ASC 718: how stock compensation becomes an expense with no cash

The problem ASC 718 exists to solve

A company that pays someone in options has paid them. The recipient works for a period and receives something with economic value in exchange. If the financial statements ignored that because no cash moved, two companies doing identical work with identical headcount would report different operating costs purely because one paid in equity.

ASC 718 closes that gap. Share-based payment is compensation, so it goes through the income statement as compensation cost. The credit side goes to equity rather than to cash, which is why share-based compensation shows up as an add-back in the operating section of a cash flow statement prepared using the indirect method.

Grant-date fair value

The measurement date for an equity-classified award is the grant date, and FASB describes the grant date as the date at which the grantor and the grantee reach a mutual understanding of the key terms and conditions of the award. That definition matters in practice: an award the board discussed but never approved, or one where the recipient has not been told the strike price, may not have a grant date yet.

Fair value is not the intrinsic value of the option. An option to buy a share at its current fair market value has zero intrinsic value on day one and considerable fair value, because it carries the right to buy at a fixed price for years. Companies measure that with an option-pricing model — commonly Black-Scholes-Merton, sometimes a lattice model for awards whose terms make a closed-form solution inappropriate.

Two of these inputs are where private-company accounting gets awkward. There is no observable share price, so the fair market value determination that supports the strike price also feeds the expense — which is one reason 409A valuations and ASC 718 expense are usually done by the same people. And there is no observable volatility, so it is inferred from public comparables chosen by the preparer.

FASB has added practical expedients for nonpublic entities in this area, including one in ASU 2021-07 addressing how a nonpublic entity determines the current price input for equity-classified awards. Whether a particular expedient is available and elected is an accounting policy question for the company’s auditors.

The expensing period

Grant-date fair value is computed once, then recognised as cost over the requisite service period — the period the recipient must work to earn the award. For a standard option vesting monthly over four years with a one-year cliff, that is four years of expense from a single measurement.

This is why share-based compensation expense in any given year is not a measure of grants made that year. It is the accumulation of every unvested award still running, from grants made across several previous years. A company that granted heavily two years ago and stopped granting entirely will still report substantial expense today.

Forfeitures

Most equity grants in a startup are never earned in full. People leave, and unvested awards lapse. Under Topic 718 the effect of forfeitures is taken into account by recognising compensation cost only for instruments for which the requisite service has been rendered; no cost is ultimately recognised for instruments forfeited because a service or performance condition was not satisfied.

ASU 2016-09 gave companies a choice about how to get there. An entity may make an entity-wide accounting policy election either to estimate the number of awards expected to vest and true that estimate up to actual experience, or to account for forfeitures as they occur. Whichever is chosen has to be disclosed as an accounting policy and applied consistently.

Market conditions behave differently and are a frequent source of error. Where an award’s vesting depends on a market condition, the condition is reflected in the grant-date fair value itself, and failing to meet it does not reverse expense that has already been recognised for a recipient who provided the required service.

Book expense is not the tax deduction

ASC 718 is accounting. The corporate tax deduction for the same award is a separate calculation under the Internal Revenue Code, and the two deliberately do not track each other. For incentive stock options, section 421(a)(2) denies the employer a deduction under section 162 with respect to a qualifying transfer of the shares. If the holder makes a disqualifying disposition, section 421(b) allows the employer deduction but places it in the taxable year in which the disposition occurred.

So a company can recognise years of ASC 718 expense for an ISO grant and never take a tax deduction for it, or take one abruptly in a later year because someone sold early. ASU 2016-09 also changed where the difference lands, requiring excess tax benefits and deficiencies to be recognised in the income statement rather than in additional paid-in capital. The result is a book-tax difference that is normal, expected, and needs to be tracked rather than reconciled away.

What this means operationally

ASC 718 expense is computed from grant-level data: grant date, recipient, share count, exercise price, vesting schedule, and the fair market value determination in force at grant. If the equity records are approximate, so is the expense — and it is an audited number. The commonest cause of an ASC 718 problem at audit is not a modelling error but a cap table where grant dates and board approval dates disagree.

Awards to contractors and advisers are in scope too. ASU 2018-07 aligned the accounting for most nonemployee share-based payment awards with the employee model, requiring grant-date fair value measurement, which removed the old remeasurement treatment that made adviser grants unpredictable to report.