The percentage is calculated by dividing the daily short share trade volume by the total volume as reported by the exchanges to FINRA. In fact, the FINRA tracks all exchange trades and each trade that involves a sale of short shares is reflected by the daily short shares total. In a TRADE, someone sells and someone buys. If the sale involves SHORT SHARES (requiring a borrowing of shares by the seller), the sale/trade is tracked as a SHORT SALE.
So, the simple answer is #1. I'm not fully understanding the "dump to cash" in #2, but the tallies reflect real trades on the exchanges per FINRA documentation (as previously posted to the Board).
This page at FINRA is a good starting point for all their trade report files: