The London Interbank Offered Rate (LIBOR), the most commonly used reference rate in financial contracts, bid farewell in June 2023 as several banks were accused of rigging the benchmark interest rate for their benefit, resulting in substantial fines and irreparable damage to their reputations. As a result, alternative reference rates, such as the Secured Overnight Financing Rate (SOFR), are set to take the spotlight.
The transition away from LIBOR is expected to significantly impact many companies. In light of this and the extended cessation date of USD LIBOR from December 31, 2021 to June 30, 2023, an update was issued, deferring the applicability of the Reference Rate Reform from December 31, 2022, to December 31, 2024. This extension gives companies more time to implement necessary updates in response to the transition.
Preparing for the impact of the reform will require a multidisciplinary team to identify where LIBOR is used and negotiate changes to contracts. It may also create challenges for accounting and hedging relationships.
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What is a Reference Rate?
Imagine you are building a house and need to find the right wood for your project at an affordable price. The task can be challenging as you want to ensure the wood meets your project requirements while fitting within your budget. To achieve this, you may need to visit multiple hardware stores, comparing the prices and quality of the wood they offer. By taking the time to explore various options, you increase your chances of finding the best deals.
In the world of finance, reference rates streamline this process. Benchmark administrators like ICE Benchmark Administration (for LIBOR) and the New York Fed (for SOFR) gather interest rate details from different banks and use them to calculate reference rates. These rates serve as benchmarks, enabling decision-makers to compare interest rates on various financial products based on prevailing market conditions, much like how you compare wood prices to find the best deal for your house.
Understanding the Reference Rate Reform
With the exit of LIBOR, companies face challenges as it is a widely used reference rate in many financial products. This means that institutions may have to amend a large number of contracts to reflect a new reference rate, which can be complex and time-consuming. If contracts remain unamended, there is a potential risk that parties may not agree on terms, particularly of the calculation of interest payable after the cessation of LIBOR.
On March 12, 2020, the Financial Accounting Standards Board (FASB) issued ASU 2020-04, Reference Rate Reform (Topic 848), Facilitation of the Effects of Reference Rate Reform on Financial Reporting, to provide practical expedients and exceptions from applying modification accounting to contracts if certain criteria are met. The amendments aim to reduce operational challenges companies will face in applying modification accounting to all revised contracts. Two categories exist for these optional expedients: contract modification relief and hedge accounting relief.
However, only changes made to financial contracts specifically related to the transition away from LIBOR, or reference rates expected to be discontinued, and towards alternative reference rates will be eligible for the practical expedients and exceptions in ASC 848. Any amendments made to contracts unrelated to reference rate reform, even if made at the same time as reference rate reform-related changes, will not be eligible for the application of ASC 848 and should be assessed under other applicable accounting guidance.
How Can You Simplify Contractual Modifications under Reference Rate Reform?
The reference rate reform introduces optional expedients that provide entities with flexibility in treating qualifying contractual amendments. These expedients allow entities to consider these amendments as continuations of existing contracts, eliminating the need for the usual assessment required under GAAP. By doing so, entities can streamline their processes more efficiently and effectively.
One expedient available under the reform is the simplified approach for contracts involving the replacement of LIBOR or another reference rate expected to be discontinued. This approach can be utilized if the changes made to the contracts only impact the interest rate and do not affect the overall cash flows of the contracts. However, it is important to note that the company must consistently apply this approach to all eligible contract modifications within the same accounting guidelines (e.g., ASC 310, ASC 470, etc.).
Here are the optional expedients a company can choose from to handle contract modifications:
Financial Assets under ASC 310, Receivables—contract modifications are prospectively accounted for as minor modifications, resulting in the continuation of the existing contract without recognizing any gain or loss. At the same time, the amortized cost basis incorporates the remaining basis of the original loan along with additional fees received and direct loan origination costs associated with the restructuring, establishing a new effective yield based on the revised cash flows.
Debt Agreements under ASC 470, Debt—contract modifications are prospectively accounted for as not substantial modifications, resulting in the continuation of the existing contract without gain or loss recognition. The carrying amount is adjusted to include the original debt and additional fees, establishing a new effective yield and the revised cash flows. ASC 470-50-40-12(f) includes a “lookback period” for assessing substantial differences in debt modifications within a year, but once a modification is accounted for under ASC 848, prior modifications are not subject to the “lookback period.”
Leases under ASC 840 or ASC 842, Leases—lease contract modification is not treated as a separate contract, a company is not obligated to reassess lease classification and discount rate, remeasure lease payments, or perform other typical reassessments or remeasurements required by ASC 840 or ASC 842.
Derivatives under ASC 815, Derivatives and Hedging—contract modifications of derivatives due to reference rate reform, a company is relieved from the obligation to reassess if the derivative is a hybrid instrument or includes a significant financing element, as well as the reassessment of embedded derivatives.
The Reference Rate Reform also provides an optional election for instruments with modification guidance in other areas of GAAP, treating the modification as an event that does not require contract remeasurement or reassessment under the relevant ASC Topic or Industry Subtopic.
How Can You Maintain Hedge Accounting under Reference Rate Reform?
The accounting standards specify when and how companies can apply hedge accounting to their hedging activities. Even slight modifications in the hedging relationship, such as changes in hedge documentation, terms of the instrument, or terms of the financial instrument (hedged item), can lead to the need for “de-designation” of the hedging relationship. However, ASC 848 offers optional expedients that help maintain the hedging relationship without de-designation when changes or expected changes to critical terms occur due to reference rate reform.
Here are the other optional expedients a company may elect to use:
All Types of Hedging Relationships
• Hedging instrument contractual terms can be changed via direct contract amendments or by entering into a fully offsetting derivative contract to replace the original with revised terms.
• Systematic and rational methods used can be changed to recognize any excluded components in earnings.
Fair Value Hedges
• Change the designated benchmark interest rate that either adjusts the hedged item’s cumulative fair value hedge basis adjustment or maintains the hedged item’s cumulative basis adjustment.
• Disregard certain qualifying conditions for the shortcut method in a fair value hedging relationship for the entire duration of the relationship.
Cash Flow Hedges
• Disregard potential changes when assessing hedged forecasted transaction probability, and continue the cash flow hedge accounting if highly effective or optional expedients are used.
• Continue to apply the shortcut method for cash flow hedges despite not meeting certain qualifying conditions.
• Adjust hedge effectiveness assessment methods to disregard certain mismatches.
• Use a qualitative method to assess subsequent hedge effectiveness, suspending the required assessments.
• Disregard shared risk exposure for cash flow hedges of portfolios of forecasted transactions.
A company can apply optional expedients for hedge accounting relationships on an individual basis, allowing for the choice of electing them for certain hedging relationships while not electing them for others of a similar nature, unlike the optional expedients for contract modifications.
It’s Time to Get Ready
With the discontinuance of USD LIBOR settings on June 30, 2023, it’s crucial for companies to promptly review and revise contracts and leverage optional expedients offered by the Reference Rate Reform.
