By the end of 2021, the London Interbank Offered Rate (LIBOR) will be phased out as a benchmark interest rate. Once the most common reference rate in the global financial markets, previous scandals have prompted banks and other entities to move away from LIBOR as a benchmark interest rate.
Reference rate reform impacts trillions of dollars in loans, derivatives and other financial contracts. Companies in all industries with contracts that reference LIBOR, should feel a sense of urgency to modify those contracts in order to transition them away from LIBOR.
In 2017, global regulators decided to discontinue the use of LIBOR after bankers were caught manipulating it to profit on the financial instruments supported by LIBOR. Published reports suggest that the rate-fixing scheme might have been taking place since 2005 — or even as early as 2003.
LIBOR, a daily calculation, is supposed to represent the rate banks pay to borrow money from each other. It approximates the risk-free cost of borrowing and serves as the foundation of variable interest rate financial products. Banks have used LIBOR to determine what rates to charge on various types of loans. It also may be incorporated into other contracts, including:
- Customer agreements
- Supply agreements
- Pension plans
- Insurance policies
- Intercompany loans and receivables
One reason the transition from LIBOR presents challenges is that contract management isn’t centralized in many organizations. In addition, the change isn’t as simple as replacing LIBOR with an alternative rate, such as the Secured Overnight Financing Rate (SOFR). LIBOR provides a theoretical rate that a major bank might charge a competitor to borrow funds overnight. However, SOFR is based on interest rates associated with loan repurchasing agreements. Because SOFR is transaction-based, it’s also less susceptible to manipulation.
After the cessation of LIBOR was announced, U.S. companies raised concerns about the operational challenges the change would impose in accounting for contract modifications and hedge accounting. Normally, under U.S. Generally Accepted Accounting Principles, contract modifications must be evaluated to determine whether the modifications result in the establishment of new contracts or the continuation of existing contracts.
Depending on the number of contracts involved, companies could incur huge costs as they implement the changes and the burdens would be challenging. Stakeholders also said the financial reporting results should reflect the intended continuation of such contracts and arrangements during the period of the market-wide transition to alternative reference rates.
Another major concern stems from fears that rate reform could disallow the application of certain hedge accounting guidance. As a result, certain hedging relationships may not qualify as “highly effective” during the rate reform transition period and cause financial reporting outcomes that don’t reflect companies’ intended hedging strategies.
FASB Steps In
The Financial Accounting Standards Board (FASB) has provided guidance to help companies transition away from LIBOR. In March 2020, the FASB published Accounting Standards Update (ASU) No. 2020-04, Reference Rate Reform: Facilitation of the Effects of Reference Rate Reform on Financial Reporting. Companies must consistently apply this guidance to all contracts and hedging transactions that reference LIBOR.
The updated guidance allows companies to:
- Account for eligible contracts that are modified as a continuation of those contracts, eliminating the need to reassess or remeasure the contracts for accounting purposes
- Preserve their hedge accounting during the transition period
- Make a one-time election to transfer or sell held-to-maturity debt securities that are affected by rate reform
These alternatives and exceptions don’t apply to contract modifications made and hedging relationships entered into or evaluated after December 31, 2022. (An exception is hedging relationships existing as of December 31, 2022, that an entity has elected certain optional expedients for and are retained through the end of the hedging relationship.)
Are You Ready?
Though ASU 2020-04 took effect immediately, some entities still haven’t addressed the effects of reference rate reform on their year-end financial statements.
Contact us with questions about your LIBOR transition program. We are here to help.