Recently, I've been railing on the "big screw" of outside investors perpetrated by corporations giving massive grants of stock options without expensing them. The Motley Fool has pounded on this issue for years, as have others -- notably, Michigan Sen. Carl Levin, Warren Buffett, and former SEC Chairman Arthur Levitt. More recently, this has become the predominant issue as Americans seem tired of feeling they're losing tons of money, while inside executives rake in millions.

I've been amazed by how few in the media, in Washington, and even in corporate America seem to "get" the elements surrounding options expensing. Sen. Joe Lieberman, the leader of a 1993 attack on the Financial Accounting Standards Board (FASB) after it initially proposed options expensing, said recently that accounting rules would punish rank-and-file employees who have "done nothing wrong." Rep. Nancy Pelosi and four other California Democrats stated this week that encouraging stock options for more workers would not only benefit workers but also the economy.

Each time a media organization or a corporate spokesperson mentions the effects of expensing options, they note that doing so would "cost" shareholders an exorbitant amount of money. All of this despite the fact that expensing would not change the intrinsic value of a company at all. Our legislators and much of the media are completely ignorant of this fact.

When people discuss this "cost," they're referring to the effect on reported earnings, which obviously drop for each added expense. The impression is if reported earnings are lower, there must have been an economic effect. This is, of course, logical. It's also wrong. This false impression damns the level of homework people do before making investing decisions.

"The number" isn't science
Let me be blunt. If your investment criteria are highly dependent upon the single "earnings-per-share number," you're going to find investing a fruitless challenge for the long term. Far too many people look at EPS, then at a company's P/E, and then want to be able to say, "This company is expensive" or "I like this company at this price," and make a purchase decision. Bad plan. And this has nothing to do with fraud, stock options, or a company's financial condition.

It has everything to do with the fact that that single number, EPS, is largely fiction. Yes, it's based upon the reality of a company's financial performance, but it should neither be considered a point of precision nor, more importantly, the sole point upon which an investment decision is based. Accounting isn't that black and white. Those who focus on "the number" without so much as a cursory glance at balance or cash flow statements, much less cracking open the annual report, are fooling themselves if they think better financial disclosure will help them. What good are disclosures if you don't read them?

EPS represents the culmination of estimates that accrual accounting makes necessary. Things like bad debt reserves, pension return accounting, trading portfolio valuation, depreciation, goodwill, and even actual revenues are estimated. They are not precise, and in large, complex corporate entities -- even ones with the best of intentions to provide accurate information -- they can't be.

Two accountants could have access to the exact same material from a company and come up with significantly different numbers for earnings per share, both of which fall under accepted accounting principles. Without this basic understanding of accounting, a person might look at a lower EPS number and say, "Options accounting cost me." No, it didn't. Accounting options doesn't affect the company's intrinsic value.

More and more companies have decided to expense stock options. The latest is General Motors (NYSE: GM), and I applaud the company's decision to do so.

I've received a great deal of correspondence from people revolted by the level of greed in America's corporate suites. It's been going on for years, and congressional legislation is partly to blame. Investors are also to blame -- when we were all getting rich, no one cared that executives were making a thousand times more than us. Ah, but the stock market gravy train stopped and suddenly CEOs went from rock stars to robber barons.

In truth, they're neither, and our own financial returns shouldn't color our opinions about what's right. If we say, "I don't care what they do, as long as I get rich," the massive losses in our portfolios are squarely on our own heads as well.

What Washington should do
The market has been unbelievably turbulent, as investors have become more and more skeptical about whether they're being lied to. Stock options grants and their distortive effect are culpable in no small way. Washington has helped create an environment in which corporate abuses are in the best short-term interest of companies. Here's what our government can do to encourage more responsible treatment of options by companies:

1. Get out of the FASB's way. The FASB tried to require stock options accounting in 1993 and was met by a firestorm of opposition by legislators under heavy pressure from corporate lobbyists (including my nemesis, the AeA.). Sen. Carl Levin's bill reverses this, not by instituting a congressional mandate on accounting but by reversing the meddling by telling the FASB to make an "appropriate" decision. 

2. End double taxation on dividends. Dividends yields once stood at about 6% per year. They're now at about 2%, and many big companies don't give them at all. Dividends are taxed at the corporate level as income, then again at the investor level, so they're a fairly inefficient way to return retained earnings to shareholders. With the double tax on dividends, companies instead chose to retain earnings by seeking higher share prices and took on more debt in concert with the larger asset base. It may be some time before investors trust company financial statements again, but they'll trust the cash from dividends, and a company that pays a dividend must also have real earnings. A greater emphasis on dividends may also bring investors back into the market sooner -- they'd be a bit more interested in a company with a lower stock price if it comes with a requisite higher yield.

3. Get rid of the cap on corporate salaries. In an effort to "solve the problem of economic inequality," legislation sponsored in 1993 by Rep. Martin Olav Sabo of Minnesota capped the amount of an executive's salary that can be deductible from taxes as a business expense at $1 million. Talk about the law of unintended consequences -- this forced companies to look to stock options for a fair portion of an executive's salary. Sabo is at it again, trying to link the tax deduction to a multiplier of the lowest full-time employee's salary. The distortion of executive salary accounting started here -- this was a stupid law to start with, as far as I'm concerned. Yes, to most of us, $1 million is a great deal of money. But the amount and form of compensation ought to be left to shareholders, not to some social engineering experiment by the federal government.

I doubt my position is popular, and the chance of a politician standing up for higher executive salaries is about as high as one mitigating Iraq by giving it the state of Texas. Certainly, executives ought to be paid well for a job well done, in whatever form shareholders elect to pay them. By creating a tax incentive and an accounting advantage for options, and by treating cash compensation with a tax deterrent, Washington has created disincentives to companies for pay packages optimized for shareholder interests. Clearly, Washington can worsen any issue.

These things would be of long-term benefit to investors, as they would lower the incentive for companies to issue mega-grants of options. While it's nice to see Washington finally interested in the long-standing problem of poor corporate governance, government policies won't protect those who refuse to take minimum pains to keep abreast of goings-on at their companies. No investor will be completely safe from those who commit outright fraud, though the number of companies doing so, I maintain, is still extremely small. But investors who don't take pains to familiarize themselves with anything more than "the number" truly have no basis to complain when things go bad.

Fool on!
Bill Mann, TMFOtter on the Fool discussion boards.

Bill Mann's hold music is "Sabotage." He owned none of the companies mentioned in this column. The Motley Fool is investors writing for investors.