FASB’s proposed relief from reference rate reform – September 2019

Authored by Erin Scherbert

Background

In 2014 the Financial Accounting Standards Board (FASB) began monitoring the global reference rate reform initiatives to determine appropriate alternatives to unsecured market benchmarks based on interbank offered rates. As a result of this monitoring initiative, the FASB and the Federal Reserve Bank of New York formed the Alternative Reference Rate Committee (ARRC) to aid in the identification of a suitable alternative to U.S. Dollar London Inter-bank Offer Rate (LIBOR) and to create a plan of adoption to alternative reference rates. This initiative resulted in the ARRC identifying the Secured Overnight Financing Rate (SOFR) as the alternative reference rate to be utilized. Once the ARRC determined the SOFR was a suitable alternative, the Federal Reserve Bank of New York started publishing a daily SOFR rate and announced a transition plan into financial markets in 2018.

This initiative to find a suitable replacement to LIBOR was a worldwide concern, which caused regulators around the globe to undertake reference rate reform initiatives to identify alternative reference rates that are transactional-based and less susceptible to manipulation. The FASB has undergone this process to largely consider changes to generally accepted accounting principles (GAAP) as a way to aid the market-wide transition from LIBOR and other interbank offered rates (collectively referred to as IBORs).

As part of the initiative, the FASB solicited feedback from various types of users in order to identify accounting issues related to the market-wide transition from IBORs. They cited the feedback received centered around two primary issues:

1. “The operational costs to preparers when assessing significant volumes of contract modifications under guidance for accounting for contract modifications in accordance with the various areas of GAAP.”
2. “The potential inability to retain hedge accounting for existing hedges due to anticipated changes to the critical terms of hedging relationships, which would require automatic designation of a hedging relationship in accordance with GAAP, as well as potentially having the inability to qualify for hedge accounting due to reference rate reform.”

In order to address the two primary issues outlined above, the FASB faced several challenges. It was determined they needed to address the nature of the contracts requiring relief and the timing of issuance of guidance to correlate with contract modifications occurring in the normal course of business.

The nature of the contracts requiring relief, this hurdle is related to the extensiveness of expected modifications across the various types of contracts; for example, debt agreements, lease agreements, and derivative instruments. These instruments will need to be modified to replace the discontinued rates (e.g., LIBOR) with references to replacement rates (e.g., SOFR).

Timing of the proposed Accounting Standards Update (ASU) became a critical initiative of the FASB in order to allow companies to evaluate whether the modifications resulted in the establishment of a new contract or the continuation of an existing contract since the cost of implementing this accounting standard could be significant due to the large number of contracts being affected and the financial reporting results should reflect the intended continuation of these contracts and arrangements.

This ultimately correlates to the second accounting issue the FASB received feedback on. Feedback received noted the changes to reference rate reform could disallow the application of various hedge accounting guidance and some hedge relationships may not qualify as highly effective during the period of market-wide transition to a replacement rate, leading to financial reporting results of companies inappropriately reflecting hedging strategies when those strategies continue to operate as effective hedges.

Ultimately, the combination of the global market and FASB initiatives lead the FASB to issue a proposed ASU, “Referenced Rate Reform (Topic 848),” on Sept. 5, 2019. The proposed ASU will provide temporary optional guidance to alleviate the potential problems with accounting for and recognizing reference rate reform in financial reporting. The comment period for the proposed ASU ends on Oct. 7, 2019.

Primary provisions in the proposed ASU

As stated above, the amendments of the proposed ASU will provide only temporary optional expedient and exceptions for applying GAAP to contracts affected by referenced rate reform, if applicable criteria are met. Meaning only those contracts and hedging relationships which reference LIBOR or another reference rate will be discontinued upon implementation of reference rate reform.

Reference: “FASB InFocus – Reference Rate Reform” article dated Sept. 5, 2019

The proposed guidance outlines optional expedients aiding companies to reduce costs and accounting complexities of this reference rate reform. The primary expedients affected by reference rate reform are:

1. Optional expedients for accounting for contract modifications; or simply put, simplified accounting under current GAAP for contract modifications, if the following are met:
   a )     For those contract modifications of loans (Topic 310), debt (Topic 740), and other financial instruments would be accounted for prospectively by adjusting the effective interest rate.
   b )     Lease (Topic 842) modifications are accounted for as a continuation of the existing contract with no reassessment or remeasurement.
   c )     Modification of these contracts would not require reassessment as to whether or not an embedded derivative should be accounted for as a separate instrument.
   d )     Modified contracts where explicit guidance is not proposed are accounted for as a continuation of the contract with no reassessment.
2. For existing hedging relationships, allow the company to continue the existing hedge accounting rather than dedesignation of the hedging relationship once the following are modified:
   a )     Change in critical terms of a designated hedging instrument in a fair value cash flow or net investment hedge.
3. For existing fair value hedges, allow the company to change the hedged benchmark interest rate and allow continuation of this method for the remainder of the hedging relationship.
4. For existing and new cash flow hedges, provide temporary optional expedients as follows:
   a )     The company would ignore the potential change in the designated hedged risk that may occur due to reference rate reform when the entity assesses whether the hedged forecasted transaction is probable and an entity may continue hedge accounting for an existing cash flow hedge for which the hedged risk changes if either the hedge is highly effective or an optional expedient method is elected.
   b )     In an instance where the existing cash flow hedge, which the shortcut or another method assumes a perfect hedge effectiveness is applied, the company would be permitted to continue to apply this method.
   c )      If either the hedging instrument or hedged forecasted transactions would refer to a rate that is directly affected by reference rate reform, you are permitted to adjust application of the methods used to initially assess whether cash flow hedge accounting may be applied to ignore the mismatch in variable interest rate indexes between the designated hedging instrument and the hedged item.
   d )     In regards to new cash flow hedges of portfolios with forecasted transactions with reference rates affected by the rate reform, the company may disregard the requirement that the group of individual transactions share the same risk exposure for which they are being hedged by.
   e )     Existing and new cash flow hedges may adjust methods to subsequently assess whether cash flow hedge accounting may be applied to disregard mismatch in variable interest rate indexes between the designated hedging instrument and the hedged item resulting from reference rate reform. Or the company may elect an optional expedient to continue cash flow hedge accounting if qualifying criteria are met each period.

A company may elect to apply the amendments by electing the optional expedient for contract modifications applied consistently for all contracts or transactions within the applicable Topic, Subtopic, or Industry Subtopic, or elected on an individual hedging relationship.

Companies affected and effective dates

The proposed Update amendments are elective and apply to those companies who are subject to qualification criteria for contract modifications or hedging relationships which reference LIBOR or another reference rate affected by this rate reform.

The proposed amendment would be effective for all entities upon the issuance of a final Update. Upon adoption, an entity may elect to apply the proposed amendments prospectively to contract modifications made and to hedging relationships existing as of or entered into on or after the date of adoption and through Dec. 31, 2022. The proposed amendments would not apply to contract modifications made and hedging relationships entered into or evaluated after Dec. 31, 2022.

For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.

Sources:

1. Proposed Accounting Standards Update: “Reference Rate Reform (Topic 848)”
2. “FASB InFocus – Reference Rate Reform”