ASC 718 Stock Compensation for Private Companies: Grant-Date Fair Value, Practical Expedients and Audit Testing

ASC 718, Compensation—Stock Compensation, applies whenever an entity pays employees or nonemployees with its own equity instruments, or with liabilities whose amount is based on the price of its equity. Venture-backed startups with option pools are the obvious case, but restricted stock in a family business, phantom equity plans and profits interests in LLCs can all land in its scope.

This guide covers measurement, the practical expedients available to nonpublic entities, recognition and the forfeiture election, classification, and what auditors test. It paraphrases the Codification and the related ASUs and is not a substitute for them.

The basic model

ASC 718 measures equity-classified awards at their grant-date fair value (more precisely, a fair-value-based measure, because some features such as service vesting conditions are excluded from the measurement). That amount is recognized as compensation cost over the period during which the grantee must provide service or goods to earn the award, usually the vesting period.

Three dates and terms matter:

• Grant date: the date the employer and grantee reach a mutual understanding of the key terms and conditions, the employer is contingently obligated to issue equity on satisfaction of the vesting conditions, and any required approvals (often the board) have been obtained.
• Service inception date: usually the grant date, but it can be earlier if service begins before the grant is finalized.
• Requisite service period: the period over which cost is recognized, inferred from the vesting conditions.

Grant-date measurement means that, for equity-classified awards, later changes in the value of the company's stock do not change the expense unless the award is modified.

Measuring fair value for a private company

Option-pricing models

Stock options are usually valued with the Black-Scholes-Merton formula or a lattice model. The inputs are the current price of the underlying share, exercise price, expected term, expected volatility, expected dividends and the risk-free rate. For a private company, three of those inputs are hard: the share price, the volatility and the expected term. ASC 718 provides relief on each.

Current price of the underlying share

Private companies typically rely on an independent valuation of common stock, often prepared for purposes of Internal Revenue Code Section 409A. ASU 2021-07 added a practical expedient for nonpublic entities: they may determine the current price input of equity-classified share-option and similar awards using a valuation performed in accordance with a reasonable application of a reasonable valuation method, as described in the Section 409A regulations. The expedient is optional and applies only to equity-classified awards, not liability-classified awards.

The expedient does not make every 409A report acceptable. The valuation still has to be current, reflect material events since its date, and be prepared using a reasonable method. A valuation that predates a priced financing round or other significant event may no longer be current.

Expected volatility and calculated value

A nonpublic entity that cannot reasonably estimate the expected volatility of its own share price may use the historical volatility of an appropriate industry sector index instead. The resulting measure is called calculated value. The index should reflect the entity's industry and size, and the method is applied consistently.

Expected term

For awards that meet certain conditions, a nonpublic entity may elect a practical expedient to estimate the expected term. For awards with only a service condition, the expected term is the midpoint between the requisite service period and the contractual term. Awards with performance conditions have their own rules depending on whether the condition is probable. This expedient came from ASU 2016-09.

Restricted stock

For restricted stock and restricted stock units, fair value is generally the value of the underlying share on the grant date, adjusted for any dividends the holder does not receive during vesting. No option model is needed, but the share value input still depends on the valuation.

Recognition

Vesting conditions

• Service conditions require the grantee to remain with the entity for a period. Cost is recognized over that period.
• Performance conditions depend on an operating outcome such as revenue or an IPO. Cost is recognized only when it is probable that the condition will be achieved. For private companies, awards that vest only on a liquidity event (an IPO or change in control) are generally not considered probable until the event happens, so no cost is recognized before then.
• Market conditions depend on share price or shareholder return. They are reflected in the grant-date fair value, and cost is recognized over the service period whether or not the condition is met, as long as the service is provided.

Graded vesting attribution

For awards with graded vesting and only service conditions, the entity elects a policy to recognize cost either on a straight-line basis over the total requisite service period or on an accelerated basis as if each tranche were a separate award. Under the straight-line method, cumulative cost recognized at any date must be at least equal to the grant-date value of the vested portion.

Forfeiture election

ASU 2016-09 introduced an entity-wide accounting policy election for service-condition forfeitures: either estimate the number of awards expected to vest and true up as actual forfeitures occur, or account for forfeitures when they occur, reversing previously recognized cost for the unvested awards forfeited. The second approach is simpler to administer. The election must be disclosed and applied consistently. The election covers forfeitures from failing a service condition. The probability assessment for performance conditions is separate.

Classification: equity or liability

Most employee options and restricted stock are equity-classified. Awards are liability-classified when, for example, they are settled in cash or other assets, the underlying shares are themselves classified as liabilities, or repurchase features allow the grantee to avoid bearing the risks and rewards of ownership for a reasonable period. Phantom stock and stock appreciation rights settled in cash are liabilities.

Liability awards are remeasured at each reporting date until settlement. A nonpublic entity may make a policy election to measure all liability-classified awards at intrinsic value instead of fair value, which simplifies the remeasurement.

Watch for repurchase rights on termination, put rights, and a pattern of cash settlement. A company that routinely buys back shares from departing employees shortly after exercise may have converted equity awards into liabilities in substance.

Nonemployee awards

ASU 2018-07 brought share-based payments to nonemployees into the scope of ASC 718, so awards to consultants, advisors and board members for services are measured using the same grant-date model as employee awards, with some differences in attribution. Share-based awards granted to customers as consideration payable in a revenue contract are measured and classified under ASC 718 (ASU 2019-08) and presented as a reduction of revenue under ASC 606.

Profits interests

LLCs and partnerships frequently grant profits interests to employees. Whether a profits interest is in the scope of ASC 718, or is instead a bonus arrangement or other compensation, depends on its terms. ASU 2024-01 added illustrative examples to help entities make that determination; for entities other than PBEs it is effective for annual periods beginning after December 15, 2025. Review the operating agreement, the distribution waterfall and any forfeiture and repurchase terms before concluding.

Modifications

A change in the terms of an award, such as repricing underwater options or accelerating vesting on a termination, is a modification. Incremental cost is generally measured as the excess of the fair value of the modified award over the fair value of the original award immediately before the change. ASU 2017-09 clarified that modification accounting is not required if the fair value (or calculated or intrinsic value), vesting conditions and classification are all unchanged.

Disclosures

Disclosures include a description of the plans, the method used to measure compensation cost, the significant assumptions, activity for the period, the policy elections made (forfeitures, attribution, expedients) and the total compensation cost recognized. ASC 718-10-50 reduces some disclosure requirements for nonpublic entities. A GAAP disclosure checklist can be used to track them.

What auditors test

Stock compensation is an accounting estimate under AU-C 540. When the company uses an outside valuation firm, the valuation specialist is a management's specialist, and AU-C 501 (the requirements moved there from AU-C 500 under SAS 142) requires the auditor to evaluate the specialist's competence, capabilities and objectivity, obtain an understanding of the work, and evaluate the work as audit evidence. A practical program:

1. Grant listing. Obtain the award listing for the period and agree it to board minutes, approved grant documents and the plan document. Confirm the grant date used is the date approval and mutual understanding existed.
2. Cap table rollforward. Roll the cap table and option ledger from the prior year: grants, exercises, forfeitures, expirations and repurchases. Agree to equity accounts and to the shares authorized in the charter.
3. Valuation inputs. Read the 409A or other valuation report. Test the date, method and key assumptions, and compare with recent financing rounds and secondary transactions. Consider whether events between the valuation date and grant dates make the valuation stale.
4. Model inputs. Recompute the fair value of a sample of grants. Check volatility peers or index, expected term method, risk-free rate source and dividend assumption.
5. Expense recalculation. Recompute cost for the period under the elected attribution and forfeiture policies.
6. Performance conditions. Evaluate management's probability assessment, particularly for liquidity-event vesting.
7. Classification. Read agreements for cash settlement, put rights and repurchase terms. Inquire about the entity's history of repurchases.
8. Modifications. Identify repricings, accelerations and extensions, often found in separation agreements reviewed for other purposes.
9. Disclosures and representations. Read the footnote and obtain representations about the completeness of award agreements and side arrangements (AU-C 580).

Assess any misstatements against materiality. Misstatements in equity awards can be qualitatively significant to investors even when small.

Common errors

• Using the incorporation date or offer-letter date as the grant date when board approval came later.
• Relying on a 409A valuation dated before a financing round.
• Recognizing cost for IPO-contingent awards before the IPO.
• Ignoring early exercise features, where cash received for unvested shares is a liability until vesting.
• No documentation of the policy elections.

Frequently asked questions

Can a private company use a 409A valuation for ASC 718?

Yes, within limits. ASU 2021-07 lets nonpublic entities determine the current share price input for equity-classified awards using a valuation performed under a reasonable application of a reasonable valuation method consistent with the Section 409A regulations. The valuation must still be current and reflect material events.

What is calculated value?

Calculated value is the measure a nonpublic entity uses when it cannot reasonably estimate the expected volatility of its own shares. It substitutes the historical volatility of an appropriate industry sector index into the option-pricing model.

Should we estimate forfeitures or account for them as they occur?

Either is permitted for service-condition forfeitures as an entity-wide policy election under ASU 2016-09. Accounting for forfeitures as they occur is simpler to administer, and the policy election is disclosed.

When is expense recognized for an award that vests on an IPO?

Generally not until the IPO occurs. A liquidity event is usually not considered probable until it happens, so cumulative cost for the service already rendered is recognized at that point.

Are profits interests in the scope of ASC 718?

It depends on the terms. Some profits interests are share-based payments under ASC 718 and others are compensation arrangements under other guidance. ASU 2024-01 added examples to help make the determination.

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Sources

• FASB ASC 718, Compensation, Stock Compensation (including 718-10-25, 718-10-30, 718-10-35, 718-30)
• FASB ASU 2016-09 (forfeiture election, expected term practical expedient for nonpublic entities)
• FASB ASU 2017-09 (scope of modification accounting); ASU 2018-07 (nonemployee share-based payments); ASU 2019-08 (awards granted to customers)
• FASB ASU 2021-07, Determining the Current Price of an Underlying Share for Equity-Classified Share-Based Awards of Nonpublic Entities
• FASB ASU 2024-01, Scope Application of Profits Interest and Similar Awards
• Treas. Reg. 1.409A-1(b)(5)(iv) (valuation of stock for Section 409A): https://www.ecfr.gov/current/title-26/section-1.409A-1
• AICPA, AU-C Section 501 (management's specialist, as revised by SAS No. 142), 540, 580; AU-C 620 (auditor's specialist)

AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error