Accounting mismatch
Also written Accounting mismatch on derivatives
The gap between a derivative, measured at fair value, and the exposure it hedges, usually measured at cost — the very mismatch hedge accounting exists to offset.
In plain language
A company that hedges typically holds two things: the derivative it bought as protection, and the underlying exposure it is protecting — inventory, a receivable, a future purchase. These two things are usually measured differently on the books.
The derivative is valued at fair value — roughly, what it would fetch if sold today. The exposure it protects is often still carried at cost. When prices move, the derivative's value on the balance sheet jumps around while the hedged item, sitting at cost, does not. That gap between the two measurement bases is the accounting mismatch.
How it works
The workbook states this directly: fair value is the price received for selling an asset, or paid for transferring a liability, in an arm's-length transaction between knowledgeable, willing counterparties. "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."
Hedge accounting exists to offset this mismatch: its objective is to ensure the gain or loss on a hedging instrument is recognised in the same period as the gain or loss on the hedged item, so profit reflects the economics of the hedge rather than an artefact of two different measurement conventions. To use hedge accounting, two conditions must be met: there must be formal documentation, including a board-approved risk management policy and strategy; and the hedge's effectiveness must be assessed and recorded on an ongoing basis throughout the reporting period.
A worked example
A refiner holds physical crude oil inventory carried at its purchase cost of Rs 50,00,000, and separately holds a short crude oil futures position as a hedge, which is marked to fair value daily. If crude prices fall by 4%, the futures position shows a fair-value gain of roughly Rs 2,00,000 in the books immediately — but the inventory, still sitting at its original Rs 50,00,000 cost, shows no offsetting loss at all, even though its real market value has also fallen by a similar amount.
Without hedge accounting, the refiner's income statement would show a large derivative gain with no matching inventory loss in the same period — an accounting mismatch that misrepresents what actually happened economically. With hedge accounting properly documented and its effectiveness tracked, the inventory's carrying value is adjusted for the hedged risk too, so the gain and loss largely offset in the same period's profit and loss.
Why NISM asks about it
Chapter 9 (Accounting and Taxation), section 9.1, introduces the accounting mismatch immediately after defining fair value, as the reason hedge accounting exists at all. Expect a question on what causes the mismatch (different measurement bases — fair value versus cost) and on the two conditions required to qualify for hedge accounting.
Common exam traps
- The mismatch is a measurement-basis problem (fair value versus cost), not a market-risk problem like basis risk. Two different things can both cause profit volatility, but for different reasons.
- Hedge accounting requires both conditions together — formal, board-approved documentation, and ongoing effectiveness assessment. Meeting only one is not enough.
- Even a well-documented hedge is not automatically 100% effective — where it is not, some P&L impact from the mismatch remains even after hedge accounting is applied.
Check yourself
1.In Company Z's cash flow hedge of forecast copper sales, where is the mark-to-market of the futures contract carried at the 31 March year end, and where is it eventually released?
- a)In the profit and loss account at year end, with no later release
- b)In the Cash Flow Hedging Reserve, released to the profit and loss statement — potentially into the sales line — when the sales are booked
- c)In inventory, released to cost of goods sold when the inventory is sold
- d)In a contingent liability note, released only if the forecast sales fail to occur
Show the answer
Answer: (b) In the Cash Flow Hedging Reserve, released to the profit and loss statement — potentially into the sales line — when the sales are booked
At year end: "RECORD A DERIVATIVE ASSET/LIABILITY BASED ON THE FAIR VALUE (MTM) OF THE COMMODITY FUTURES CONTRACT, WITH A CORRESPONDING CREDIT/DEBIT TO THE CASH FLOW HEDGING RESERVE."
The reserve is described precisely: "It is 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."
On release: ⚠️ "Assuming that the sales occur as expected, THE MTM CARRIED IN THE CASH FLOW HEDGING RESERVE WILL BE RECLASSIFIED TO THE STATEMENT OF PROFIT AND LOSS WHEN THE SALES ARE BOOKED... Such reclassification CAN BE MADE IN THE SALES LINE ITEM, WHICH POTENTIALLY RECORDS THE SALES AT THE HEDGED PRICE."
That final phrase is the point of the whole exercise. Company Z sold futures in January precisely so that its September sales would effectively realise January's price. Routing the reserve through the sales line makes the accounts say exactly that — the business achieved the price it set out to lock in.
Option (c) describes the FAIR VALUE hedge treatment, which the workbook works through as the alternative designation of the same contract: there, the MTM goes through profit and loss immediately, inventory carries a separate hedge accounting adjustment, and the release is into cost of goods sold.
Same company, same futures contract, same price movement, two entirely different sets of entries — decided purely by what the company designated the hedge against. Designation is not a formality; it drives the accounting.
Why nothing hits P&L at March in the cash flow model: the forecast sales are not yet in the books. Recording the hedge's MTM in P&L would show a loss on a position protecting something the accounts do not yet recognise — which is the accounting mismatch hedge accounting exists to remove.
Where this is taught
Free preparation for NISM Series XVIRelated terms
- Fair valueThe theoretical futures price — spot plus the cost of carrying the commodity to expiry — at which a buyer is indifferent between buying today and buying forward.
- Cash Flow Hedging ReserveThe equity account in which the fair-value gains and losses of a derivative designated as a cash flow hedge are parked until the hedged forecast transaction hits profit and loss.
- Exit priceThe ICAI Guidance Note's definition of fair value for a derivative — the price to sell or transfer the position to a willing counterparty today, factoring in available collateral.
- Hedging instrumentIn hedge accounting, the derivative — a forward, future or option — used to reduce the risk of the hedged item, whose gains and losses are matched against that item under the ICAI Guidance Note.
- Retrospective effectiveness testingThe mandatory check, at each reporting date, that a designated hedge actually was highly effective — its results falling within 80 to 125 per cent — as a condition of continuing hedge accounting.
- Contingent liability on written optionsThe entry an option seller must record for a probable commitment to buy or deliver goods on exercise, since a written option is an open-ended obligation, unlike a purchased option, which is simply an asset.
- Prospective effectiveness testingThe forward-looking test, done at hedge inception and at every reporting date after, that checks whether a hedge is expected to offset nearly all of the change in the hedged item.
- ICAI Guidance NoteICAI's revised 2021 note on accounting for derivative contracts, effective for accounting periods beginning on or after 1 April 2021, requiring every derivative on the balance sheet at fair value.
- Inventory hedge accounting adjustmentA separate basis adjustment carrying the fair value change of hedged inventory, kept apart from the AS 2 valuation, and released to cost of goods sold when the inventory is finally sold.