What Does Reference Rate Reform Mean for Financial Reporting?
November 12, 2020
By William Van Aken and Kushal Dagli
The London Interbank Offered Rate (“LIBOR”) has been the benchmark interest rate for financial contracts, lease agreements and derivatives for decades. However, global markets, participants, and regulators (like the U.K. Financial Conduct Authority) expect the termination of LIBOR by the end of 2021. In anticipation to this cessation risk, the Financial Accounting Standards Board (“FASB”) has issued Accounting Standards Update (“ASU”) 2020-04, Reference Rate Reform (Topic 848), directly addressing the effects of reference rate reform on financial reporting.
The amendment is effective March 12, 2020, through December 31, 2022. It provides optional expedients and exceptions for applying generally accepted accounting principles to contracts, hedging relationships and other transactions affected by reference rate reform by virtue of referencing LIBOR or another reference rate expected to be discontinued. The optional expedients outlined in the ASU are:
- Modifications of contracts within the scope of Topics 310, Receivables, and 470, Debt, should be accounted for by prospectively adjusting the effective interest rate.
- Modifications of contracts within the scope of Topics 840, Leases, and 842, Leases, should be accounted for as a continuation of the existing contracts with no reassessments of the lease classification and the discount rate (e.g., the incremental borrowing rate) or re-measurements of lease payments that otherwise would be required under those topics for modifications not accounted for as separate contracts.
- Modifications of contracts do not require an entity to reassess its original conclusion about whether that contract contains an embedded derivative that is clearly and closely related to the economic characteristics and risks of the host contract under Subtopic 815-15, Derivatives and Hedging-Embedded Derivatives.
Further, a general principle is included in the ASU permitting entities to consider contract modifications due to reference rate reform not to require contract re-measurement at the modification date or reassessment of a previously made accounting determination.
Companies should identify and inventory all contracts that contain interest reference rates and perform an impact assessment of LIBOR discontinuation. Contracts need to be evaluated and mitigation, if any, needs to be completed for existing contracts. This evaluation and risk mitigation may span several reporting periods. Companies should consider disclosing the status of its efforts to date and the significant matters yet to be address.
The impact of the reform may span numerous areas of organizations, including:
Long-term adjustments – An interest-reference-rate transition may affect whether a loan term adjustment is a new loan or a loan modification. The accounting is different for each. ASC 470-50, Debt Modification and Extinguishments, provides guidance.
Debt covenant changes – Debt contracts may need to be renegotiated. Some debt contracts may contain interest-reference-rate “fallback” clauses that would impact the reference-rate difference impacts. A different reference rate could, however, result in a higher interest expense that may indirectly impact debt covenants and cash flow.
Interest rate hedges – Companies utilize interest rate swaps to reduce their risk exposure to asset and liability fair-value changes or to cash-flow risk exposure due to interest-rate fluctuations. Hedges could become ineffective if the interest reference rate changed on either the hedged item (debt) or the hedge (interest rate swap).
Internal control updates – Internal controls need to be updated along with accounting and financial processes. This includes debt compliance, inputs used in valuation models, and potential income tax consequences. Operating management will need to understand the differences between LIBOR and the Secured Overnight Financing Rate (“SOFR”) or other alternative rates, as well as how this affects contract negotiations and interest cost calculations. Valuation models may include an interest reference rate, and a rate change may impact discount rates.
Communication with the investors – Companies should communicate to their investors the potential accounting and financial changes and the impact on the expected return due to potential increase in the borrowing cost, hedge ineffectiveness and change in the valuation.
In 2017, the Alternative Reference Rates Committee identified SOFR as the best representation to replace LIBOR for certain new financial contracts and USD derivatives. As this transition still holds uncertainty, SOFR may not be the only alternative rate available for contracts and derivatives. This will certainly be looked at on a deal-by-deal basis, so it is imperative to examine the ramifications with your trusted business advisor.