures is a common point of argument with auditors. It is ultimately a management judgement call, but should be based on a consistent and reasonable approach.
Remember that this is an estimate of management's future expectations of forfeitures (i.e., awards that will never vest). As such, when using actual historical estimates, you should make sure to adjust for outliers, such as terminations due to layoffs. Additionally, there is the question of whether to include the current forfeitures in the calculation of the rate (i.e., applying it retrospectively or applying it at the beginning of the period, prospectively).
We often use a calculation of actual forfeitures in the periods prior to the period in which you are applying the rate. In addition, the guidance requires that you apply the forfeiture rate to participants with similar forfeiture experiences―also known as creating experience groups. This could mean executive vs. "rank and file" employees, or award type categories, or geographic groups, with certain countries having higher rates than others.
Another question is what to do for a brand new company with little to no termination and/or granting history. If you granted 10 options and one person left, would a 10% rate make sense? Or if no one left, would 0% make sense? New companies often go with a minimal rate, say 2% or 5%, but it is really a guesstimate at the end of the day, until more history is established.
The time required to determine a consistent rate can be distracting. The additional time and money to recalculate expense using anything other than a flat rate is even more of a distraction. Most equity systems use a compounded rate these days, which means auditor recalculations will take more time as they come back to you with questions on what the effective rate should be in year X. It's possible, but I see more time spent scrutinizing these calculations than others, even though they compose a smaller piece of the stock compensation pie. This means more hours out of your day, and more money to auditors/consultants that work with you on the numbers.
With ASU 2016-09, the forfeiture estimates can be eliminated (yay!). The catch? You have the option to apply no forfeiture rate, and recognize forfeitures as they occur, but you must adopt all the other provisions of this ASU. We are recommending that companies adopt no forfeiture rate, to simplify their lives. If you do decide to eliminate the forfeiture rate, the adjustment will flow through Retained Earnings.
As a public company, you must adhere to the guidance that is effective for annual periods beginning after December 15, 2016, or if you are not public, annual periods after December 15, 2017, and interim periods within annual periods beginning after December 15, 2018. An entity can be an early adopter as long as it adopts all of the provisions.
Contact the Equity Management Consulting team for help with forfeiture rate adoption or to learn more about the new guidance. In addition, Armanino has a team of tax professionals dedicated to share-based compensation. They can assist you with the tax transition under ASU 2016-09, which includes major changes.
