On September 5, 2019, the Financial Accounting Standards Board (FASB) issued a proposed accounting standards update (ASU), Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting.
The proposed ASU is intended to provide temporary accounting relief for entities required to modify existing contracts and hedging relationships as a result of the market-wide migration from interbank offered rates (IBORs) to alternative reference rates.
Background
The London Interbank Offered Rate (LIBOR) is the most commonly used reference rate in the global financial market. LIBOR is used as a benchmark in both commercial and financial contracts, including corporate and municipal bonds and loans, floating rate mortgages, asset-backed securities, consumer loans, interest rate swaps, and other derivatives. However, it’s expected that many private-sector banks currently reporting information used to set LIBOR will stop doing so after 2021 when their current reporting commitment ends.
On July 12, 2019, the SEC issued a staff statement on managing the transition from LIBOR. Per the SEC staff, the expected discontinuation of LIBOR could significantly impact financial markets and may present a material risk for certain market participants, including public companies, investment advisers, investment companies, and broker-dealers. The risks associated with this discontinuation and transition will be exacerbated if the transition to an alternative reference rate isn’t completed in a timely manner.
While not all issues related to reference rate reform have been resolved, the SEC staff recommends entities begin the process of identifying existing contracts that extend past 2021 to determine their exposure to LIBOR and other reference rates that are expected to be discontinued as a result of reference rate reform.
Concerns about the sustainability of LIBOR and other IBORs have led to an effort to identify alternative reference rates, and the FASB launched the reference rate reform project in 2018 to address the accounting challenges expected to arise from the transition from LIBOR and other IBORs.
Key Provisions
The proposed ASU introduces Topic 848, a new topic that provides temporary optional expedients to ease the accounting requirements related to the transition away from LIBOR—or other reference rates that are expected to be discontinued—to alternative reference rates. Under the proposed guidance, entities may elect not to apply certain aspects of contract modification accounting to modifications related to reference rate reform and to continue to apply hedge accounting for hedging relationships that are modified due to reference rate reform, if certain criteria are met.
The proposed guidance would only apply to contracts or hedging relationships that are affected by reference rate reform and that reference LIBOR or another reference rate expected to be discontinued due to reference rate reform. The effects of reference rate reform are expected to be temporary, so the proposed relief would only apply to contract modifications made or hedging relationships entered into or evaluated prior to December 31, 2022.
Contract Modifications
Under current generally accepted accounting principles (GAAP), contract modifications are required to be evaluated to determine whether the modification results in the establishment of a new contract or the continuation of an existing contract.
The proposed ASU would simplify the accounting analysis for contract modifications affected by reference rate reform by permitting the following optional expedients:
- Modifications within the scope of Topic 310, Receivables, and Topic 470, Debt, would be accounted for by prospectively adjusting the effective interest rate.
- Modifications within the scope of Topic 842, Leases, would be accounted for as a continuation of the existing contract with no reassessments or remeasurements.
- Modifications within the scope of Topic 815-15, Derivatives and Hedging—Embedded Derivatives, wouldn’t require a reassessment of whether or not an embedded derivative should be accounted for as a separate instrument.
- Modifications for which explicit guidance isn’t proposed would be accounted for as a continuation of those contracts without having to reassess previous determinations.
These simplifications could only be applied to modifications related to the replacement of a reference rate. If contemporaneous changes are also made to other terms in the contract that change, or have the potential to change, the amount or timing of contractual cash flows, those changes must also be related to the replacement of a reference rate in order to apply the proposed relief.
If a modification is made to a term that changes, or has the potential to change, the amount or timing of contractual cash flows and is unrelated to the replacement of a reference rate, the proposed guidance could not be applied to those modifications.
If elected, the proposed guidance must be applied consistently to all modified contracts within the relevant codification topic or subtopic.
Hedging Relationships
Under current GAAP, changes in a reference rate could disallow the application of hedge accounting, and certain hedging relationships may no longer qualify as highly effective.
The proposed ASU would provide exceptions to current guidance, allowing the following changes due to reference rate reform to not result in the dedesignation of the hedging relationship:
- A change in the critical terms of a designated hedging instrument in a fair value, cash flow, or net investment hedge
- A change to rebalance or adjust a fair value or cash flow hedge
- A change in the method used to assess hedge effectiveness for a cash flow hedge, when initially applying an optional expedient method and reverting back to current GAAP
The proposed ASU also provides the following optional expedients for existing fair value hedging relationships affected by reference rate reform if certain criteria are met:
- Entities would be able to change the designated benchmark rate documented at hedge inception to a different eligible benchmark rate without dedesignating the relationship.
- Entities that applied the shortcut method or another method that assumes perfect hedge effectiveness will be allowed to continue to apply that method for the remainder of the hedging relationship even though certain requirements to apply this method may no longer be met as a result of reference rate reform.
Additionally, the proposed ASU provides the following temporary optional expedients for cash flow hedging relationships affected by reference rate reform:
- Entities would disregard the potential change in the designated hedged risk due to reference rate reform when assessing whether the occurrence of the hedged forecasted transaction continues to be probable.
- Entities would be permitted to continue hedge accounting when the hedged risk changes if the hedge is either highly effective or an optional expedient method is elected.
For new cash flow hedges that are impacted by reference rate reform, the proposed ASU provides temporary optional expedients that are intended to make it easier for entities to continue to apply hedge accounting.
The above exceptions and expedients would be applied on a hedge-by-hedge basis and may only be elected if an entity has adopted the new hedge accounting guidance in ASU 2017-12, Targeted Improvements to Accounting for Hedging Activities.
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