[MUSIC] Welcome back. In a previous example, we talked about basic stock options and stock options with vesting periods. Let's add another layer of complexity now and talk about forfeitures. Why would we talk about forfeitures? Well, stock option sometimes apply to a large group, or a relatively a large group, of employees. And the amount of compensation that you recognize as expense here will have to consider estimated forfeitures for options that fail to vest. Sp particularly, if I have a five year vesting period and there's maybe 50 executives involved, some of them will probably find better opportunities. Some of them may even go to their internal reward, and they won't vest in the stock options. And we have to take that into account when we're measuring compensation expense. So let's look at estimated forfeitures again, go back to our Auto Chauffer example. They initiate a stock comp plan for ten of its senior executives. At the grant date, AC authorizes 500,000 shares at $10 per share. That's the current market price that will vest in five years. The fair value of the options is $3 million. They estimate that 10% of the options will be forfeited due to turnover, which the equivalent of one of the executives not staying for ten years. So the annual compensation expense will be the 3 million, the fair value of the stock options, times 90%, the amount that's expected to vest, or 2.7 million. And we'll take that 2.7 million and we'll divide it by 5 years vesting period and recognize compensation expense of 540,000 per year. Now the journal entries will otherwise be the same as we discussed in the previous lesson. It's just that the amount we're recognizing is going to be less, because it's going to take into the account the probability of forfeitures. So, What happens if they're forfeited? Of course, you don't reverse any previously recognized expense if the options do expire unexercised. The amounts will just remain in additional paid in capital. It'll be the equivalent of a capital contribution to the firm. What if there's a change in estimate though as we're going forward? It's not like a typical change in estimate that we'll talk about in a subsequent module, which is usually accounted for prospectively only. The accounting is a retrospective adjustment, and then prospective adjustment accounting for the revised estimate, as if that revised estimate had been in effect from the beginning. So it's kind of like a accumulative catch up. In the third year, you don't go back and restate the previous years. But you make accumulative catch up in the year that you change the estimate. And then you account for the rest them as if that initial estimate, that revised estimate, had been in effect since the beginning. If that sounds kind of complicated, it's not really. I'll show you an example. So let's have a change in year three. Auto Chauffeur changes their estimate. No one's going to forfeit their shares, it's way too valuable. So retrospectively, I'm going to add in an extra $60,000 a year for years one, two and three as if the estimate was always zero forfeits. So in year three, I'll recognize 540,000, which was my original estimate. As you'll recall, we were going to recognize 540,000 a year over five years. Well, I'm going to put in 60,000 for year one, 60,000 for year two, and 60,000 for year three. I'm going to add 180,000 to that from my change in estimate to zero forfeitures. So during year three, I'll recognize the total of $720,000. You could view that as 600,000 for the current year and 60 for each of years one and two. And now I'm going to recognize in years four and five, the amount that reflects zero forfeitures, which would be 3 million divided by 5, which equals 600,000 for each of those next two years. So now that's if the estimate goes down of forfeitures, from 10% to 0%. So what if the estimate of the forfeitures goes up, that there's going to be a 20% forfeiture? We've already lost one executive and we expect we might lose another one before it's over. So now the compensation expense is going to be less because I've got more forfeitures involved in the computation. So I'm going to have to go back and recognize accumulative adjustment downwards. So I would've recognized 540,000 in year three under the original amortization schedule, the original plan. But now I'm going to go back and adjust for 60,000 less in year one, 60,000 less in year two, and of course, 60,000 less in year three, or 180,000 less overall in year three with that cumulative catch-up. And now, in year four and five, I'll only recognize $480,000. So I do a cumulative catch-up for the impact for years one, two, and three. And then years four and five, I'm going to recognize it as if that schedule had been in effect from the very first day. So that can be kind of complicated. And the FASB did recently, in 2016, in one of its improvements standards as part of their simplification project, they did provide a policy election that allows you to recognize the effect for which the requisite service is not rendered. Which is a complicated way of saying when the award is forfeited, they allowed you to recognize it when it happens. So previously recognized compensation cost is reversed in a period that the award is forfeited. You don't have to estimate what's going to happen in the future, uou account for it when it happens. This is a practical expedient, which is FASB speak for something that they're going to permit that they don't think is quite conceptual but it does simplify the accounting. This just came into effect. The standard was just passed in 2016. So this is something new that you may see out there in 2017 and 2018. So that concludes our discussion on forfeitures. Thank you very much.
