Reference Rate Reform
On March 12, 2020, the Financial Accounting Standards Board (FASB) issued an Accounting Standards Update (ASU) to provide temporary optional guidance to ease the potential burden in accounting for reference rate reform.
Why Is the FASB Issuing This ASU?
In response to concerns about structural risks of interbank offered rates (IBORs), and, particularly, the risk of cessation of the London Interbank Offered Rate (LIBOR), regulators in several jurisdictions around the world have undertaken reference rate reform initiatives to identify alternative reference rates that are more observable or transaction based and less susceptible to manipulation.
Stakeholders raised certain operational challenges likely to arise in accounting for contract modifications and hedge accounting because of reference rate reform. Some of those challenges relate to the significant volume of contracts and other arrangements, such as debt agreements, lease agreements, and derivative instruments, which will be modified to replace references to discontinued rates with references to replacement rates.
For accounting purposes, such contract modifications are required to be evaluated in determining whether the modifications result in the establishment of new contracts or the continuation of existing contracts. Stakeholders indicated that due to the significant volume of affected contracts and other arrangements, together with a compressed time frame for making contract modifications, the application of existing accounting standards on modifications could be costly and burdensome. In addition, stakeholders indicated that financial reporting results should reflect the intended continuation of such contracts and arrangements during the period of the market-wide transition to alternative reference rates.
Stakeholders raised additional accounting issues specific to hedge accounting. In particular, changes in a reference rate could disallow the application of certain hedge accounting guidance, and certain hedge relationships may not qualify as highly effective during the period of the market-wide transition to a replacement rate.
Stakeholders indicated that 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.
What Are the Main Provisions in ASU?
The amendments in the ASU provide 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 amendments in the ASU apply only to contracts, hedging relationships, and other transactions that reference LIBOR or another reference rate expected to be discontinued due to reference rate reform. The expedients and exceptions provided by the amendments do not apply to contract modifications made and hedging relationships entered into or evaluated after December 31, 2022, except for hedging relationships existing as of December 31, 2022, that an entity has elected certain optional expedients for and are retained through the end of the hedging relationship.
The guidance provides the following optional expedients that reduce costs and complexity of accounting for reference rate reform:
- Simplify accounting analyses under current GAAP for contract modifications if qualifying criteria are met.
- Modifications of loans and debt are accounted for by prospectively adjusting the effective interest rate.
- Modifications of leases do not require reassessment of the lease classification, the discount rate (for example, the incremental borrowing rate), or remeasurements of lease payments that would otherwise be required under current GAAP.
- Modifications of contracts do not require a reassessment of whether an embedded derivative should be accounted for as a separate instrument.
- Modifications of contracts for which explicit relief is not stated are not considered an event that requires contract remeasurement at the modification date or reassessment of a previous accounting determination.
- Allow hedging relationships to continue without dedesignation upon the following changes in the critical terms of an existing hedging relationship due to reference rate reform.
- A change in the critical terms of a designated hedging instrument in a fair value hedge, a cash flow hedge, or a net investment hedge.
- A change to rebalance or adjust the hedging relationship.
- For a cash flow hedge, a change in the method used to assess hedge effectiveness when initially applying an optional expedient method and when reverting to the requirements under current GAAP.
- Allow a change in the systematic and rational method used to recognize in earnings the components excluded from the assessment of hedge effectiveness.
- Provide optional expedients for fair value hedging relationships for which the derivative designated as the hedging instrument is affected by reference rate reform:
- An entity may change the designated benchmark interest rate documented at hedge inception to a different eligible benchmark interest rate.
- 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 conditions for the remainder of the hedging relationship.
- Provide optional expedients for cash flow hedging relationships affected by reference rate reform:
- An entity should disregard the potential change in the designated hedged interest rate risk that may occur when the entity assesses whether the hedged forecasted transaction is probable and an entity may continue hedge accounting for a cash flow hedge.
- For cash flow hedges for which the shortcut method or another method that assumes perfect hedge effectiveness has been applied, entities may continue to apply that method.
- An entity 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 because of reference rate reform.
- If an entity has performed an initial hedge effectiveness assessment for a cash flow hedge, the entity may elect to subsequently assess hedge effectiveness using a qualitative method.
- For cash flow hedges of portfolios of forecasted transactions, an entity may disregard the requirement that the group of individual transactions must share the same risk exposure for which they are designated as being hedged.
- Allow a one-time election to sell or transfer, or both sell and transfer, debt securities classified as held to maturity that reference a rate affected by reference rate reform and are classified as held to maturity before January 1, 2020.
- The optional expedients for contract modifications are applied consistently for all eligible contracts or eligible transactions within the relevant Topic or Industry Subtopic within the Codification that contains the guidance that otherwise would be required to be applied.
- The optional expedients for hedging relationships are elected on an individual hedging relationship basis.
- The one-time election to sell or transfer, or both sell and transfer, debt securities classified as held to maturity does not require an entity to transfer all its remaining debt securities that meet the qualifying conditions.
Who Will Be Affected by the Amendments in This ASU?
The amendments in the ASU are elective and apply to all entities, subject to meeting certain criteria, that have contracts, hedging relationships, and other transactions that reference LIBOR or another reference rate expected to be discontinued due to reference rate reform.
When Will the Changes Be Effective?
The amendments are effective for all entities from the beginning of an interim period that includes the issuance date of the ASU. An entity may elect to apply the amendments prospectively through December 31, 2022.