LIBOR Transition: Understanding FASB's Latest Reference Rate Reform Guidance

In March, the FASB issued ASU 2020-04 on the “Facilitation of the Effects of Reference Rate Reform on Financial Reporting.”

This guidance provides optional practical expedients and exceptions to GAAP for contracts, hedge relationships and other transactions subject to modifications resulting from the elimination of IBORs and the implementation of reference rate reform.

The main objective is to ensure that the transition away from LIBOR does not trigger accounting issues. The FASB has come up with optional expedients to make the transition as easy as possible, taking into consideration the fact that the transition is likely to happen over time rather than all at once and there will be a very high volume of contracts that transition. This ASU applies to contract modifications and hedge relationship evaluations on or before December 31, 2022.

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The Main Hedge Accounting Related Provisions

Contract Changes Due to Reference Rate Reform (RFR) Will Not Impact Prior Accounting Determinations.

Most of the changes are allowed on a hedge-by-hedge basis. Interest rate hedgers applying ASC 815 will not be required to de-designate and re-designate their hedge relationships due to:

  • Changes in the critical terms of the hedged item or hedge instrument for Cash Flow, Fair Value or Net Investment hedges that are related to rate changes
  • A change to re-balance hedge relationships in a Cash Flow or Fair Value hedge
  • A change in the method of assessing effectiveness in a Cash Flow hedge

Excluded Component Permitted Modifications

  • An entity may change its systematic and rational method of recognizing changes in the excluded component
  • If rate reform impacts the fair value of the excluded component the change in fair value can be recognized in current earnings
  • These optional expedients can be elected based on individual hedging relationships

Fair Value Hedges

  • A change in the designated benchmark is permitted
  • Changes to short-cut assumptions made at inception can be ignored for reference rate changes
  • Changing the proportion hedged or combining two hedge instruments into a hedge relationship is permitted and effectiveness can be assessed via a new method

Cash Flow Hedges

  • Probability assessments for designated hedged interest rate risk subject to rate reform can be made assuming no rate change
  • Cash Flow hedge accounting can continue if the relationship remains highly effective utilizing a new reference rate
  • Cash Flow hedges taking short-cut can continue even though reference rates have changed
  • If a highly effective hedge relationship has been determined and an optional expedient is used then effectiveness can be assessed on a qualitative basis thereafter and subsequent quantitative effectiveness assessments suspended through December 31, 2022
  • For a forecasted portfolio of transactions subject to rate reform, the requirement that all individual transactions must share the same risk exposure can be disregarded during the transition

Embedded Derivatives

A contract modified due to rate reform shall not be subject to re-evaluating whether the contract contains an embedded derivative that remains clearly and closely related

Applicable Dates

This update is effective beginning March 12, 2020 through December 31, 2022 – a year after the projected cessation of LIBOR.

Using any optional expedients from this update must be documented in the existing hedge inception designation documentation:

  • De-designation/re-designation is not required
  • For public companies designation documentation changes (administrative updates) must be completed no later than on the date of the next effectiveness assessment
  • For private companies designation documentation changes (administrative updates) must be completed no later than the release of interim financial statements (if applicable) or the release of its annual financial statement

Conclusion

ASU 2020-04 was issued in March of this year. Its objective is to ease the accounting transition related to the elimination of certain “IBOR” based interest rate indexes and migration to new reference rates based on reference rate reform.

To allow a much easier transition around contracts, hedge accounting and other transactions, certain practical optional expedients are permitted. Under most conditions, hedge relationships will not be required to be de-designated. All optional expedients implemented must be documented as an administrative update of the original hedge designation documents. Most of the expedients expire on December 31, 2022.

See ASU 2020-04 and topic ASC 848 for more information on reference rate reform. If you or your team have any questions related to transitioning from IBOR-based interest rates to new reference rates, please contact us.