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Accounting standards boards respond to IBOR reform

Accounting standard setters address stakeholder concerns about benchmark rate transition.

From the IFRS Institute – February 28, 2020

An alternative benchmark rate is expected to replace the London Interbank Offered Rate (LIBOR) by the end of 2021. This change may pose stability and liquidity risks for global markets, and introduces financial risks and accounting challenges to all companies with LIBOR exposures – banks and corporates alike. Regulators, accounting standard setters and industry participants are engaged in developing a smooth transition to alternative benchmark rates, such as the Secured Overnight Financing Rate (SOFR) in the US. Both the International Accounting Standards Board and the FASB are developing transition relief for hedge accounting, and modifications to financial instruments and leasing.

What is happening to LIBOR as we know it?

LIBOR1 and certain other Interbank Offered Rates (IBORs) are expected to be replaced as market participants transition their exposure to various alternative benchmark rates by the end of 2021 (‘IBOR reform’). Working groups have been established in major jurisdictions to identify alternative benchmark rates or to strengthen the calculation methodology for IBORs that will not be replaced. The transition away from IBORs in jurisdictions where an alternative benchmark rate is identified is intended to be a gradual market shift, rather than a flip of the switch at the end of 2021.

Transition is already underway in many markets. In fact, the number of SOFR derivatives increased 1,243%2 in the last quarter of 2019 from its fourth quarter 2018 trading levels. Trading activity of SOFR derivatives is expected to continually rise in the coming months, particularly as the market is beginning to see newly issued cash instruments reference SOFR instead of LIBOR. For example, in December 2019, a government-sponsored enterprise priced the first commercial mortgage securitization to contain a class of bonds indexed to SOFR.

Stacy Keating, KPMG Partner—US Accounting Advisory and LIBOR Lead, observes: “IBOR reform has been given more focus by US preparers lately. This is partly attributable to the push by accounting standard setters and regulators across the world to address new challenges that this market-wide shift will have over the next two years. Companies need to closely monitor the transition away from LIBOR and other IBORs since the replacement alternative benchmark rate varies across global jurisdictions and the market for specific benchmark rates may shift at different times.”

What are the accounting impacts of IBOR reform?

Absent standard setting, the shift in benchmark rate could have significant and unintended effects on companies’ financial statements. For example, hedge accounting relationships may need to be terminated because of difficulty asserting that the future hedged cash flows are highly probable, if the cash flows are indexed to a benchmark interest rate that is expected to go away – e.g. an IBOR-indexed loan. Modification of financial instruments and/or lease contracts to change the contractual benchmark rate may result in a reassessment of the existing contracts.

IASB® Board project Phase I: pre-IBOR reform issues

The IASB Board has a two-phase project to assist in a smoother transition away from IBOR.

The Phase I amendments3 provide targeted and temporary relief to hedge accounting in the lead up to IBOR reform. They provide the ability to continue hedge accounting in certain circumstances and apply to all hedging relationships directly affected by uncertainties related to IBOR reform. The amendments are mandatory – to avoid cherry-picking relationships that would be terminated or continued – and effective in 2020. Earlier application is permitted.

The amendments cover the following issues:

Existing hedge accounting requirement

Phase I amendments require companies with hedges affected by IBOR reform to:

Assessment of whether the future cash flows are ‘highly probable’
  • Assume the interest rate benchmark on which hedged cash flows are based is not altered by IBOR reform.
  • For discontinued hedging relationships, apply the same assumption for determining whether hedged future cash flows are expected to occur.
Prospective assessment of whether the economic relationship between the hedged item and the hedging instrument exists
  • Assume the interest rate benchmark on which the hedged item and the hedging instrument are based is not altered by IBOR reform.
Retrospective assessment (IAS 39 only)
  • Not discontinue a hedging relationship during the period of uncertainty arising from IBOR reform solely because the actual results of the hedge are outside the 80–125% range.
  • If a hedging relationship is outside the 80–125% range, apply the other conditions in IAS 394, including the prospective assessment, to assess whether the hedging relationship should be discontinued.
Eligibility of certain risk components (for a hedge of a non-contractually specified benchmark component of interest rate risk)
  • Allow an exception so that the ‘separately identifiable’ requirement is applied only at inception of the hedging relationship.
  • Apply the same exception to the redesignation of hedged items in hedges where dedesignation and redesignation take place frequently (e.g. macro hedges).
Disclosures

For hedging relationships directly affected by IBOR reform, disclose:

  • the significant interest rate benchmarks to which hedging relationships are exposed;
  • the extent of risk exposure that is affected by IBOR reform;
  • how the transition to alternative benchmark interest rates is being managed;
  • a description of significant assumptions made in applying the amendments; and
  • the nominal amount of the hedging instruments in those hedging relationships
End of application
  • Cease application of hedge accounting relief prospectively, at the earlier of when: (1) the uncertainty regarding the timing and the amount of interest rate benchmark based cash flows is no longer present, or (2) the hedging relationship is discontinued or all amounts from the cash flow hedge reserve have been reclassified.
  • Perform the assessment of uncertainty on an item-by-item basis for hedges involving groups of items.

IASB Board project Phase II: post-IBOR reform issues

Discussions of Phase II of the IASB Board’s project launched in September 2019 and focuses on accounting matters that will arise once an existing benchmark rate is replaced with an alternative benchmark rate. The topics addressed cover classification and measurement, hedge accounting, the effects of IBOR reform on financial reporting and key disclosure requirements. The IASB Board is considering reliefs for modifications to financial instruments and amendments to hedge documentation that are related to IBOR reform. Other standards, such as leases and insurance contracts, may also be amended.

The following key reliefs are being proposed by the IASB Board5:

  1. A practical expedient for ‘modifications directly required by the IBOR reform’ would allow the effective interest rate to be updated based on the revised cash flows without adjusting the carrying amount. After applying the practical expedient, companies would apply the current IFRS 9 requirements to assess any other modifications to that financial instrument.
  2. Amending hedge documentation to reflect modifications directly required by IBOR reform would not result in a discontinuation of the hedge in certain instances.
  3. Lessees would receive a practical expedient under which they can account for lease modifications directly required by IBOR reform under existing guidance (IFRS 16) related to changes in floating interest rates.
  4. The currently effective insurance contracts standard (IFRS 4) would be amended so that insurers applying IAS 39 can also apply the amendments and practical expedient in accounting for modifications of financial instruments directly required by IBOR reform.
  5. As an explicit requirement, companies would disclose the nature and extent of risks arising from IBOR reform to which they are exposed, and how they are managing those risks.

The IASB Board is expected to issue its Phase II exposure draft in April 2020.

For more on IASB Board standard setting activity related to IBOR reform visit our website, KPMG Insights: IBOR reform.

The FASB response to IBOR reform

The FASB also has a proposal6 – expected to be issued as a final standard shortly – to address accounting issues relating to contract modifications and hedge accounting related to reference rate reform. Unlike IFRS Standards, the FASB would provide practical expedients and exceptions to existing US GAAP that may be applied optionally on a Codification Topic-by-Topic basis. The expedients and exceptions would stop applying to contract modifications made and hedging relationships entered into, or evaluated after, December 31, 2022.

For more on FASB standard-setting activity related to IBOR reform visit our website, KPMG Insights, Transitioning to LIBOR.

How have regulators responded?

Regulators around the world are encouraging companies to proactively resolve identified issues, discuss transition plans with counterparties, and implement alternative reference rates in advance of the discontinuation date.

In 2019, the SEC encouraged7 companies to add additional disclosures relating to IBOR reform, including steps to evaluate and mitigate the expected risks, identified material exposures, and potential effects of the reform on the company. In addition, the SEC will closely track and evaluate8 IBOR reform. Companies should evaluate their exposure to IBOR, for example, by reviewing fallback language in contracts and its use of benchmarks and indices. Accounting systems and risk models may also be impacted.

The European Securities and Markets Authority (ESMA) drew attention to the IASB Board Phase I amendments in its 2019 European common enforcement priorities. Regulators in the United Kingdom9 have observed that there continues to be comprehensive reliance on and use of IBOR, and they expect companies to consider tools and metrics to monitor exposure to IBOR.

Regulatory scrutiny is expected to continue to increase in 2020 as LIBOR and certain other IBORs transition away. For example, the New York State Department of Financial Services required its regulated depository and non-depository institutions, insurers and pension funds to submit to the Department their plans to address their LIBOR transition risk plan by February 10, 2020. In addition, LIBOR transition was discussed at the SEC Investor Advisory Committee meeting on February 27, 2020.

Key takeaways

  • Certain markets will gradually shift from LIBOR and other IBORs to the designated alternative benchmark rate before the end of 2021.
  • Companies need to adequately disclose their exposure to IBOR reform, the expected impacts, and how the entity is managing the financial and operational impacts of the reform.
  • All companies applying IFRS Standards must apply the amendments to IFRS 9, IAS 39 and IFRS 7 relating to hedge accounting from Phase I, effective January 1, 2020.
  • Phase II of the IASB Board project should provide targeted relief post-IBOR reform for classification and measurement, hedge accounting and other effects on financial statements.
  • Dual reporters should monitor standard-setting activity expected in the coming year, for potential differences between IFRS Standards and US GAAP.   

Footnotes

1 LIBOR is quoted for five currencies throughout the world.  The use of LIBOR in this article refers to the US dollar LIBOR. The use of IBOR in this article refers to any interbank offered rate that is impacted by reform, which may include LIBOR.

2 International Swaps and Derivatives Association (ISDA),  Interest Rate and Credit Derivatives Weekly Trading Volume; weeks ending: October 5, 2018 through December 29, 2018, and October 4, 2019 through December 13, 2019

3 Interest Rate Benchmark Reform (amendments to IFRS® 9 Financial Instruments, IAS® 39 Financial Instruments: Recognition and Measurement, and IFRS 7 Financial Instruments: Disclosures) are effective for annual periods beginning on or after January 1, 2020. They apply retrospectively for those hedging relationships that existed at the beginning of the reporting period in which the company first applies the amendments.

4 IAS 39, Financial Instruments, para 88

5 IBOR Reform and its Effects on Financial Reporting—Phase 2, IASB Board project page

6 FASB Proposed Accounting Standards Update, Facilitation of the Effects of Reference Rate Reform on Financial Reporting

7 SEC Staff Statement on LIBOR Transition, July 2019

8 SEC 2020 Examination Priorities, January 2020

9 Bank of England Prudential Regulation Authority, Firms’ preparations for transition from London InterBank Offered Rate (LIBOR) to risk-free rates (RFRs): Key themes, good practice, and next steps, June 2019

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Stacy Keating
Partner, Accounting Advisory Services, KPMG US
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Stacy Keating
Partner, Accounting Advisory Services, KPMG US
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Partner, Dept. of Professional Practice, KPMG US
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