Many companies pay interest on variable rate loans, based on the London Interbank Offered Rate (LIBOR). In response to a series of scandals in which regulators uncovered banks colluding in an attempt to manipulate LIBOR and profit from financial instruments supported by LIBOR, LIBOR will phase out by 2021.
How will LIBOR’s disappearance impact company financial statements? The Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) are evaluating the issue, and urging public and private companies to do the same.
What is LIBOR?
Today, LIBOR is the most common reference rate in global financial markets. LIBOR, in its simplest form, provides a theoretical rate that a major bank might charge a competitor to borrow funds overnight. It can also be considered a risk-free cost for borrowing.
The Federal Reserve estimates that LIBOR underpins about $200 trillion in transactions, including short-term loans, derivatives and other contracts. That’s roughly 10 times the U.S. gross domestic product (GDP).
By the end of 2021, more than $35 trillion of that total will not mature when LIBOR is phased out. Many contracts have no fallback language to replace LIBOR, or their fallback language assumes LIBOR’s dissipation is temporary. It could convert floating rate to fixed rate contacts when the rate is discontinued.
What are the next steps?
The Federal Reserve Bank of New York provides a possible alternative to LIBOR: Secured Overnight Financing Rate (SOFR). The SOFR addresses LIBOR’s shortcomings by using interest rates associated with repurchasing agreements, which involves a large volume of overnight lending activity.
Secured by U.S. government securities, such as Treasury bills and bonds, these repurchasing agreements are real-world transactions. So, SOFR closely approximates the risk-free rate.
Switching SOFR for LIBOR minimizes the potential for market manipulation because the Federal Reserve assumes responsibility for aggregation and reporting, rather than a corporation. By comparison, individual companies assume responsibility for LIBOR aggregation and reporting.
The FASB prepares for the transition
The FASB plans to issue a proposal aimed at addressing reference rate reform effects on financial reporting, including the shift away from LIBOR and other reference rates, by late summer or early fall. The FASB plans to issue quickly a proposal for public comment.
The details aren’t yet solidified, but the FASB has agreed that contract reference rate changes, such as LIBOR, would be considered contributions of that contract, provided they met certain criteria. In addition, the changes will be principles-based and specify that LIBOR qualifies in the modifications scope. If finalized, the relief guidance would need to be applied prospectively and would end by January 1, 2023.
“The overall goal of the whole project is to not have the accounting complexity get in the way of the transition from LIBOR or any other IBORs,” said Shayne Kuhaneck, FASB’s Acting Technical Director. “We didn’t specify the rate that you had to shift to — so if you’re shifting to SOFR or you’re shifting to some other rate, as long as you meet the criteria, you would…be afforded the relief for the contract modification.”
Private companies typically lag behind public companies when adopting new accounting rules. In this case, however, the FASB stated that accounting relief would be applicable to both private and public companies simultaneously. This is because changes are driven by regulatory reform outside of the FASB’s control.
The SEC responds
Meanwhile, the SEC recently issued a staff statement urging companies that have yet to evaluate the risks associated with the LIBOR transitions to start doing so now. The market regulator is concerned that, if companies wait too long, it will be too late to address important issues associated with the global reference rate discontinuation.
“The risks the statement highlights deserve careful attention and I draw particular attention to the staff’s observation: ‘For many market participants, waiting until all open questions have been answered to begin this important work likely could prove to be too late to accomplish the challenging task required,’” said SEC Chairman Jay Clayton. “The SEC will continue to monitor disclosure and risk management efforts related to the LIBOR transition, and we welcome engagement from market participants on these important matters.”
An interest rate benchmark can have a pervasive impact on a company’s financial reporting and the staff has been monitoring transition efforts, according to the SEC’s Office of the Chief Accountant. Some issues that could affect accounting and financial reporting are:
- Terms modifications within debt instruments
- Hedging activities
- Inputs used in valuation models
- Potential income tax consequences
The SEC emphasized the need for robust disclosures on LIBOR’s anticipated discontinuation. Staff encouraged companies to consider the following guidance when deciding which disclosures are relevant and appropriate:
- The transition may span several reporting periods, so companies should consider disclosing the status of their efforts to date and the significant matters yet to be addressed
- When a company has identified a material exposure to LIBOR but doesn’t yet know the expected impact, it should consider disclosing
- Disclosures that allow investors to see this issue through management’s eyes are likely to be the most useful
In the real estate, banking and insurance industries, LIBOR transition disclosures are most common so far. The staff also noted that the larger the company, the more likely it is to disclose the risks. “However, for every contract held by one of these companies providing disclosure, there is a counterparty that may not yet be aware of the risks it faces or the actions needed to mitigate those risks,” notes the SEC.
For additional information
For assistance or questions on how the reference rate reform is likely to affect your organization, contact a Weaver professional today.
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