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Counter-intuitive as it may seem, sometimes it's better for a company to not do something that could help its financial results.
Take hedge accounting - the special, beneficial treatment a company uses for its derivatives. It reduces year-to-year volatility in earnings, which companies and investors tend to see as a good thing.
Yet some companies choose not to use it. Why?
A soon-to-be-released academic study suggests that the cost and complexity of the hedge-accounting process, along with other factors like the availability of alternative types of hedges that don't require the special accounting treatment, may have convinced some companies that using hedge accounting isn't worth the trouble. The companies include giants like General Mills Inc. (GIS) and ConocoPhillips (COP).
"I think it's becoming quite common for them not to apply hedge accounting when they have the option," said Charles Mulford, an accounting professor at Georgia Institute of Technology and director of the Georgia Tech Financial Analysis Lab, which conducted the study.
Accounting rulemakers are in the process of revising their procedures to make it easier for companies to use hedge accounting. But Mulford says that given the current rules, it's only to be expected that some companies would opt out.
"When you look at the reasons, you're not surprised," said Mulford, who co-authored the study with Eugene Comiskey, another Georgia Tech accounting professor.
Hedge accounting allows companies to exclude from current earnings any ups or downs in the value of the derivatives they use to hedge their exposure to risks like interest-rate changes or foreign-currency fluctuations. Instead, the changes are "smoothed" into earnings over time, thus minimizing earnings volatility from one year to the next and making it easier for the companies to show steady earnings growth.
But gaining that special accounting status requires a company to document and monitor its hedges, which can be expensive and complex. That's the first reason some companies shy away from hedge accounting, the report says.
Food company General Mills, for instance - which uses hedges to protect itself against price increases in crucial commodities like wheat and oats - said in this year's annual report that it had stopped hedge accounting for new derivatives positions in those commodities because of "the rising compliance costs and the complexity associated with the application of hedge accounting." Donal Mulligan, General Mills' chief financial officer, said hedge accounting had been causing the company an "increased administrative burden."
Other companies, the report says, have found "natural" hedges - things they can do in the course of their regular business to hedge their risk, without resorting to a special derivative for which they would have to seek hedge-accounting approval. "There is little incentive to incur the costs associated with the documentation and monitoring of accounting hedges if a natural hedge can in some cases achieve the same outcome," the report says.
TierOne Corp. (TONE), a banking company, mitigates the interest-rate risk from its loan commitments by entering into forward sales contracts. The fair value of the loan commitments and the forward sales contracts generally move in opposite directions, the company said in its filings, resulting in a "generally inconsequential" impact on net income.
Even with the difficulty and cost of hedge accounting, "you still want to be able to mitigate the potential risk," said David Kellogg, TierOne's controller.
New accounting rules are broadening the range of these natural hedges that are available to companies, the report says - another reason some companies are avoiding hedge accounting. Energy company ConocoPhillips says a new rule allowing companies to value assets and liabilities at face value achieves "an accounting result similar to a fair-value hedge without having to comply with complex hedge accounting rules." The company didn't provide any comment.
Finally, the report notes, sometimes companies don't use hedge accounting because hedges that would qualify for it simply aren't available or aren't economically feasible. The Federal Home Loan Bank of New York cited that reason in its latest annual report; a spokesman said the bank wouldn't have any further comment.
In addition, the report cited a fifth potential reason for not using hedge accounting: Some companies may be afraid of an increased risk of earnings restatement. No companies mentioned that risk, but a number of large companies have had to restate earnings in recent years because their hedge accounting has been found to contain errors or other defects.
The decision to use hedge accounting can have a significant effect. Mulford and Comiskey crunched the numbers for the past three years on a handful of companies who opted out of hedge accounting, and they found that if earnings were adjusted as if the companies had used hedge accounting, pretax income for a given year might have gone up as much as 38% or down as much as 25%.
The companies who don't use hedge accounting are well aware of the potential for volatility. General Mills said in its annual report that because it wasn't using hedge accounting, the changes in the value of its derivatives would be recorded in current earnings, "resulting in volatility in both gross margin and net earnings."
For its most recent fiscal year, General Mills recorded $59.6 million in net gains because its commodity derivatives were marked to market. Mulligan said the company has been clear about the impact on its earnings of not using hedge accounting.
Fortunately for these companies, measures to make hedge accounting simpler and easier are on the way. A new rule allowing companies to value assets and liabilities at fair value is expected to make financial reporting easier and to allow companies to hedge risks more easily. Also, a proposed revision of the accounting rule governing derivatives would simplify the standards for hedge accounting.
As a result, "we think we'll find more hedge accounting" in the future, Mulford said.
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