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360° Approach to Libor Transition

Libor Transition


360° Approach to Libor Transition

Libor Transition

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What you need to know:

  • London Interbank Offered Rate (LIBOR) ends on December 31, 2021.
  • ASU 2020-04 – Reference Rate Reform (Topic 848) provides temporary optional expedients and exceptions to the US GAAP guidance on contract modifications and hedge accounting. The ASU is effective immediately and all entities would be able to apply it until December 31, 2022.
  • Cessation of LIBOR would expose businesses to various risks such as liquidity risk, technology risk, operational risk, and financial reporting and compliance risk.
  • The U.S. Treasury Department and Internal Revenue Service (IRS) released the Proposed Interbank Offered Rate (IBOR) Regulations in October 2019 to address the tax treatment of alterations made to instruments to replace an IBOR-based rate with an alternative rate.

LIBOR is currently produced in 7 tenors (overnight/spot next, one week, one month, two months, three months, six months, and 12 months) across 5 currencies. In the US and global markets, LIBOR is widely used as a reference interest rate in commercial agreements and a broad range of financial instruments. However, in 2017, the U.K. Financial Conduct Authority announced that all currency and term variants of LIBOR (IBORs) are expected to cease after the end of 2021. This decision was made due to the increasing absence of active underlying markets and the scarcity of term unsecured deposit transactions which led to serious questions about the future sustainability of the LIBOR benchmarks.

FASB proposed optional expedients and exceptions to the guidance in U.S. GAAP to contracts, hedging relationships, and other transactions affected by reference rate reform.

In March 2020, the Financial Accounting* Standards Board (FASB) released ASU No. 2020-04 in response to the cessation of the LIBOR. Several issues and challenges that are likely to arise due to this were raised by stakeholders:

  • Voluminous contracts and other arrangements will need to be modified to replace reference rates.
  • Application of existing accounting* standards to contracts and other arrangements could be costly and burdensome.
  • The inability to apply hedge accounting* because of reference rate reform could result in financial reporting outcomes that do not reflect entities’ intended hedging strategies.

Key Considerations Include:

Affected Contract
Optional Expedients and Exceptions

Contract Modifications

—Allows an entity to account for and present the modified contract as a continuation of the contract that existed before the modification rather than a derecognition or extinguishment
—The contract references LIBOR or another reference interest rate that is expected to be discontinued due to reference rate reform.
—Consider embedded features to be clearly and closely related to the host contract without reassessment.
—Any contemporaneous changes to other contract terms (i.e., those that do not directly replace or have the potential to replace a reference rate) that change, or have the potential to change, the amount and timing of contractual cash flows must be related to the replacement of the reference rate.
Hedging Accountinge

Critical terms of hedging relationships
—Provide optional expedients to enable entities to change critical terms and continue to apply hedge accounting

Fair value hedges
—Allows an entity to change the designated benchmark interest rate documented at hedge inception to a different eligible benchmark interest rate under Subtopic 815-20
—An entity may disregard certain qualifying conditions for the shortcut method that are not met because of reference rate reform and may continue to disregard those qualifying conditions for the remainder of the fair value hedging relationship (including for the remainder of hedging relationships that end after December 31, 2022).

Cash flow hedges
—Allows an entity to assert that it remains probable that the hedged forecasted transaction will occur.
—Continue hedge accounting upon a change in the hedged risk as long as the hedge is still highly effective
—Allows an entity may revert to hedge accounting requirements in Subtopics 815-20 and 815-30 without de-designating the hedging relationship

Critical terms of hedging relationships
—Perform some effectiveness assessments in ways that disregard certain potential sources of ineffectiveness.

Fair value hedges
—The hedge is expected to remain highly effective
—The optional expedients for fair value hedging relationships may be elected on an individual hedging relationship basis

Cash flow hedges
—An entity may continue hedge accounting for a cash flow hedge for which the hedged interest rate risk changes if either the hedge is highly effective under an assessment method in Subtopics 815-20 and 815-30 or an optional expedient method in this Update is elected.
—An entity should disregard the potential change in the designated hedged interest rate risk that may occur because of reference rate reform when the entity assesses whether the hedged forecasted transaction is probable in accordance with the requirements of Topic 815.

Debt securities classified as Held-to maturity
—An entity may make a one-time election to sell, transfer, or both sell and transfer debt securities classified as held to maturity that reference a rate affected by reference rate reform and that are classified as held to maturity before January 1, 2020.

Contract modifications The following decision tree summarizes whether a contract modification is eligible to apply for the optional relief in ASC 848-20-55-1.

ASU No. 2020-04 also provides optional expedients for applying the requirements of certain topics that require analysis of contract modification:

  • Modifications of contracts within the scope of Topics 310, Receivables and Topic 470, Debt should be accounted for by prospectively adjusting the effective interest rate
  • Modifications of contracts within the scope of Topics 840, Leases and Topic 842, Leases should be accounted for as a continuation of the existing contracts with no reassessments of the lease classification and the discount rate (for example, the incremental borrowing rate) or remeasurements of lease payments that otherwise would be required under those Topics for modifications not accounted for as separate contracts; and
  • Modifications of contracts do not require an entity to reassess its original conclusion about whether that contract contains an embedded derivative that is clearly and closely related to the economic characteristics and risks of the host contract under Subtopic 815-15, Derivatives and Hedging— Embedded Derivatives.


Changes that are related to the replacement of a reference rate

To be eligible for the optional expedients in Subtopic 848-20, modifications of contractual terms that change (or have the potential to change) the amount or timing of contractual cash flows must be related to the replacement of a reference rate. Changes made to effect the transition for reference rate reform are considere