From the IFRS Institute – March 5, 2021
The International Accounting Standards Board (the IASB® Board) has a two-phase IBOR1 reform project. Phase I amendments (now effective) provide targeted relief for hedge accounting. Phase II amendments are effective in 2021 and focus on post-IBOR reform issues. Read this article for an IBOR reform update and to understand how the amendments apply to your company.
What’s the latest on IBOR reform?
The sunset date for discontinuation of most tenors of IBOR is December 31, 2021. In November 2020, Intercontinental Exchange (the administrator of LIBOR) proposed to extend the use of certain USD LIBOR tenors to June 30, 2023. This was based on feedback from panel banks and regulators, and excludes one-week and two-month tenors, which are intended to cease being published by December 2021.
This move, if confirmed, could be misread as an extension of LIBOR. Instead, it is designed to smooth transition by allowing most legacy contracts indexed to USD LIBOR to mature before LIBOR is discontinued. US federal banking agencies issued a joint statement encouraging companies to cease using LIBOR for new contracts as soon as practicable or no later than December 31, 2021, to facilitate an orderly LIBOR transition.
Global efforts are well underway to transition from IBORs to alternative benchmark rates – e.g. the Secured Overnight Financing Rate (SOFR) in the US – but progress is slow. For example, the issuance of SOFR-linked debt and SOFR futures trading activity increased steadily throughout 2020; however, issuance of SOFR-linked debt is significantly concentrated in government-sponsored enterprises (> 60%) and banks (~ 30%), rather than corporates.2 Additionally, USD derivatives have been slow to transition to SOFR when compared to other markets – e.g. UK GBP derivatives.3,4
While some progress has been made in transitioning LIBOR-based derivatives to SOFR-based derivatives, only 5.6% of all USD risk in cleared over-the-counter and exchanged-traded interest-rate derivative transactions were tied to SOFR as of November 2020. The slow progress in transitioning to SOFR could undermine a smooth transition away from LIBOR – posing risk to financial stability, and delaying the Alternative Reference Rate Committee’s ability to develop a forward-looking term reference rate.5
Transition delays related to COVID-19 have also been reported, and recent SEC filings6 show companies are increasingly disclosing risks related to the transition to meet regulatory and accounting disclosure requirements.7 Although companies have had to focus on the urgent matter of dealing with COVID-19, regulators and central banks have been clear that preparation for the IBOR transition process should not be delayed.
In June 2020, the SEC’s Office of Compliance Inspections and Examinations announced its intention to conduct examinations to assess companies’ preparation for IBOR transition. Further, a November 2020 public statement by the SEC Chairman “encourage[s] registrants to proactively transition to market-based reference rates and stand ready to assist market participants.” These explicit statements by the SEC should serve as motivation for all companies to be proactive about transitioning away from LIBOR.
Reza van Roosmalen, KPMG Principal – US Accounting Advisory, observed: “Despite the COVID-19 pandemic disruption, companies should not lose sight of fully transitioning away from IBOR. Companies need to identify the accounting and operational impacts to their organization and then apply the practical expedients provided by the IASB Board’s two-phase project.”
The IASB Board’s IBOR reform project
In August 2020, the IASB Board published its IBOR reform Phase II amendments, the final touch to its two-phase IBOR reform project.
Phase I amendments provide targeted and temporary relief to hedge accounting in the period leading up to IBOR replacement, which is discussed in KPMG article, IFRS Perspectives: Accounting standards boards respond to IBOR reform.
The Phase II amendments are broader. They address the accounting once a new benchmark rate is in place and companies update reference rates in their contracts. This includes dealing with the effects of changes to contractual cash flows or hedging relationships arising from benchmark rate replacement. The relief comes in the form of mandatory practical expedients and temporary exceptions.
The Phase II amendments apply retrospectively for annual periods beginning on or after January 1, 2021, with earlier application permitted.
Phase II: post-IBOR reform relief for financial assets and liabilities, and leases
The Phase II amendments cover the following issues:
|Accounting area||Phase II amendments require companies to:|
Modification of a financial asset or financial liability
- First apply the practical expedient if the transition to an alternative benchmark rate is necessary as a direct consequence of IBOR reform and the change occurs on an ‘economically equivalent’ basis.
- Do not recognize a modification gain or loss or change the carrying amount of the financial instrument; instead, update the effective interest rate prospectively to reflect the change in benchmark rate.
- If there are other changes to the contractual cash flows, apply appropriate requirements of IFRS 9.
- Insurers applying IAS 399 will also apply similar amendments.
Modification of a lease – lessees only
- Apply the practical expedient for a lease modification required by IBOR reform by remeasuring the lease liability using a revised discount rate reflecting the change in interest rate.
|Transition – No requirement to restate prior periods||Amendments are applied retrospectively. Prior periods may be restated only if possible without the use of hindsight.|
Required disclosures include:
- qualitative information about how the company is managing its IBOR transition, its transition progress at the reporting date, and the risks arising from financial instruments because of the transition;
- quantitative information about the financial instruments yet to be transitioned at the reporting date, disaggregated by each significant interest rate benchmark, and showing nonderivative financial assets, nonderivative financial liabilities and derivatives separately; and
- to the extent that IBOR reform has resulted in changes to the company’s risk management strategy, disclose them.
Phase II: post-IBOR reform relief for hedging relationships
The Phase II amendments do not provide exceptions to the measurement requirements for hedged items and hedging instruments. Once the hedged risk or the hedging instrument transitions to the new benchmark rate, it is remeasured based on the new rate and subject to normal hedge accounting rules – e.g. hedge ineffectiveness is recognized in profit or loss.
However, under the amendments, a company can avoid discontinuing existing hedging relationships, if that relationship would be discontinued solely due to IBOR reform. If so, the IBOR reform temporary exceptions are applied; if not, existing guidance applies.
The Phase II amendments may require companies to reinstate hedging relationships that were previously discontinued solely due to changes required by IBOR reform had the Phase II amendments been applied at the time of discontinuation and the discontinued hedging relationship meets all qualifying criteria for hedge accounting at the beginning of the reporting period in which the Phase II amendments are applied.
Once a company ceases to apply the IBOR Phase I amendments to a hedging relationship, it will apply the following Phase II amendment exceptions.