NISM Series XVI · Chapter 9: Accounting and Taxation

L1 · Foundation

Foundation — Hedge accounting and the three types of hedge

The ICAI guidance note of 2021 and why hedge accounting exists at all; the hedged item and the hedging instrument; fair value and the accounting mismatch it creates; the two conditions for hedge accounting including board-approved documentation; fair value hedges, cash flow hedges and net investment hedges, and where each records its gains and losses; hedge effectiveness with prospective and retrospective testing and the 80 to 125 per cent band; and the accounting treatment of bought and written options.

20 min read · Worth 5% of the paper · Written from pages 180–189 of the official NISM workbook · Updated 18 September 2026

Hedge accounting

1. Where the rules come from

⚠️ "The accounting treatment for COMMODITY FUTURES/OPTIONS TRANSACTIONS are largely governed by the REVISED GUIDANCE NOTE ISSUED IN 2021 BY THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA (ICAI), from the viewpoint of the parties who enter into such futures contracts AS BUYERS OR SELLERS."

In plain words: the ICAI's revised Guidance Note of 2021 sets the accounting rules for commodity futures and options. It applies to accounting periods starting on or after 1 April 2021.

2. What hedging means in accounting terms

⚠️ "HEDGING refers to AN ACTION INITIATED TO MINIMIZE/ELIMINATE UNCERTAINTY OF VALUE OF ASSETS, VALUE OF LIABILITIES, CASH FLOWS, FIRM COMMITMENTS."

⚠️ "FORWARD CONTRACTS, COMMODITY FUTURES AND COMMODITY OPTIONS ARE EXAMPLES OF HEDGING INSTRUMENTS in general available to a commodity market stakeholder."

In plain words: a hedge has two parts. The hedged item carries the risk. The hedging instrument, such as a forward, future or option, reduces it.

⚠️ "From the accounting point of view there are THREE TYPES OF HEDGES: FAIR VALUE HEDGE, CASH FLOW HEDGE AND NET INVESTMENT HEDGE."

In plain words: you can only hedge a risk you actually have. Accounting sorts hedges into three types.

2.1 The gateway test

In plain words: first show that the position was taken to manage risk. Only then can hedge accounting be used.

Read that as a gate rather than a formality. A company cannot decide after the fact that a profitable derivative position was a hedge. It must be able to show, from the outset, that the exposure was taken for risk management.

3. Fair value and the mismatch problem

⚠️ "FAIR VALUE IS THE PRICE RECEIVED FOR SELLING AN ASSET OR THE PRICE PAID FOR TRANSFERRING A LIABILITY IN AN ARMS-LENGTH TRANSACTION BETWEEN KNOWLEDGEABLE AND WILLING COUNTERPARTIES."

In plain words: fair value is the price that informed, willing parties would agree in a normal sale.

In plain words: the derivative is shown at market value, but the goods are shown at cost. That mismatch distorts profit. Hedge accounting fixes it.

This is the whole point of the chapter in one sentence. A hedge works economically — the loss on one side cancels the gain on the other. But if the derivative is marked to market this year while the inventory it protects sits at cost until sold next year, the accounts will show a large loss in year one and a large gain in year two on a position that never risked anything. Hedge accounting exists to stop the books from misdescribing a business that is, in fact, protected.

3.1 The two conditions

In plain words: two conditions apply. The hedge needs formal papers and a board-approved risk policy. And its effectiveness must be checked and recorded all through the period.

4. Fair value hedge

In plain words: a fair value hedge protects the value of something you hold or have firmly committed to. The risk must be one that could affect reported profit.

⚠️ "In a fair value hedge, THE GAIN OR LOSS FROM REVALUING THE HEDGING INSTRUMENT AT FAIR VALUE IS RECOGNIZED IMMEDIATELY IN THE INCOME STATEMENT. At the same time, THE CARRYING AMOUNT OF THE HEDGED ITEM IS ADJUSTED FOR THE GAIN OR LOSS OF THE HEDGED RISK, AND THE CHANGE IS ALSO RECOGNIZED IMMEDIATELY IN THE INCOME STATEMENT TO OFFSET THE CHANGE IN THE VALUE OF THE DERIVATIVE."

In plain words: both the derivative's gain or loss and the hedged item's change go to the income statement at once. The two offset each other.

⚠️ "For example, INVENTORY OF COMMODITIES HAS TO BE VALUED ON FAIR VALUE, ALONG WITH VALUATION OF HEDGING INSTRUMENT LIKE SHORT SALE OF FUTURES. IF HEDGING IS NOT 100% EFFECTIVE, THERE WILL BE SOME IMPACT IN PROFIT AND LOSS ACCOUNT due to mismatch of gain and loss on underlying and hedge instrument versus the value of the asset or liability that is hedged."

In plain words: inventory and the short futures are both shown at fair value. If the hedge is not perfect, the gap shows up in profit or loss.

5. Cash flow hedge

⚠️ "Volatility in future cash flows will result from CHANGES IN INTEREST RATES, EXCHANGE RATES, EQUITY PRICES OR COMMODITY PRICES. For example, it may be related to FOREIGN CURRENCY HEDGING IN IMPORT OR EXPORT, OR INTEREST RATE SWAPS in floating rate borrowing or lending."

In plain words: a cash flow hedge protects future cash flows that may swing. The cause may be interest rates, exchange rates, share prices or commodity prices.

In plain words: both sides first go to equity, not profit and loss. Later they move to profit and loss together, as one net figure.

5.1 Firm commitments

⚠️ "THE HEDGE OF A FIRM COMMITMENT IS ACCOUNTED FOR AS A FAIR VALUE HEDGE, provided that all the criteria for hedge accounting are met. A HEDGE OF THE FOREIGN CURRENCY RISK ASSOCIATED WITH FIRM COMMITMENTS MAY BE DESIGNATED AS A CASH FLOW HEDGE OR A FAIR VALUE HEDGE, as such a foreign currency risk AFFECTS BOTH THE CASH FLOWS AND THE HEDGED ITEM'S FAIR VALUE."

The difference between the two models, in one line: a fair value hedge puts both sides through the profit and loss account immediately; a cash flow hedge parks both sides in equity and releases them together when the forecast transaction actually happens.

6. Hedge effectiveness

In plain words: only a highly effective hedge qualifies. The ICAI does not fix a test method but gives examples, such as regression or a dollar offset test.

⚠️ "There are SEPARATE TESTS TO BE APPLIED PROSPECTIVELY AND RETROSPECTIVELY, AND THESE TESTS ARE MANDATORY."

Test	⚠️ When	⚠️ What it must show
⚠️ PROSPECTIVE	"At INCEPTION of the hedge AND AT EACH SUBSEQUENT REPORTING DATE during the life of the hedge"	"That the undertaking EXPECTS changes in the fair value or cash flows of the hedged item TO BE ALMOST FULLY OFFSET (i.e. NEARLY 100%) by the changes in the hedging instrument"
⚠️ RETROSPECTIVE	"At EACH REPORTING DATE throughout the life of the hedge, following a methodology set out in the hedge documentation"	"That the hedging relationship HAS BEEN HIGHLY EFFECTIVE, by showing that ACTUAL RESULTS OF THE HEDGE ARE WITHIN THE VALUE RANGE OF 80-125%"

Note the asymmetry in the two standards. Looking forward, you must expect nearly 100 per cent offset. Looking back, actual results are acceptable anywhere in the 80 to 125 per cent band — because real markets never move in perfect lockstep, and demanding exactly 100 per cent in hindsight would disqualify every genuine hedge.

7. Accounting for options

7.1 Buying calls and puts

⚠️ "It is BUYING A RIGHT — paying a premium to buy an asset. PURCHASED OPTIONS ARE RECOGNIZED AS FINANCIAL ASSETS ON THE DATE OF PURCHASING."

In plain words: a bought option is a right you paid for. It is recorded as an asset from the day you buy it.

In plain words: an option protects rather than fully hedges. So its gains and losses are kept apart from the underlying asset.

⚠️ "In equity markets, IT IS SIMILAR TO BUYING A RIGHTS ENTITLEMENT OR A WARRANT that has the right to subscribe to equities."

The three outcomes:

⚠️ "UPON EXERCISE OF A CALL OPTION, THE OPTION PREMIUM IS ADDED TO THE COST OF UNDERLYING ASSETS PURCHASED to arrive at a combined cost"
⚠️ "UPON EXERCISE OF A PUT OPTION, THE OPTION PREMIUM IS REDUCED FROM THE SALES PROCEEDS OF ASSETS"
⚠️ "UPON LAPSING WITHOUT EXERCISE OR DEVOLVEMENT INTO FUTURES, OPTION PREMIUM IS DEBITED TO THE PROFIT AND LOSS ACCOUNT"

7.2 Selling calls and puts

⚠️ "Here, PREMIUM INCOME IS RECEIVED WITH CERTAINTY. Hence, PREMIUM INCOME IS IMMEDIATELY RECOGNIZED IN PROFIT AND LOSS ACCOUNT."

In plain words: the seller is sure of the premium, so it is booked as income at once.

On exercise:

⚠️ "UPON EXERCISE OF CALL OPTION, SELLER WILL RAISE BILL ON BUYER FOR SELLING COMMODITY TO HIM, for which NORMAL SALE ACCOUNTING IS DONE"
⚠️ "UPON EXERCISE OF PUT OPTION, OPTION SELLER WILL HAVE TO PURCHASE COMMODITY and hence WILL MAKE NORMAL ACCOUNTING ENTRY FOR PURCHASE"
⚠️ "UPON LAPSING WITHOUT EXERCISE OR DEVOLVEMENT INTO FUTURES, NO FURTHER ACCOUNTING TREATMENT IS REQUIRED. But accounting treatment in relation to FUTURES BUY/SELL POSITIONS WILL BE REQUIRED IN CASE OF DEVOLVEMENT IN FUTURES."

The asymmetry mirrors the economics exactly. The buyer has paid out a certain sum for an uncertain benefit, so the premium sits as an asset until the outcome is known. The seller has received a certain sum against an uncertain obligation, so the premium goes straight to income and the obligation is disclosed as a contingent liability.

Think of it like this

The insurance premium recorded in the wrong year

A factory insures its godown in March and the fire happens in April. If the accountant records the premium as a March loss and the claim as an April gain, the accounts show a company that lost money in one year and made money in the next — when in truth it was simply protected throughout.

⚠️ That is the mismatch hedge accounting exists to remove. "There could be AN ACCOUNTING MISMATCH BETWEEN THE DERIVATIVE INSTRUMENT, WHICH IS MEASURED AT A FAIR PRICE, AND THE UNDERLYING EXPOSURE, WHICH IS MEASURED AT THE ACTUAL COST."

The economics of a hedge are sound — one side cancels the other. The danger is purely one of timing in the books, and it is not a small danger: a well-hedged company can be made to look reckless, or a reckless one prudent, purely by which year each leg lands in.

The parcel held at the counter until both halves arrive

A courier office holds one half of a consignment until the second half arrives, then releases both together. Neither half is useful alone; delivering one early would only confuse the recipient.

⚠️ That is a cash flow hedge. "THE HEDGED ITEM'S DIFFERENTIAL IN CASH FLOW DUE TO VOLATILITY IS RECOGNISED IN EQUITY INSTEAD OF PROFIT AND LOSS ACCOUNT. HEDGING INSTRUMENTS' CASH FLOW IMPACT IS ALSO RECOGNISED IN EQUITY, and thereafter BOTH ARE MOVED TO PROFIT AND LOSS ACCOUNTS TOGETHER ON A NET BASIS."

The holding place has a name: the CASH FLOW HEDGING RESERVE, which the workbook describes as "like a Profit and loss account — it's CREDITED ON GAIN AND DEBITED ON LOSS, BUT IT REMAINS IN THE BALANCE SHEET TILL THE ACTUAL SALES DATE of the underlying physical commodities."

⚠️ Then: "the MTM carried in the Cash Flow Hedging Reserve WILL BE RECLASSIFIED TO THE STATEMENT OF PROFIT AND LOSS WHEN THE SALES ARE BOOKED", and it may go into "the SALES LINE ITEM, WHICH POTENTIALLY RECORDS THE SALES AT THE HEDGED PRICE."

Which is exactly what the business intended all along — to sell at the hedged price. The accounts finally say so.

The token money that becomes part of the price

Token money paid to hold a flat is not an expense while the deal is alive — it is money you may yet convert into part of the purchase price. Only when you walk away does it become a loss.

⚠️ A bought option behaves identically. "PURCHASED OPTIONS ARE RECOGNIZED AS FINANCIAL ASSETS ON THE DATE OF PURCHASING", and:

⚠️ "UPON EXERCISE OF A CALL OPTION, THE OPTION PREMIUM IS ADDED TO THE COST OF UNDERLYING ASSETS PURCHASED"
⚠️ "UPON EXERCISE OF A PUT OPTION, THE OPTION PREMIUM IS REDUCED FROM THE SALES PROCEEDS"
⚠️ "UPON LAPSING WITHOUT EXERCISE OR DEVOLVEMENT INTO FUTURES, OPTION PREMIUM IS DEBITED TO THE PROFIT AND LOSS ACCOUNT"

The seller's treatment is the mirror, and the reason is the certainty of the cash: "PREMIUM INCOME IS RECEIVED WITH CERTAINTY. Hence, PREMIUM INCOME IS IMMEDIATELY RECOGNIZED IN PROFIT AND LOSS ACCOUNT", with "A CONTINGENT LIABILITY SHOWN for the probable commitment to either pay for purchasing goods (put writing) or deliver goods (call writing)."

The pair of shoes that must fit, but not perfectly

A shoe that is one size too small is unwearable. A shoe that is a fraction loose is fine. Nobody insists on a millimetre-perfect fit — they insist on a workable range.

⚠️ Hedge effectiveness testing works the same way, and the two tests use different standards deliberately:

⚠️ PROSPECTIVE, at inception and at each reporting date: the entity must expect changes in the hedged item "TO BE ALMOST FULLY OFFSET (i.e. NEARLY 100%) by the changes in the fair value or cash flows of the hedging instrument"
⚠️ RETROSPECTIVE, at each reporting date: actual results must be "WITHIN THE VALUE RANGE OF 80-125%"

Looking forward, you must design for near-perfection. Looking back, reality is allowed a wide tolerance — because spot and futures prices "tend to move in tandem" but the movement is "not necessarily identical". That residual gap is basis risk, and a standard demanding exactly 100 per cent in hindsight would disqualify every honest hedge ever placed.

Both tests are MANDATORY, though "the ICAI Guidance Note DOES NOT PRESCRIBE ANY SPECIFIC TESTING METHODOLOGY" — offering regression analysis, the dollar offset test, critical item matching and others as examples.

The tax the seller pays on the way out

A mandi cess is collected when goods leave, not when they arrive. Whoever is doing the selling settles it, whatever the price turns out to be.

⚠️ CTT is arranged on the same principle: "CTT IS LEVIED ON SELLERS OF FUTURES AND OPTIONS. HOWEVER, ON EXERCISE OF OPTIONS, IT IS LEVIED ON PURCHASER OF OPTIONS, AS THE BUYER CHOOSES TO ENTER INTO EXERCISE DEAL."

The logic is that the tax follows whoever initiated the taxable act. A sale is initiated by the seller. An exercise is initiated by the buyer — nobody else can decide to exercise his option — so the levy shifts to him.

And note the loss-making trader still pays. In the workbook's example, gold bought at Rs 50,00,000 and sold at Rs 49,80,000 produces a Rs 20,000 loss — and on top of it, "the trader (BEING SELLER) will ALSO HAVE TO PAY THE CTT at 0.01%, i.e. Rs 49,80,000 × 0.01% = Rs 498."

⚠️ The exemption worth remembering: "THE AGRICULTURAL UNPROCESSED COMMODITIES' DERIVATIVES ARE EXEMPTED FROM CTT, THOUGH PROCESSED COMMODITIES ARE NOT." So Sugar, Guar gum, Soya Oil and all metals and energy contracts are taxed.

The bill that follows the goods across a state border

A shopkeeper in Nagpur buying from a supplier in Indore needs a GST registration for the state where he takes delivery. Without it the tax paid at the other end cannot be set off, and a routine purchase becomes an expensive one.

⚠️ The workbook flags exactly this in commodity delivery: "As the exchange DOES NOT DEAL WITH IGST but ensures collection of ONLY CGST AND SGST — and that too AT THE TIME OF FINAL SETTLEMENT OF THE DELIVERY — BUYERS MAY FACE ISSUES IF THE SELLERS AND BUYERS TAGGED FOR DELIVERY ARE FROM DIFFERENT STATES, AND BUYERS DO NOT HAVE GSTN FOR THE DELIVERY STATE."

How GST arises on a commodity delivery: "GST IS LEVIED BY SELLER OF GOODS ON BUYER OF GOODS AT THE TIME OF BILLING FOR DELIVERY... AT THE POINT OF DELIVERY OF GOODS AFTER ASSIGNMENT OF DELIVERY OBLIGATIONS", and "ON BILLED AMOUNT WHICH IS FINAL SETTLEMENT PRICE OF THE GOODS TO BE DELIVERED."

⚠️ And the practical trap in what GST replaced: "IT SUBSUMES EXCISE, SALES TAX, OCTROI AND MANDI TAX. BUT IT DOES NOT SUBSUME MANDI CESS AND CUSTOM DUTY."

Mandi cess survives because the mandi is a State institution and spot trade is a State subject — the same constitutional line that keeps SEBI out of the mandi keeps mandi cess out of GST.

Key terms in this chapter

Accounting mismatch: The problem hedge accounting solves — a derivative measured at fair value against an underlying exposure measured at actual cost, so that an economically neutral hedge produces a loss in one year and a gain in another.
Cash flow hedge: A hedge of exposure to variability in cash flows from a recognised asset or liability, an unrecognised firm commitment in foreign currency, or a highly probable forecast transaction. Both legs are recognised in equity and moved to profit and loss together on a net basis.
Cash Flow Hedging Reserve: The balance sheet account holding the mark-to-market of a cash flow hedging instrument. It behaves like a profit and loss account but stays in the balance sheet until the actual sale, when it is reclassified — often into the sales line, so sales are recorded at the hedged price.
CGST, SGST and IGST: Central and State GST are levied on intra-state supply by the Centre and the States respectively; Integrated GST is levied and administered by the Centre on every inter-state supply.
Commodities Transaction Tax: Introduced by the Finance Act 2013 at 0.01 per cent to bring parity with STT, and extended to options on futures by the Finance Act 2018. Determined at the end of each trading day, aggregated at contract level for each client code, and shown on the daily contract note.
Contingent liability on written options: The disclosure an option writer makes for the probable commitment to pay for goods (put writing) or deliver goods (call writing), while the premium income itself is recognised immediately in profit and loss.
CTT exemption: Derivatives on unprocessed agricultural commodities are exempt from CTT; processed ones are not — so sugar, guar gum, soya oil and all metals and energy contracts are taxed.
CTT on exercise: Where an option is exercised, the tax shifts from the seller to the purchaser, because the buyer chooses to enter into the exercise deal. Rates are 0.0001 per cent of settlement value on delivery-based exercise and 0.125 per cent where settlement is other than by physical delivery.
Exit price: What fair value means for a derivative — the price that would be paid to transfer a liability or received on transferring an asset to a knowledgeable, willing counterparty.
Fair value: The price received for selling an asset or paid for transferring a liability in an arms-length transaction between knowledgeable, willing counterparties. For a derivative it means the exit price, with collateral factored in.
Fair value hedge: A hedge of exposure to changes in the fair value of an asset, liability or unrecognised firm commitment. Both the derivative revaluation and the adjustment to the hedged item's carrying amount go through the income statement immediately.
Farmer and FPO fund: The separate fund exchanges must create with the regulatory fee SEBI forgoes on agricultural commodity derivatives, with investment income ploughed back, used exclusively for farmers' and FPOs' participation — from broker fees to warehousing charges — under SEBI's framework of 20 March 2019.
Goods and Services Tax: A destination-based tax on consumption levied at all stages from manufacture to final consumption, with credit of taxes paid at earlier stages available as setoff, so that only value addition is taxed.
Hedged item: The asset, liability, cash flow or firm commitment that carries the risk being protected. A hedge presupposes the existence of an underlying exposure in the commodity.
Hedging instrument: The contract used to reduce the risk on the hedged item. Forward contracts, commodity futures and commodity options are all examples available to a commodity market participant.
ICAI Guidance Note: The revised note issued by the Institute of Chartered Accountants of India in 2021, effective for accounting periods beginning on or after 1 April 2021, governing the accounting treatment of derivative transactions including commodity futures and options.
Inter-state delivery problem: Because the exchange collects only CGST and SGST at final settlement and does not deal with IGST, a buyer randomly allocated to a seller in another state may be unable to claim credit if he holds no GST registration for the delivery state.
Inventory hedge accounting adjustment: A separate basis adjustment recording the fair value change of hedged inventory, kept distinct from the AS 2 valuation because AS 2 requires inventories at the lower of cost and net realisable value. It is released to cost of goods sold when the inventory is sold.
Net investment hedge: The third accounting hedge type, alongside fair value and cash flow hedges, covering hedges of net investments in foreign operations — for which separate disclosures are required.
Prospective effectiveness testing: Performed at inception and at each subsequent reporting date, demonstrating that the entity expects changes in the hedged item to be almost fully — nearly 100 per cent — offset by the hedging instrument.
Retrospective effectiveness testing: Performed at each reporting date following the documented methodology, demonstrating that actual results of the hedge fall within the 80 to 125 per cent range.
SEBI turnover fees: Rs 15 per Rs 1 crore of broker turnover, or 0.00015 per cent, reduced to Re 1 per crore for agricultural commodities.
Uniform stamp duty regime: Effective 1 July 2020, exchanges levy stamp duty on brokers based on client trades and deposit it with the state in which the buyer is registered, tracked from Uniform Client Code data, at a uniform Rs 2 per Rs 1 lakh — about 0.002 per cent.
What GST subsumes: Excise, sales tax, octroi and mandi tax are subsumed; mandi cess and customs duty are not — mandi cess surviving because the mandi is a State institution and spot trade a State subject.

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Original explanatory writing based on the official NISM workbook for Series XVI, which is published and copyrighted by NISM. Check figures against the current edition at nism.ac.in.

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