It was one of those articles that only unrepentant accounting and finance geeks would have found interesting: a brief note from Bloomberg News saying the Council of Institutional Investors is considering support of a proposal by the International Accounting Standards Board (IASB) that provides a framework for stock option accounting. Try to contain your excitement.

The IASB does not have any control over United States accounting practices, which are applied by the Financial Accounting Standards Board (FASB). But IASB is chartered to try to harmonize the accounting standards around the world, and is an influential organization. That a group of institutional investors is considering throwing support behind its proposal is very important.

Many once high-flying companies are currently foundering, but even in situations where executive teams have failed to provide any value to shareholders many executives are receiving massive pay packages in the form of stock options and other grants. In one of the most egregious cases of pay having little to do with management results, Lucent (NYSE: LU) provided its ousted CEO and CFO with severance packages that, including stock option grants, exceeded $18 million -- despite the fact that those two individuals presided over one of the largest destructions of capital since the Germans bombed London in World War II.

But Lucent is not alone. As executive compensation has surged, many corporate leaders now negotiate terms of separation when accepting a job. This, however, throws the argument of "stock options aligning management and shareholder interests" out the window. As far as I know, there is no "in case I fail" clause available to outside investors. These are only component parts of a massive rise in management compensation rates, but the most troubling part of this rise is that so much of this compensation comes in the form of stock options.

Stock options became popular in the late 1980s in the U.S. as a way to reward executives for performance. They have become so popular that current executives of the companies in the S&P 500 own more than 13% of all outstanding shares. Granted, some of these were acquired other ways, but a big portion came from stock option grants. In 1999, Apple Computer (Nasdaq: AAPL) issued options that, if all were exercised, would have increased its sharecount by 18%.

Companies like this practice because stock options have almost no effect on their stated earnings: Options need not be reported on financials according to U.S. Generally Accepted Accounting Practices (GAAP), so a company can print nearly limitless amounts of options and only disclose it in a footnote. The shareholder may not notice the effect of the dilution, but it is there. Between 1991 and 2000 Microsoft (Nasdaq: MSFT), for example, issued 1.6 billion shares in options, also buying 677 million of its own shares on the open market, for a cost of $16.2 billion.

That means any existing shareholder from 1991 to today has endured a more than 18% dilution of his proportionate ownership in Microsoft, and further received no beneficial gain from the $16.2 billion that was used simply to keep the dilution from being worse. Admittedly, a shareowner in Microsoft from 1991 to today has enjoyed a fairly dramatic rise in the value of his investment, but those billions of dollars and that enormous dilution has nevertheless eaten substantially into his potential gains.

If they're not an expense, why're they so expensive?
The problem, as has been identified by the IASB, the Council of Institutional Investors, FASB (which put forth an option expensing methodology that was rejected as a result of heavy lobbying by U.S. corporations), and such influential investors as CalPERS, TIAA-CREF, and even Warren Buffett, is that there is no real accounting treatment of options.

Buffett, the chairman of Berkshire Hathaway (NYSE: BRK.A) -- he uses cash bonuses for his company's executives -- famously argued once that options are a form of compensation, compensation costs are expenses, and expenses should go into the calculation of earnings. He's right -- or else all of the "earnings" many companies have racked up over the last decade or so are mere illusions of accounting.

What has been frustrating to proponents of expensing options is that robust methods already exist to calculate their value, most notably the Black-Scholes formula. Granted, these valuations are going to be necessarily esoteric, but this does not stop GAAP in other areas. It is not as if depreciation is an exact science, for example, and many companies operate out of facilities that were reduced to zero value on their balance sheets long ago.

Accounting for option costs is right, and it should have been done long ago. In 1995, FASB's attempt to have option pricing reflected in financial statements was fought vigorously, in particular by Silicon Valley tech companies, which relied upon them heavily for compensation. The reason? Expensing options would have cost them too much.

But it wouldn't have, really. Companies would not have to open up their pocketbooks anymore than they do now. The issue, rather, is that options expensing would have made their earnings numbers look much worse. Fine, but would it not also mean that the financial statements would have reflected reality better? What is it that investors are buying? The true economic return of a company, or a really good story that should not be besmirched by bad stuff, whether or not it really exists?

I applaud the IASB and the Council for Institutional Investors for taking up the charge to get options properly represented in company financials. IASB may be able to place enough pressure to get a change in U.S. (and foreign) GAAP where FASB, acting alone, failed. Investors do not need happy financial statements, but ones that clearly and accurately depict the economic return of companies. Where stock options have an obvious and clear impact on shareholder returns, they need to be disclosed in no uncertain terms.

Fool on!

Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann wanted his daughter to dress up as "Tiny Elvis" for Halloween. His wife was not amused. He owns shares in Berkshire Hathaway. The Motley Fool is investors writing for investors.