LIBOR Replacement & Hedge Accounting
The clock is ticking for the ultimate end of LIBOR. Here’s what companies should consider now for their hedge designations.
Global contracts representing hundreds of trillions of dollars, a number that’s likely multiples of annual global GDP, reference a rate that’s being replaced by the end of 2021. The LIBOR (London Inter-bank Offered Rate) is arguably the most important number in the world and many companies are asking if they are prepared for a transition that will happen in less than 18 months. Specifically, some companies are asking how the transition away from LIBOR will impact existing hedge accounting designations. The following is a discussion of:
- Why LIBOR is being phased out;
- What will replace it;
- What actions that can be taken now; and
- Hedge accounting considerations.
Why Is LIBOR Going Away & What Will Replace It?
LIBOR is based on various banks’ proprietary observations rather than robust market transactions. This has left the rate vulnerable to manipulation and major rate-fixing scandals that came to light starting in 2007. As a result, the U.K.’s Financial Conduct Authority (FCA) decided that it will no longer compel banks to submit LIBOR estimates by the end of 2021. Once banks aren’t required to submit estimates, the banks will likely no longer provide the information and the rate discontinues. Even considering the recent coronavirus pandemic, regulators and industry organizations have no plans to delay the end of LIBOR.
The U.S. Federal Reserve Board (the “Fed”) convened the Alternative Reference Rates Committee (ARRC) in 2014 to establish a viable alternative to the U.S. dollar LIBOR. The ARRC determined in 2017 that the overnight indexed swap (OIS) rate based on the Secured Overnight Financing Rate (SOFR), a broad treasury repurchase agreement financing rate used when banks borrow or loan treasuries overnight, would be its preferred alternative reference rate. The industry belief is that SOFR is harder to manipulate than LIBOR as it’s based on real transactions, unlike LIBOR. The current transition timeline proposed by AARC has SOFR being the primary replacement for LIBOR in the U.S. by the end of 2021.
Even with the short timeline to a transition away from LIBOR, many companies aren’t in a position to support SOFR-linked debt products. One area of concern is that LIBOR incorporates a premium reflecting credit and liquidity risk for a borrowing bank if it’s not able to repay an interbank loan. SOFR doesn’t incorporate this risk and would require a spread between the two rates. This will require some form of adjustment during the transition. In addition, the SOFR market isn’t as mature and currently doesn’t offer a similar variety of products.
What Actions Should Companies Take Now?
The primary action companies should take at this time is to increase organizational awareness, carefully monitor the execution of new agreements and inventory existing agreements and valuation models referencing LIBOR. While some may be aware of the impending LIBOR replacement, there may be a lack of appreciation of how broadly the event will impact the organization beyond hedging and debt activities. Increasing awareness throughout the organization will also assist in monitoring the execution of new agreements referencing LIBOR.
"The primary action companies should take at this time is to increase organizational awareness, carefully monitor the execution of new agreements and inventory existing agreements and valuation models referencing LIBOR."
When executing new agreements, management should carefully consider language addressing alternative or fallback rates if LIBOR is unable to be determined. If contracts aren’t amended to include alternative rates or fallback provisions in the absence of LIBOR before the relevant LIBOR index is discontinued, it could cause settlement issues or render contracts invalid.
From an accounting and financial reporting standpoint, the impact could be substantial. The primary areas affected include hedge accounting and accounting for debt modifications. In addition, discount rates for impairment testing, lease accounting, asset retirement obligations and fair value estimates will need to be assessed. Fortunately, both the U.S. and international accounting regulatory bodies, Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB), appear to be aligned and will provide significant relief for the transition, particularly in the area of hedge accounting.
Hedge Accounting Considerations
There are two major provisions to achieve hedge accounting that’s required under both U.S. GAAP and IFRS, documentation and effectiveness assessment. Documentation is something done at the inception of the hedge relationship, and the requirements are very specific. Documentation requirements include documenting the nature of the hedged risk, identifying the hedging instrument, defining the hedged item and stating how effectiveness assessment requirements will be met. For interest rate hedge designations, the underlying interest rate is key to all these documentation requirements and to performing the associated effectiveness assessment testing.
"When executing new agreements, management should carefully consider language addressing alternative or fallback rates if LIBOR is unable to be determined."
The FASB issued optional relief in ASC 848, Reference Rate Reform. The guidance provides expedients that can be applied to derivatives, debt contracts and other agreements impacted when LIBOR is no longer available. ASC 848 provides optional relief; this means that it’s an accounting election. Accounting elections require formal documentation stating that the company meets the requirements of an accounting election and that the company is making the associated election. If the documentation isn’t performed, the election cannot be taken.
If the election is made and appropriately documented, companies can ignore certain economic mismatches that arise due to the reference rate reform in hedge designations. Specifically, the guidance:
- Allows hedging relationships to continue without de-designation if there are qualifying changes in the critical terms of an existing hedging relationship due to reference rate reform.
- Allows a change in the systematic and rational method used to recognize in earnings the components excluded from the assessment of hedge effectiveness.
- Allows a change in the designated benchmark interest rate to a different eligible benchmark interest rate in a fair value hedging relationship.
- Simplifies the assessment of hedge effectiveness and provides temporary optional expedients for cash flow hedging relationships affected by reference rate reform.
- Allows cash flow hedges where the designated hedged risk is LIBOR or other discontinued rate to assert that the hedged forecasted transaction remains probable to occur.
On April 9, 2020, the IASB released an exposure draft of phase two amendments to IFRS in response to Interbank Offered Rates (IBOR) reform. The exposure draft addresses accounting issues that arise when financial instruments complete the transition from IBOR. The comment period ended May 25, 2020, and the resulting accounting guidance is expected to be very similar to that provided by the FASB for U.S. GAAP.
The replacement of LIBOR is quickly approaching, and companies should carefully consider the impact to their existing contracts and hedge accounting designations. Opportune LLP is the industry’s leading provider of valuation and hedge accounting services. Please contact one of the firm’s experts for additional information.
About the Author:
As a Managing Director at Opportune LLP, Shane Randolph assists companies and financial institutions throughout North America, South America, Europe and Asia-Pacific in their understanding of what’s possible as they deal with the challenges of implementing risk management programs and highly technical accounting pronouncements. He oversees the risk management, derivatives, stock-based compensation and complex securities service offerings of Opportune LLP. He assists clients with the entire risk management life cycle, including strategy, execution, compliance, valuation and hedge accounting. He has undergraduate and graduate degrees in accounting from Oklahoma State University. He also is a member of the American Institute of Certified Public Accountants and maintains a Series 3 Securities License.