Why the need for a change in benchmark rates?
Change is coming! If you’ve been keeping an eye on the news impacting the accounting community, or read our blog on the trends noted at the 2019 AICPA Conference, you’ve probably started to hear some rumblings about benchmark interest rate reform and how we, as financial statement preparers, need to start thinking about it now, but what is all the fuss about?
Well, for more than 40 years, the financial services industry has been relying on what are known as interbank offered rates, or IBORs, as the underpinnings of the financial products they offer, including variable rate loans, bonds, derivative instruments, securitizations and more! In other words, these reference rates are used in just about everything a bank has to offer! And one IBOR in particular is very prevalently used in the US markets: the London Interbank Offered Rate (LIBOR). In fact, LIBOR underpins over $300 trillion in financial products!! So, why replace them? One of the main reasons is because there is an inherent flaw with the rates: it was possible to manipulate them, as evidenced by a rate-rigging scandal that came to light a few years back.
As a result of the lack of reliability on these IBOR rates, the UK, the US, and other countries plan to phase out IBORs and move to new benchmark rates, known as alternative reference rates (ARRs) by the end of 2021. In the US, the Secured Overnight Financing Rate (SOFR) will be the most likely replacement for LIBOR, and in the UK, it seems like the most likely replacement will be the Sterling Overnight Index Average (SONIA). But for other IBORs (i.e. EURIBOR), the replacements are less clear.
What’s the big deal with IBOR reform?
Because we are talking about benchmark rates that underpin almost all financial products based on variable interest rates, we are talking big changes that will impact ALL industries…not just financial institutions! If your entity has any of the following, you can expect an impact:
- IBOR-based debt or assets (e.g. USD LIBOR, GBP LIBOR, EURIBOR, etc.)
- Hedged debt (fixed or floating) with derivatives that reference an IBOR
- Discounted cash flows based on an IBOR-based rate in valuation models
As you can see, most entities are at least likely to check one of the boxes above. And entities can expect a few challenges to arise as a result of the move away from IBORs to ARRs:
- Renegotiation of contracts: Entities will have existing contracts referencing these IBOR rates. These contracts will need to be amended or renegotiated. These renegotiations could have an accounting impact on the financial asset or liability with which it is associated.
- Hedging relationships: Entities in hedging relationships (under IFRS or U.S. GAAP) will need to assess whether their hedge remains highly effective and still qualifies for hedge accounting after the change in rates.
- Valuation models: Any valuation model that employs a discounting technique based on an IBOR rate will need to be re-worked and adjusted to consider a more relevant and reliable ARR.
- All rates are not created equal: The rates are not created equal. IBOR is a forward-looking rate that underpins uncollateralized or unsecured debt and may have a 1-month or 3-month tenor. ARRs, like SOFR, however, are backward-looking overnight rates that assume the debt is secured by collateral. It is almost more akin to a risk-free rate. Entities will not be able to replace their 3-month LIBOR rate with a 3-month SOFR rate, because no such rate exists.
Who within the entity will feel the effects? Well, according to this resource from PwC, some cross-functional areas that could be impacted with the change in rates include:
- Risk management
- Financial reporting
What are the standard-setters doing about it?
Some of the key standard-setters and regulatory agencies have set to work in helping financial statement preparers get ready for the impending changes. Let’s see what each has been up to.
The FASB began a project to look into Reference Rate Reform and states on the project page that “Reference Rate Reform is a top priority for the FASB and the Board is working to do everything it can to help ensure a smooth transition from an accounting perspective during the lead up to the migration away from the LIBOR.”
As part of this project, the FASB approved an accounting standards update in November 2019 to help ease the burden of transitioning to a new reference rate. The final ASU will provide optional expedients and exceptions for applying generally accepted accounting principles to contract modifications and hedge accounting relationships affected by reference rate reform, facilitating a smoother transition to new reference rates. The expedients and exceptions allow, among other things, for a change in the reference interest rate to be accounted for as a continuation of that contract and companies will also be permitted to preserve their hedge accounting.
Of course, this is in addition to ASU 2018-16, which adds the Overnight Index Swap (OIS) and the Secured Overnight Financing Rate (SOFR) as benchmark rates for hedge accounting purposes.
On the other side of the pond, the IASB has also been busy trying to alleviate the burden on financial statement preparers. The IASB has created a project, IBOR Reform and its Effects on Financial Reporting and divided it into two phases:
- Phase 1: The IASB issued an amendment to IFRS 9, IAS 39, and IFRS 7 in September 2019 (effective January 1, 2020). This phase deals with pre-replacement issues, most notably as it relates to hedge accounting and the assessment of whether a forecast transaction is highly probable and effectiveness testing. The amendment also introduces some additional disclosure requirements related to Reference Rate Reform and the transition away from IBORs.
- Phase 2: This phase deals with issues that affect financial reporting when an IBOR is replaced with an ARR (or risk-free rate, RFR, in IFRS-speak). This phase of the project is still ongoing, but the IASB plans to address issues such as determining whether a modification has occurred and the accounting implications related to that decision (modification accounting, derecognition accounting, etc.). Stay tuned for more!
As you can see, this is going to be a big deal for certain entities that rely heavily on IBOR-based financial products. Therefore, it should come as no surprise, the SEC has also taken the opportunity to weigh in on this issue. They released a statement in July 2019 outlining their thoughts on what entities need to do now for a successful transition away from LIBOR. In the statement, they discuss the need to keep an eye on the global environment because different countries are evaluating what the replacement rates will be and it is still an evolving landscape. They also discuss the need to consider both existing contracts and future contracts to minimize and mitigate the exposure to IBOR-based rates.
And, in true SEC fashion, they encourage preparers to include disclosures to warn investors of the potential risks and impacts and what the company is doing about those risks. In particular, they note that the following areas may be impacted by additional disclosures:
- Risk factors
- Management’s discussion and analysis (MD&A)
- Board risk oversight
- Financial statements
What should I be doing now?
As the SEC alluded to in their statement, step one for any entity should be to begin the process of identifying existing contracts that extend out past 2021 to determine their exposure to LIBOR (or any IBOR). Step two will be to look at future contracting requirements and ensure that your entity is minimizing its future exposure to IBOR-based rates. For more on what you can be doing now, make sure to check out this great article from EY outlining 7 steps you can take to prepare for the end of LIBOR.
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