How do estimated vs. actual forfeitures of stock options affect compensation expense, and what is a true-up adjustment?

Forfeiture accounting determines how many option grants are expected to vest, directly affecting total compensation expense. The treatment differs subtly between IFRS and US GAAP.

US GAAP (ASC 718):

Companies have a policy election (since ASU 2016-09):

• Option 1: Estimate forfeitures at grant date and adjust for actual forfeitures as they occur (true-up approach)
• Option 2: Recognize forfeitures as they actually occur (no estimation)

IFRS 2:

• Companies MUST estimate expected forfeitures and revise the estimate at each reporting date. No option to recognize as they occur.

How the Estimation Works:

At each reporting date, the company revises its estimate of the number of awards expected to vest. The cumulative compensation expense is adjusted to reflect the revised estimate — this is the true-up.

Worked Example — Keystone Dynamics:

On January 1, 2024, Keystone grants 200,000 stock options to 100 employees (2,000 each). Grant-date fair value: $15/option. 3-year cliff vesting.

Estimated forfeiture rate: 5% per year

Expected to vest: 200,000 × (1 − 0.05)^3 = 200,000 × 0.8574 = 171,475 options

Total expected compensation: 171,475 × $15 = $2,572,125

Year 1:

Expense = $2,572,125 / 3 = $857,375

Actual departures: 3 employees (6,000 options forfeited)

Year 1 True-Up:

Revised estimate: 97 employees remain. New forfeiture estimate revised to 4%/year for remaining 2 years:

Expected to vest: 97 × 2,000 × (1 − 0.04)^2 = 194,000 × 0.9216 = 178,790 options

Revised total expense: 178,790 × $15 = $2,681,850

Year 1 cumulative expense should be: $2,681,850 / 3 = $893,950

Already recognized: $857,375

True-up adjustment in Year 1: $893,950 − $857,375 = $36,575 additional expense

Year 2:

Target cumulative = $2,681,850 × 2/3 = $1,787,900

Already recognized: $893,950

Year 2 expense = $1,787,900 − $893,950 = $893,950

(If another revision is needed based on Year 2 departures, another true-up occurs.)

Year 3 — Vesting Date:

Actual vesting: 90 employees × 2,000 = 180,000 options

Final total expense: 180,000 × $15 = $2,700,000

Previously recognized (cumulative): $1,787,900

Year 3 expense = $2,700,000 − $1,787,900 = $912,100

Impact on Financial Analysis:

1. True-up adjustments create P&L volatility — a sudden increase in forfeitures can reduce expense, while lower-than-expected forfeitures increase it
2. Under the no-estimation election (US GAAP), expense is reversed when forfeitures occur, creating more period-to-period variability
3. Companies with high employee turnover will have more significant forfeiture adjustments

Key Exam Points:

1. IFRS requires estimation; US GAAP allows a policy choice.
2. True-up adjustments are prospective — they affect current and future periods, not prior periods.
3. At vesting date, cumulative expense = actual awards vested × grant-date fair value.
4. The total expense over the vesting period reflects actual forfeitures regardless of the estimation method used.

Practice forfeiture scenarios in our CFA Level II question bank.