What it means
Forfeiture is a contractual consequence rather than a penalty imposed from outside. The right was always conditional, and the condition, usually staying for a period or completing a purchase, simply was not satisfied.
The most familiar version is share-based pay. Equity awards typically vest over three or four years, and an employee who resigns before a vesting date keeps whatever has vested and forfeits the rest, which is precisely the retention effect the scheme was designed to create.
It matters in accounting because the cost of an award is spread over the vesting period. When an award is forfeited, the expense relating to the unvested portion is reversed or simply never recognised, so a wave of leavers can produce a surprisingly large credit to the payroll line.
Deposits are the other everyday case. A buyer who fails to complete a property or business purchase can forfeit the deposit, and the seller recognises it as income rather than as a return of cash held on account.
Companies estimate a forfeiture rate in advance, often something like 5% to 15% a year depending on staff turnover, so that the share-based payment charge is not systematically overstated. The estimate is then adjusted to reflect what actually happened, which is why the charge moves around between quarters.
Not every failed condition counts as forfeiture in the accounting sense. Where an award depends on a market condition such as a share price target, missing that target does not reverse the expense, whereas failing a service or performance condition does.
In practice
Real-world examples
Example 1
A software company grants options to 40 engineers and assumes a 10% annual forfeiture rate. Turnover runs at 18% instead, so the share-based payment charge comes in $260,000 below budget and the finance team has to explain a favourable variance that reflects staff leaving rather than good cost control.
Example 2
A buyer places a $150,000 deposit on a commercial building and then fails to secure funding before the deadline. The contract allows the seller to keep the deposit, so the buyer forfeits the whole amount and the seller records it as other income.
Example 3
A sales director's bonus plan requires him to be employed on the payment date in March. He resigns in February and forfeits the accrued bonus of $48,000, which the company releases from its accrual back to profit. His replacement negotiates a pro-rata good leaver clause precisely because of what happened, showing how forfeiture terms shape the next contract as much as the last one.
Think of it
Think of a loyalty card that offers a free coffee after ten stamps. If you lose the card or stop visiting that cafe before reaching ten stamps, you lose your progress. Your accumulated stamps are forfeited.
Formula
Calculation
Forfeited value = number of unvested units forfeited x grant-date fair value per unit. Expense reversed or avoided = total grant value - expense already recognised for the vested portion.
An operations manager receives 4,000 shares with a grant-date fair value of $18 each, vesting 25% a year over four years. Total grant value is 4,000 x $18 = $72,000, recognised straight line at $72,000 / 4 = $18,000 a year. She resigns at the end of year two, having vested 2,000 shares worth 2,000 x $18 = $36,000, which is exactly the $18,000 x 2 = $36,000 already charged to profit. The remaining 2,000 shares are forfeited, so the $36,000 of expense that would have been recognised in years three and four never hits the income statement at all.Case study
Seen in the real world
The following is an illustrative and fictional story. Latchford Analytics, an invented data business, granted generous four-year share awards to attract staff during a growth push, budgeting the annual charge on an assumed 8% forfeiture rate.
Two years later a competitor opened an office nearby and annual staff turnover jumped to 24%. Because so many awards were forfeited before vesting, the accumulated expense on those awards was reversed, and the reported share-based payment charge fell by $1,100,000 in a single year.
The board initially treated the swing as a cost saving. The fictional chief financial officer had to explain that a large forfeiture credit is a symptom of a retention problem, not an achievement, and the following year the plan was restructured with shorter vesting and a smaller grant size.
Watch out
Common mistakes
- Believing that shares already granted are yours, when only the vested portion is safe and everything else is conditional on staying.
- Reading a fall in the share-based payment charge as cost discipline, when it is often just people leaving and forfeiting awards.
- Setting a forfeiture estimate once and never revisiting it, so the charge is materially wrong until a painful year-end adjustment corrects it.
Questions
People also ask
Does forfeiture apply to vested awards?
Usually not, except where a clawback clause covers misconduct or a serious restatement, which is a separate mechanism from ordinary forfeiture.
Is a forfeited deposit taxable for the seller?
Generally yes, it is normally treated as income or as part of the disposal proceeds rather than as a non-taxable windfall.
What happens to forfeited shares?
They typically return to the share plan pool and can be granted again to other employees, so the company does not lose the capacity to reward people.