For decades now, companies, especiallythose that are in the commodities business or depend heavily oncommodities, have been hedging. Until recently, it was hard forinvestors and analysts to understand how companies used contracts.But in 2008, the Financial Accounting Standards Board's Rule 161required public companies to classify derivatives in their publicfilings as either hedging vehicles or non-hedgederivatives.

A team of academic accountants recently examined the filings of87 oil and gas companies and found a remarkable amount of thecompanies' hedging was actually economic, or speculative, innature. According to their paper, “More than six out of every ten firms studied actuallyuse the instruments for purposes other than managing risks.”

Swaminathan Sridharan, one of the study's authors and aprofessor of accounting at Northwestern University's KelloggSchool, was surprised at the finding. “Some 62% of hedges in theoil and gas industry don't qualify for hedge accounting.”

“A true hedge should help to reduce earnings and cash flowvolatility, but the hedges that are not really true hedges actuallyincrease volatility,” Sridharan add. “You have to ask, why would afirm do that?

“We found that firms that do a lot of non-economic hedging seemto be trying to manage their earnings, for example, so that theycan meet analysts' projections,” he says. The data showed thatamong those companies whose derivatives were not structured ashedges, derivatives produced gains equal to 92.7% of earningsexcluding such gains. “They are almost doubling their earningsthrough the use of their derivatives,” Sridharan says.

The researchers say the market performance ofthe companies studied suggests such practices don't fool investors.“We find the market penalizes those companies that usenon-hedge-designated derivatives,” Sridharan says.

At least one accountingexpert questions the study's conclusions. “I suspect there is somespeculative use of derivatives going on here, but I think thereason for most of the non-hedge accounting is that companiessimply get sick of trying to comply with Rule 161,” says IraKawaller, principal of Kawaller& Co. and former vice president of the New York office ofthe Chicago Mercantile Exchange.

While FASB's goal of preventing companies from using hedging tohide real gains and losses was laudable, the regulator ended upmaking compliance with the rule “too onerous,” says Kawaller,pictured at right.

LarsLochstoer, a finance professor at Columbia Business School whohas also been examining derivative use by the energy industry, sayshe's surprised at the extent of non-hedging use, but adds, “When Italk with people in the oil industry, they think they have betterknowledge of the market and want to take advantage of it, so it'snot surprising that they are trading on that informationadvantage.”

Sridharan says the study did not analyze the specific purposesof the non-hedge derivatives. But his team plans to expand itsresearch to look at a sample of 1,500 companies that will includebusinesses in a number of industries besides oil and gas that arealso heavily reliant on commodity markets.