Stock option accounting has moved off the business pages and into the political section. Since accounting theory and public policy concerns are moving in different directions, this is an appropriate development.

On the accounting theory side, the Financial Accounting Standards Board wants stock options to be treated as a corporate compensation expense. This position has support from Warren Buffet, famed uber-investor, and financial pundits from places other than the Silicon Valley or other technology company havens.

On the policy side, legislators are looking at a two-fold concern: promoting investor protection, in the post-Enron, post-Sarbanes Oxley world, without blocking a return to the economic benefits that stock options generated to rank and file workers during the market run-up in the 1990s. If companies are required in the future to account for options as an expense (which is not required now), it will discourage companies from providing stock option benefits to employees.

The question is volatile and emotional, in part, because not everyone understands how employee stock options work. Very simply, a company that grants an employee to buy stock at a fixed price in the future, so long as the employee stays with the company. If the stock price goes up, the employee profits on the difference between the fixed purchase price and the higher market price. If the employee exercises the option, the company issues new shares to the employee. If the market price goes down, and the employee does not exercise the option, no shares are issued.

Companies don’t pay cash to issue options in their own stock. That makes the compensation expense issue tricky. Companies pay cash to pay wages, pay withholding taxes, buy worker’s compensation insurance, buy health insurance, pay bonuses and pay other out-of-pocket compensation costs, and those are expenses that can be measured by the amount of cash paid.

Since option “expense” doesn’t involve cash, it means that option expense accounting requires a company to make an estimate reflecting accounting theory, not connected to the actual operation of a company. (The word “estimate” is used in accounting because the phrase “made up number” doesn’t sound as good.)

Expensing options conceals the real impact to investors of option issuance, which is dilution of shareholders. Options reduce a company’s earnings per share (“EPS”), not because they are an expense that reduces earnings, but because the options increase the number of shares by which the earnings are divided. Simply, the more options that are issued, the more “shares” get divided into any given amount of “earnings” in calculating EPS.

That is how venture capitalists calculate the cost of stock options. When they invest in newly formed companies, VCs value companies on a fully diluted basis, a worst case scenario that measures a VC’s ownership percentage as if every single option in the option plan is issued.

VCs do not say, “Don’t give employees options because it dilutes our ownership.” VCs say; “Give employees options to recruit and retain the best people, but reflect the dilutive impact of options in the price we pay as investors.”

VCs generally are regarded as shrewd, opportunistic, calculating, self-interested, even rapacious, investors. VCs do not bargain to have their portfolio companies provide them with an accounting estimate of option expense, but they do bargain to have option dilution reflected in the price they pay for their stock.

Now Congress is considering a number of bills relating to stock options, some in support of expensing. The Broad Based Stock Option Transparency Act is sponsored in each house by bi-partisan backers. It is supported by the National Venture Capital Association and AeA (formerly American Electronics Association).

The Transparency Act would require the Securities and Exchange Commission to set new rules on employee stock option disclosure for publicly-traded companies, and prevent the SEC from setting any new accounting standard related to stock options until the rules have been given three years to work, and the SEC reports on the effect of the rules to Congress. The Transparency Act would also require a study on the impact of options in promoting growth and research and development.

The perverse result of option expensing is that a very healthy option-issuing company with strong cash flow could show a loss in its financial statements that belied its real growth and strength, by reducing earnings with an option expense estimate.

Dilution, on the other hand, is pretty easy to grasp, and to validate. Take the company’s outstanding shares, add the option plan, divide that number into earnings and you have fully diluted earnings per share. That’s transparency.

Option expense estimates, as calculated by accountants, has been part of financial statement footnote reporting for years. Investors, including savvy institutions, have been able to use option expense information to make investment decisions. If they have not, that is evidence that option expense is a calculation with a track record of its limited relevance.

Post-Enron et. al. there are many valid issues surrounding stock options, such as the amounts issued to executives, or the terms under which executives hold or exercise options. There are valid concerns about companies using their profits to buy back shares in the market to limit the impact of dilution. Those issues are separate from the option expensing question.

The question is in front of Congress now. Investors deserve a well considered answer.