ASC 718 is the accounting standard that governs how companies report stock-based compensation on their financial statements. Issued by the Financial Accounting Standards Board (FASB), it requires companies to measure the fair value of equity awards like stock options, restricted stock, and restricted stock units (RSUs) and recognize that value as a compensation expense. If you’ve encountered this term while researching equity compensation, preparing financial statements, or studying accounting, here’s what you need to know about how it works in practice.
What ASC 718 Covers
ASC 718 applies to virtually any arrangement where a company pays employees or other service providers with equity instruments rather than cash. That includes stock options, restricted stock awards, restricted stock units, stock appreciation rights, and employee stock purchase plans. The standard applies to both public and private companies, though private companies get certain simplifications (more on that below). It also covers awards granted to nonemployees, such as independent contractors or consultants who receive equity for their services.
The core principle is straightforward: when a company gives someone stock-based compensation, that compensation has a real economic cost. ASC 718 requires the company to estimate that cost, then record it as an expense on the income statement. Before this standard took effect, many companies could grant stock options without recognizing any expense at all, which made compensation costs invisible to investors reading financial statements.
How Fair Value Is Measured
The standard requires companies to determine the fair value of each equity award, typically on the grant date, which is the date the company and the employee agree to the award’s terms. How you measure that fair value depends on the type of award.
For stock options, there’s no market price to look up since the options aren’t traded on an exchange. Companies must use a valuation model instead. The two most common approaches are the Black-Scholes model and the lattice (also called binomial) model. Both require several inputs: the current stock price, the option’s exercise price, the expected term of the option (how long employees are likely to hold it before exercising), the expected volatility of the stock, the risk-free interest rate, and the expected dividend yield. Each of these inputs involves judgment, and small changes in assumptions, particularly expected volatility and expected term, can significantly shift the calculated value.
For restricted stock and RSUs, the measurement is simpler. If an employee receives shares that vest over time but is not entitled to dividends during the vesting period, the fair value equals the stock price on the grant date minus the present value of expected dividends that the employee will miss. If the employee does receive dividends while the award is unvested, the fair value is simply the grant date stock price.
When the Expense Gets Recognized
ASC 718 doesn’t let companies record the entire expense on the day an award is granted (unless the award is fully vested immediately). Instead, the expense is spread over what the standard calls the “requisite service period,” which is the time an employee must work to earn the award. For most equity grants, this is the vesting period. If you receive stock options that vest over four years, the company records one-quarter of the total compensation cost each year.
The requisite service period generally starts on the grant date. It can be defined explicitly in the award agreement (like a four-year vesting schedule), or it can be implicit based on the award’s terms. Some performance-based awards have a “derived” service period that comes from the valuation model itself, such as when an award vests only if the stock price reaches a certain level.
If an award is fully vested on the grant date, meaning the employee doesn’t need to stick around to earn it, the entire compensation cost hits the income statement immediately.
Impact on Financial Statements
When a company recognizes stock-based compensation expense, the charge flows through the income statement as part of compensation cost, reducing operating income and net income. The offsetting entry increases additional paid-in capital on the balance sheet (for equity-classified awards) or creates a liability (for cash-settled awards). This means stock-based compensation directly reduces a company’s reported earnings, which is why you’ll often see companies report both GAAP earnings, which include the expense, and non-GAAP earnings, which strip it out.
For investors reading public company filings, ASC 718 expense can be significant. Large technology companies, for example, may report billions of dollars in annual stock-based compensation. Understanding that this figure represents the estimated fair value of equity grants, not a cash outflow, helps contextualize what the numbers mean.
Handling Forfeitures
Not every equity award that’s granted actually vests. Employees leave, performance targets go unmet, and awards get forfeited. ASC 718 gives companies two choices for dealing with this reality. They can estimate forfeitures upfront, reducing the total expense recognized from the start based on how many awards they expect will never vest. Alternatively, they can recognize expense assuming all awards will vest and then reverse the expense when forfeitures actually occur. Either approach is acceptable, but the company must apply its chosen method consistently.
Private Company Simplifications
Private companies face a unique challenge under ASC 718: their stock doesn’t trade on a public exchange, making fair value harder to pin down. The FASB has offered practical expedients to ease this burden.
One key simplification allows private companies to estimate their share price using a “reasonable application of a reasonable valuation method” rather than obtaining a formal independent appraisal. Factors the company should consider include the value of its tangible and intangible assets, the present value of anticipated future cash flows, and the market value of similar companies whose stock can be objectively priced (through public trading or arm’s-length private transactions).
If a private company elects this practical expedient, it must apply the method consistently to all equity-classified awards sharing the same underlying stock and measurement date, and it must disclose the election in its financial statements. There’s an important catch for companies considering an IPO or other path to becoming publicly traded: if the company later becomes a public entity, it would need to reverse the practical expedient’s effect in its historical financial statements. That retroactive adjustment can be costly and time-consuming, so companies on a trajectory toward going public should weigh that tradeoff before electing the simplified approach.
Why ASC 718 Matters
Before fair value accounting for stock-based compensation became mandatory, companies could grant large quantities of stock options and report zero expense. This understated the true cost of employee compensation and made it harder for investors to compare companies on an apples-to-apples basis. ASC 718 closed that gap by requiring companies to treat equity awards the same way they’d treat any other form of pay: as a real cost that belongs on the income statement.
For employees receiving equity compensation, the standard doesn’t change your tax situation or what your award is worth to you personally. But it shapes how your company reports its financials, which affects earnings per share, profitability metrics, and the way analysts evaluate the business. If you’re reviewing a company’s 10-K filing or trying to understand why reported earnings look lower than expected, stock-based compensation expense under ASC 718 is often a meaningful piece of the picture.