The Financial Accounting Standards Board (FASB) issued temporary accounting relief to help ease the burden of reference rate reform. The temporary accounting relief consists of optional expedients and exceptions for applying generally accepted accounting principles (GAAP) to contracts, hedging relationships, and other transactions affected by reference rate reform if certain criteria are met.

The temporary accounting relief impacts entities that are required to modify existing contracts and hedging relationships due to the market-wide migration from interbank offered rates (IBORs) to alternative reference rates.

The optional guidance is provided in Accounting Standards Update (ASU) 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting. The FASB further refined the scope of the temporary guidance in ASU 2021-01, Reference Rate Reform (Topic 848): Scope.

Here, gain insight into key provisions entities should consider when applying the temporary accounting relief.

Effective Dates

The optional expedients and accounting relief in Topic 848 were effective for all entities upon issuance of ASU 2020-04 on March 12, 2020, and will remain effective until December 31, 2022. 

This means the practical expedients can be applied to contract modifications and eligible hedging relationships that:

• Existed as of the beginning of the interim period that includes March 12, 2020
• Were entered into after March 12, 2020, and through December 31, 2022

Entities must disclose the nature of and reason for electing the optional expedients and exceptions in each interim and annual financial statement period in the fiscal year of application.

Identifying Alternative Reference Rates

IBORs are an indicative measure of the average interest rate at which major global banks could borrow from one another and are widely used as benchmark or reference rates. 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
• Lease agreements
• Derivative instruments, including those related to interest rates, foreign currency, and various commodities

It’s expected, however, that many private-sector banks currently reporting information used to set LIBOR will stop doing so after 2021 when their current reporting commitment ends.

Concerns about the sustainability of LIBOR and other IBORs led to an effort to identify alternative reference rates. The FASB launched the reference rate reform project in 2018 to address accounting challenges expected to arise from the transition of LIBOR and other IBORs.

Topic 848 Accounting Relief

Amendments in ASU 2020-04 introduce Topic 848, Reference Rate Reform, a new topic that provides temporary optional expedients to ease accounting requirements related to transitioning from LIBOR—or other reference rates that are expected to be discontinued—to alternative reference rates.

If certain criteria are met, entities may elect not to apply certain aspects of contract modification accounting to modifications related to reference rate reform and to continue applying hedge accounting for hedging relationships that are modified due to reference rate reform.

Contracts That Qualify Under Topic 848

The effects of reference rate reform are expected to be temporary, so the accounting relief will generally only apply to contract modifications made, or hedging relationships entered into or evaluated subsequent to the beginning of the reporting period that includes March 12, 2020, and prior to December 31, 2022. 

The optional expedients and exceptions 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.

Additionally, the relief is limited to changes being made to the terms of the contract that include:

• The direct replacement of a reference rate being discontinued
• Other modifications to terms that are considered related to the replacement of a reference rate

Discounting Transition

In connection with reference rate reform, certain interest rates used to determine variable cash flows, or for valuation purposes, are transitioning to alternative rates.

Rates that may transition to alternative rates include:

• Rates used to compute the cash flows for an interest rate swap’s variable leg
• Interest rates used to discount the future cash flows of a derivative instrument to determine its fair value
• Margin payments that must be exchanged on the basis of changes in the derivative instrument’s fair value
• Compensation or interest amounts earned on margin payments—referred to as contract price alignment

Changes in the interest rates used for margining, discounting, or contract price alignment for derivative instruments that are being implemented as part of the market-wide transition to new reference rates is commonly referred to as the discounting transition.

The amendments in ASU 2021-01 clarify the scope of Topic 848 includes derivative instruments that undergo a rate modification for one of the items noted above.

Contracts That Don’t Qualify Under Topic 848

If a contract modification includes both a reference rate change and other substantive changes that are unrelated to reference rate reform, the contract won’t qualify for the practical expedients or accounting relief provided for in the reference rate reform standard.

The optional expedients and accounting relief don’t apply to modifications that occur in the ordinary course of business or for reasons unrelated to reference rate reform, such as borrowing base redeterminations, extensions, and covenant remedies.

Optional Expedients for Contract Modifications

Under current GAAP, contract modifications must be evaluated to determine whether  modifications result in either:

• Establishment of a new contract
• Continuation of an existing contract

Topic 848 simplifies the accounting analysis for contract modifications affected by reference rate reform, including rates referenced in fallback provisions. It also simplifies the accounting for contemporaneous modifications of other contract terms related to the replacement of reference rate, including contact modifications to fallback provisions.

It does this by permitting the following optional expedients.

• Receivables and debt. Modifications within the scope of Topic 310, Receivables, and Topic 470, Debt, should be accounted for by prospectively adjusting the effective interest rate.
• Leases. Modifications within the scope of Topic 842, Leases, should be accounted for as a continuation of the existing contract with no reassessments or remeasurements of lease classification, discount rates, or lease payments.
• Derivatives and hedging. Modifications within the scope of Topic 815-15, Derivatives and Hedging—Embedded Derivatives, won’t require a reassessment of whether or not an embedded derivative should be accounted for as a separate instrument.
• Lack of explicit guidance. Modifications for which explicit guidance isn’t provided should be accounted for as a continuation of those contracts without having to reassess previous determinations.

The optional expedients must be applied consistently to all modified contracts and eligible transactions within the relevant codification topic or subtopic. If elected, they must also be applied to all modifications of an interest rate used for margining, discounting, or contract price alignment for derivative instruments.

This election, however, doesn’t require the optional expedients to be applied to other modifications of derivative instruments.

When Optional Expedients Can’t Be Applied

The optional expedients may not be applied to a modification made to a term that changes, or has the potential to change, the amount or timing of contractual cash flows is unrelated to the replacement of a reference rate—with the exception of a modification to the interest rate used for margining, discounting, or contract price alignment.

Optional Expedients for 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.

Topic 848 provides exceptions to current guidance in Topic 815; the following changes won’t result in the dedesignation of the hedging relationship if they’re due to reference rate reform.

• Critical terms. Certain changes in the critical terms of a designated hedging instrument, a hedged item, or a forecasted transaction in a fair value, cash flow, or net investment hedge.
• Adjustments. A change to rebalance or adjust a fair value or cash flow hedge.
• Assessment methods. 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.
• Additional terms. A change to the terms as a result of the discounting transition.

Upon a change to the terms of a hedging relationship affected by reference rate reform, the amendments allow entities to change the systematic and rational method used to recognize in earnings the components excluded from the assessment of effectiveness. Additionally, if the change in terms impacts the fair value of the excluded component, the fair value adjustment may be recognized in current earnings. 

The optional expedients are intended to make it easier for entities to continue to apply hedge accounting.

Fair Value Hedges

If certain criteria are met, Topic 848 also provides the following optional expedients for existing fair value hedging relationships affected by either reference rate reform or the discounting transition.

• Benchmark rates. Entities may change the designated benchmark rate documented at hedge inception to a different eligible benchmark rate without dedesignating the relationship.
• Perfect hedge effectiveness methods. Entities that applied the shortcut method, or another method that assumes perfect hedge effectiveness, can continue to apply it for the remainder of the hedging relationship—including the remainder of hedging relationships that end after December 31, 2022—even though certain requirements to apply this method would no longer be met as a result of reference rate reform.

These optional expedients should be applied on a hedge-by-hedge basis. The method used to change the designated benchmark interest rate should be applied consistently across similar fair value hedging relationships.

In some cases, the cumulative fair value hedge basis adjustment may be modified for the amount of cash compensation, using a reasonable method. This can occur if the shortcut method is applied to a fair value hedging instrument that is affected by a payment or receipt of a cash settlement intended to compensate for a modification of the interest rate used to margin, discount, or align the contract price for the derivative instrument related to reference rate reform.

Cash Flow Hedges

Topic 848 provides the following optional expedients for cash flow hedging relationships affected by reference rate reform if certain criteria are met.

• Designated hedged risk. Entities may disregard potential changes in the designated hedged risk due to reference rate reform when assessing if of the occurrence of the hedged forecasted transaction continues to be probable.
• Interest rate risk changes. Entities may continue hedge accounting when the hedged interest rate risk changes if the hedge is either highly effective or an optional expedient method is elected.
• Shortcut method. Entities that applied the shortcut method, or another method that assumes perfect hedge effectiveness, can continue to apply that method even though certain requirements to apply this method may no longer be met as a result of reference rate reform.
• Disregarding mismatches. Entities may adjust the methods used to initially and subsequently assess hedge effectiveness to disregard certain mismatches between the designated hedging instrument and the hedged item when either the hedging instrument or hedged forecasted transaction reference a rate that is expected to be affected by reference rate reform.
• Qualitative method. Entities may elect to subsequently assess hedge effectiveness using a qualitative method.
• Forecasted transaction portfolios. Entities may disregard the requirement for forecasted transaction portfolios that reference a rate expected to be affected by reference rate reform to share the same risk exposure for which they’re designated as being hedged.  

The above optional expedients should be applied on a hedge-by-hedge basis. They must be discontinued as of either:

• Date the hedging instrument or hedged forecasted transaction ceases to reference a rate affected by reference rate reform
• After December 31, 2022

The amount recorded in accumulated other comprehensive income may be adjusted for the amount of cash compensation exchanged using a reasonable method. This is only true, however, if a cash flow hedging instrument is affected by a payment or receipt of a cash settlement intended to compensate for a modification of the interest rate used for margining, discounting, or contract price alignment for the derivative instrument related to reference rate reform.

Net Investment Hedges

Topic 848 allows a receive-variable rate, pay-variable rate cross-currency interest rate swap to be designated as the hedging instrument in a net investment hedge if the repricing terms of the swap’s variable legs don’t match because of reference rate reform.

Applicability of Optional Expedients for Hedge Accounting

Entities may only elect the following optional expedients for hedge accounting if the amendments in ASU 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, haven’t yet been adopted.

• Critical terms. Changes in critical terms of a hedging relationship.
• Elected method. Changing the method used to assess hedge effectiveness in a cash flow hedge if the optional expedient method elected is the simplified hedge accounting approach for initial hedge effectiveness or subsequent hedge effectiveness. This expedient only applies to eligible private companies.
• Probable to occur. Assuming the hedged forecasted transaction in a cash flow hedge is probable to occur.
• Quantitative-basis measurement. Assuming the reference rate won’t be replaced for the remainder of the hedging relationships when the entity is using the quantitative basis to assess and measure hedge effectiveness in a cash flow hedge.
• Simplified hedge accounting requirements. Disregarding certain requirements of the simplified hedge accounting approach for initial or subsequent hedge effectiveness in a cash flow hedge. This expedient only applies to eligible private companies.

Selling or Transferring Debt Securities

Topic 848 allows entities to may make a one-time election to sell or transfer certain debt securities classified as held to maturity, without calling into question the entity’s prior intent to hold those debt securities to maturity.

At the time of applying the one-time election, the entity may sell, transfer, or both sell and transfer, debt securities classified as held to maturity if they meet both of the following criteria:

• Reference a rate affected by reference rate reform
• Classified as held to maturity before January 1, 2020

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