What Is ASC 718?
ASC 718, Compensation — Stock Compensation, is the FASB accounting standard that governs how companies recognise the cost of equity-based compensation in their financial statements. Under ASC 718, when a company grants stock options to employees, it must:
- Measure the fair value of the options on the grant date
- Recognise that fair value as compensation expense on the income statement over the vesting period
- Disclose the methodology, assumptions, and amounts in the financial statement footnotes
ASC 718 applies to all private and public companies that grant equity compensation — it is not optional. For startups preparing for institutional funding rounds, M&A, or IPO, compliant ASC 718 accounting is essential.
The Direct Connection Between 409A and ASC 718
The fair value of a stock option under ASC 718 is calculated using the Black-Scholes option pricing model (or a binomial lattice model for more complex grants). Black-Scholes requires five inputs:
| Input | Source | Note |
|---|---|---|
| Stock price (S) | 409A valuation FMV | The most important input — directly from your 409A report |
| Exercise price (K) | Option grant agreement | Must equal or exceed 409A FMV |
| Expected term (T) | Historical exercise data or simplified method | Typically 5–7 years for startup options |
| Volatility (σ) | Comparable public company analysis | Annualised; typically 55–85% for tech |
| Risk-free rate (r) | US Treasury yields | Matched to expected term |
Because the 409A FMV is the stock price input, a higher 409A directly increases your ASC 718 expense. A 409A that is $0.50 higher per share will increase the Black-Scholes fair value of each option, which multiplied across all options granted in the period can create materially higher compensation expense.
ASC 718 Expense: A Worked Example
Suppose you grant 100,000 options at a strike price of $1.00 (your 409A FMV). Using Black-Scholes with typical inputs (volatility 70%, term 6 years, risk-free rate 4.5%), the fair value per option comes to approximately $0.68. The total ASC 718 compensation expense for this grant is $68,000, recognised over the 4-year vesting period — approximately $17,000 per year.
If your 409A had produced an FMV of $1.50 instead of $1.00 (with the same strike price), the Black-Scholes output would be approximately $0.92 per option — $92,000 total, $23,000 per year. The 50% increase in FMV drove a 35% increase in compensation expense.
How Auditors Test ASC 718
For companies with financial statement audits (typically required at Series A+), external auditors treat ASC 718 as a primary audit area. Their procedures include:
- Independently re-performing the Black-Scholes calculation for a sample of grants
- Reviewing and challenging the 409A FMV used as the stock price input
- Testing the reasonableness of volatility, expected term, and risk-free rate assumptions
- Evaluating whether the 409A report was completed by a qualified, independent appraiser
- Comparing your 409A conclusions to their own internal estimate of FMV
If auditors conclude your 409A-based stock price was materially misstated, they will propose an audit adjustment that increases your reported compensation expense — potentially requiring restatement of prior periods.
Pre-IPO ASC 718 Scrutiny
The SEC reviews stock-based compensation disclosures carefully in S-1 filings. Specifically, they examine grants made in the 12–18 months before the IPO price is set and compare the 409A strike prices to the IPO price. A large, unexplained gap between recent grant prices and the IPO price will generate SEC comment letters, delay the offering, and require detailed written explanations of the valuation progression.
Best practice for pre-IPO companies: conduct 409A valuations quarterly in the 12 months before the roadshow, ensuring a smooth, well-documented progression of FMV leading up to the IPO price.