(FORTUNE Magazine) – For the second time in a decade, war has broken out between the group that sets the nation's accounting standards and much of corporate America. At issue are employee stock options, which publicly traded companies doled out like candy during most of the 1990s, making countless executives--and more than a few rank-and-file employees--enormously wealthy.

While options represent a very real cost to existing shareholders, companies are not obliged under current accounting rules to deduct that cost from their earnings. Back in 1994, the Financial Accounting Standards Board tried--and failed--to change that. Now FASB is on the offensive again: It is expected to unveil this quarter a draft of new rules that would require option expensing starting in 2005. As was the case ten years ago, high-powered corporate leaders, particularly those in the technology sector, are protesting vigorously, arguing that it's impossible to calculate a reliable expense figure for stock options. They're furiously lobbying Congress to block the rules; most observers predict they'll fail. Investors, meanwhile, would be well advised to follow the battle closely. If FASB prevails, reported earnings for many companies will get whacked, and stock valuations that appear lofty today could look downright stratospheric when the rules kick in.

The appeal of stock options to employees is clear: Workers get the right to buy a set number of shares at a fixed price over a certain period. If the stock price rises thereafter, the employee can make a bundle. But that windfall comes at a big cost to shareholders. For starters, when employees exercise their options (i.e. buy the stock at the preset price), the company has to issue new shares. That dilutes the earnings stake of existing shareholders.

There's another cost here: the opportunity cost of selling dirt-cheap shares to employees when they could be sold to investors at the going market price. That is more than just a hypothetical concept. To offset dilution, companies routinely repurchase enough shares to match those acquired by employees, using cash that belongs to existing shareholders. Worse, that typically happens when the stock price is high and employees are most likely to exercise their options.

But you won't find the cost anywhere on the income statement. "The majority of the value of options is missed in the current diluted earnings-per-share calculation," says Richard Farmer, a technology analyst at Merrill Lynch. Instead, that value is buried in the footnotes to the financial statements.

We're not talking small numbers here. In 2002 reported earnings for S&P 500 companies were overstated by an aggregate of 23% because companies didn't have to expense stock options, according to Jack Ciesielski, the respected publisher of the Analyst's Accounting Observer. In the technology sector, where options are a key element of compensation for thousands of employees, the overstatement was a whopping 51%. According to the most recent data for 2003, the reported earnings of companies like Network Appliance, Apple Computer, and EMC would have been wiped out completely had the companies expensed options.

Opponents of stock-option expensing have hardly thrown in the towel. Tech executives have been descending on Washington in droves, seeking sympathetic ears in Congress. But in this post-Enron environment, observers say, legislators aren't eager to thwart the intentions of the nation's accounting regulators.

The war many not be over, but with stock valuations already soaring--the price/earnings ratio of the Nasdaq now stands at a heady 93--investors would be wise to consider the consequences of a FASB victory. Otherwise, 2005 could bring a rude awakening.