Introduction
BC1. The following summarizes the Board’s considerations in reaching the conclusions in this Update. It includes reasons for accepting certain approaches and rejecting others. Individual Board members gave greater weight to some factors than to others.
Background Information
BC2. Since 2014, the Board has been actively monitoring the reference rate reform initiative undertaken globally to identify suitable alternatives to unsecured market benchmarks based on interbank offered rates. In March 2020, the Board issued Accounting Standards Update No. 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting. The amendments in that Update provide optional guidance for a limited time period to ease the potential burden on financial reporting in accounting for (or recognizing the effects of) reference rate reform.
BC3. Since the issuance of Topic 848, the Board has continued to monitor global reference rate reform developments to identify whether further improvements to the guidance in Topic 848 are needed to assist stakeholders. One such recent development relates to market-wide changes in the interest rates used for margining, discounting, or contract price alignment for derivative instruments related to reference rate reform (commonly referred to as the “discounting transition”). The discounting transition is not limited to derivative trades cleared by a central counterparty; bilateral trades of noncleared derivatives may undergo the discounting transition as well.
BC4. The discounting transition may result in an immediate increase or decrease in a derivative instrument’s fair value upon the change in the discount rate used by a market participant to value the affected derivative instrument, which may trigger a corresponding change in the related margining requirement. A cash compensation payment (or equivalent) may be exchanged to neutralize the effect of the change in the fair value of the derivative instrument, and the neutralizing adjustment may offset the receipt of or the requirement to post additional margin.
BC5. The specific mechanics of the discounting transition and the effect it will have on individual market participants has been evolving over the past several months. Recently, market participants began analyzing the accounting implications of those mechanics against the available exceptions and expedients within Topic 848.
BC6. Stakeholders raised questions about whether the guidance in Topic 848 can be applied to derivatives that do not reference a rate that is expected to be discontinued but that are affected by reference rate reform as a result of the discounting transition. Stakeholders raised concerns about the potential need to reassess previous accounting determinations related to those contracts. Stakeholders also raised concerns about the possible hedge accounting consequences of the discounting transition. To avoid potential diversity in practice emerging under current GAAP, timely standard setting was needed to ensure consistent application of available exceptions and optional expedients in Topic 848 for all derivative instruments and hedging relationships affected by the discounting transition.
BC7. On October 29, 2020, the Board issued proposed Accounting Standards Update, Reference Rate Reform (Topic 848): Scope Refinement, with comments due on November 13, 2020. The Board received 11 comment letters on the amendments in that proposed Update. Overall, respondents supported the proposed amendments and noted that the proposed amendments would ease the potential accounting burden arising from the discounting transition. Some respondents made suggestions to clarify specific aspects of the proposed amendments, which are described below in the basis for conclusions section. Some respondents also highlighted other accounting consequences related to reference rate reform that they indicated the Board should consider.
Benefits and Costs
BC8. The objective of financial reporting is to provide information that is useful to present and potential investors, creditors, donors, and other capital market participants in making rational investment, credit, and similar resource allocation decisions. However, the benefits of providing information for that purpose should justify the related costs. Present and potential investors, creditors, donors, and other users of financial information benefit from improvements in financial reporting, while the costs to implement new guidance are borne primarily by present investors. The Board’s assessment of the costs and benefits of issuing new guidance is unavoidably more qualitative than quantitative because there is no method to objectively measure the costs to implement new guidance or to quantify the value of improved information in financial statements.
BC9. The Board concluded that the amendments in this Update will reduce or mitigate the costs and complexity of accounting for contract modifications and hedging relationships affected by reference rate reform by providing optional expedients and exceptions to existing accounting requirements. Given the pervasiveness of contracts affected by reference rate reform, and the discounting transition in particular, the Board notes that the scope clarification in this Update will provide cost savings to a wide array of financial statement preparers. Furthermore, the amendments will result in financial reporting that reflects the intended continuation of contracts and hedging relationships. The Board determined that reassessing prior derivative accounting conclusions and discontinuing hedge accounting because of the discounting transition would not provide decision-useful information to users of financial statements. Similarly, the Board concluded that disallowing net investment hedges executed with receive-variable-rate, pay-variable-rate cross-currency interest rate swaps if a leg is modified as a result of reference rate reform would not reflect a meaningful change to a hedging strategy and, thus, would not provide decision-useful information to users of financial statements. Overall, the Board concluded that the expected benefits, including cost savings for financial statement preparers, should justify any expected costs of adopting the amendments.
Basis for Conclusions
Scope
BC10. The current scope of Topic 848 could be interpreted as limited to contracts and transactions that reference LIBOR or a reference rate that is expected to be discontinued as a result of reference rate reform. Modifications to terms that are considered related to the replacement of the reference rate are those made to effectuate the transition away from LIBOR or another reference rate expected to be discontinued and are not the result of a business decision that is separate from or in addition to changes to the terms of a contract to effect that transition.
BC11. The Board recognizes that the current scope of Topic 848 may be interpreted as precluding derivative instruments that are affected by the discounting transition from qualifying for relief if the derivative does not reference LIBOR or another rate expected to be discontinued due to reference rate reform. However, the Board observes that the changes being made to those derivative instruments because of the discounting transition also stem from reference rate reform. Furthermore, the nature of the changes arising from the discounting transition are consistent, in a broad sense, with the notion of modifications “related to the replacement of a reference rate” under the criteria in paragraph 848-20-15-5. Specifically, paragraph 848-20-15-5(h), which indicates changes that are necessary to comply with laws or regulations or to align with market conventions for the replacement rate, is an illustration of the type of event that the Board considered to be related to the replacement of a reference rate.
BC12. The Board acknowledges that the inability to qualify for accounting relief would be an operational burden for market participants with derivatives indexed to reference rates that are continuing after reference rate reform (for example, the Effective Federal Funds Rate [EFFR]) when those derivatives are undergoing the same discounting transition as derivatives that are indexed to reference rates that are expected to be discontinued because of reference rate reform (for example, LIBOR). The Board concluded that the financial reporting outcomes of reassessing accounting conclusions for such derivative instruments and for hedging relationships that include those derivatives as hedging instruments would not provide decision-useful information to users of financial statements.
BC13. For those reasons and to reduce potential diversity in practice, the Board decided to clarify the scope of Topic 848 to explicitly include derivatives affected by the discounting transition that do not reference LIBOR or another rate expected to be discontinued due to reference rate reform. As a result, certain provisions of the guidance in Topic 848, if elected by an entity, apply to derivative instruments that do not reference a rate being discontinued due to reference rate reform but that use an interest rate for margining, discounting, or contract price alignment that is modified as a result of reference rate reform.
BC14. The Board concluded that the scope clarification results in financial reporting that better reflects the economic substance of derivative instruments affected by the discounting transition. The Board observed that the discounting transition, in and of itself, should not cause entities to reassess previous accounting conclusions or result in the discontinuation of hedge accounting if those hedging relationships otherwise continue to be highly effective.
BC15. As a consequence of clarifying the scope of Topic 848, both derivatives that reference a rate that is expected to be discontinued as a result of reference rate reform and those that reference a rate that is expected to continue after reference rate reform that are affected by the discounting transition are eligible for the contract modification relief in Topic 848. That is consistent with the Board’s belief that modifications related to reference rate reform are not considered an event that requires reassessment of previous accounting conclusions. The Board decided that the election to apply contract modification relief in Subtopic 848-20 to account for derivative instruments that change the interest rate used for margining, discounting, or contract price alignment is separate from the election to apply that relief to account for other derivative instrument modifications.
BC16. The scope clarification in this Update also provides for certain hedge accounting optional exceptions and expedients to be applied to derivative instruments that are subject to the discounting transition but that do not reference a rate that is expected to be discontinued as a result of reference rate reform. The amendments extend the following relief to address potential challenges of applying hedge accounting to such hedging relationships:
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For a derivative designated as a hedging instrument in a fair value, cash flow, or net investment hedge, an entity may continue hedge accounting rather than consider the discounting transition to cause a change in critical terms of the hedging relationship, which would otherwise require an entity to dedesignate the hedging relationship.
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For a derivative designated as a hedging instrument in a fair value, cash flow, or net investment hedge, upon the discounting transition an entity may change its systematic and rational method used to recognize the excluded component into earnings and adjust the fair value of the excluded component through earnings.
BC17. Stakeholders also noted several unique accounting complexities that may arise for existing fair value and cash flow hedging relationships due to the discounting transition. Those complexities relate to the change in the discount rate and may arise as a result of the accounting for the cash compensation payment (or equivalent) that may be exchanged to neutralize the effect of the change in the fair value of the derivative instrument as part of the discounting transition. Stakeholders indicated that those hedge accounting complexities may arise for both derivatives that reference a rate that is expected to be discontinued as a result of reference rate reform (that is, derivatives that meet the scope of paragraph 848-10-15-3) and those that reference a rate that is expected to continue after reference rate reform (that is, derivatives that meet the scope of paragraph 848-10-15-3A).
BC18. Specifically, if the change in the fair value of the hedging instrument related to the discounting transition in a cash flow hedge is not reflected in accumulated other comprehensive income because of the neutralizing adjustment, there could be a mismatch between the fair value of the derivative and the amount deferred in accumulated other comprehensive income. Accordingly, as a consequence of clarifying the scope of Topic 848 to include derivative instruments affected by the discounting transition, the amendments in this Update allow an entity flexibility in adjusting the amount recorded in accumulated other comprehensive income using a reasonable method, which includes immediate recognition of the amount in current-period earnings.
BC19. An entity applying a reasonable method to adjust the amount recorded in accumulated other comprehensive income may continue to apply an assessment method that assumes perfect effectiveness if the affected hedge was previously applying that method. In the Board’s view, that adjustment is similar to the spread adjustment that is expected to be reflected in derivative instruments as a result of the transition from LIBOR (or another rate that is expected to be discontinued) to a replacement rate, which is considered to be related to reference rate reform in paragraph 848-20-15-5(b). The inclusion of that spread adjustment was not intended to disrupt the application of hedge accounting.
BC20. In a fair value hedging relationship accounted for under the shortcut method, if the change in fair value of the hedging instrument related to the discounting transition is not reflected in the basis adjustment of the hedged item because of the neutralizing adjustment, there could be a mismatch between the fair value of the derivative and the fair value hedge basis adjustment. In connection with clarifying the scope of Topic 848, the amendments in this Update provide an entity with the option to apply an approach that adjusts the hedged item’s cumulative fair value hedge basis adjustment for the amount of that difference using a reasonable method. In that circumstance, an entity could continue to account for the fair value hedge under the shortcut method if the affected hedge was previously applying that method. In the Board’s view, that is consistent with the relief provisions related to a change in the benchmark rate in a fair value hedge under the shortcut method as a result of reference rate reform as well as the inclusion of the spread adjustment in paragraph 848-20-15-5(b).
BC21. The proposed Update included prescriptive guidance on adding a basis swap to an existing hedging relationship because of the discounting transition. In consideration of feedback received on the proposed Update that the basis swap guidance would create unnecessary complexity, the Board decided to remove it. However, the Board retained the optional relief that allows an entity to continue the application of the shortcut method after a basis swap is added to change the reference rate index of the hedging instrument in a fair value hedge. Stakeholders did not raise similar complexity concerns about that provision.
Net Investment Hedges
BC22. In response to a question for respondents in the proposed Update on other accounting consequences related to reference rate reform that the Board should consider, stakeholders identified an issue related to the effect of reference rate reform on receive-variable-rate, pay-variable-rate cross-currency interest rate swaps designated as hedging instruments in net investment hedges. Stakeholders requested that the Board consider providing relief that would allow a receive-variable-rate, pay-variable-rate cross-currency interest rate swap to be an eligible hedging instrument in a net investment hedge if the repricing intervals and dates of the variable legs of the swap do not match as required by paragraph 815-20-25-67(a)(2) because of reference rate reform.
BC23. The Board observed that the suggested relief is consistent with the intent of facilitating the market transition for reference rate reform and is akin to similar amendments in Update 2020-04 that allow for a temporary misalignment in reset dates between the forecasted transaction and the hedging instrument for cash flow hedges. Thus, the Board decided to add relief that allows a receive-variable-rate, pay-variable-rate cross-currency interest rate swap to be designated as the hedging instrument in a net investment hedge if the repricing terms of the variable legs of the swap do not match because of reference rate reform. The Board notes that the amendments in this Update provide relief from considering the mismatched terms in the assessment of hedge effectiveness for affected hedges.
Effective Date and Transition
BC24. The Board decided that the amendments in this Update should be effective for all entities upon issuance of this Update on January 7, 2021. Consistent with all exceptions and expedients within Topic 848, the amendments related to the discounting transition are optional.
BC25. An entity, regardless of whether it has adopted the amendments in Accounting Standards Update No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, may elect to apply the amendments in this Update for contract modifications that change the interest rate used for margining, discounting, or contract price alignment on a full retrospective basis as of any date from the beginning of the interim period that includes or is subsequent to March 12, 2020, or on a prospective basis to new modifications from any date within the interim period that includes or is subsequent to January 7, 2021, up to the date that financial statements are available to be issued.
BC26. An entity may elect to apply the amendments in this Update (a) to eligible hedging relationships existing as of the beginning of the interim period that includes March 12, 2020, and (b) to new eligible hedging relationships entered into after the beginning of the interim period that includes March 12, 2020. If an entity elects to apply any of the amendments for an eligible hedging relationship, any adjustments as a result of those elections must be reflected as of the date that the entity applies the election. Consistent with the transition provisions in Update 2020-04, an entity that has not adopted the amendments in Update 2017-12 may apply only certain elements of the hedge accounting relief in this Update before it adopts the amendments in Update 2017-12.
BC27. The Board notes that an entity can no longer apply the optional exceptions and expedients for contract modifications and hedging relationships for reporting periods after December 31, 2022, with the exception of certain optional expedients. That exception is consistent with the existing sunset provisions within Topic 848 in which the accounting effects of certain optional expedients are recognized over the remaining life of the hedging relationship, and that hedging relationship may extend beyond December 31, 2022. The Board also notes that reference rate reform is expected to be temporary in nature, and the objective of the amendments in this Update is to facilitate the effects of reference rate reform on financial reporting for the market-wide transition period in which an entity replaces reference rates with alternative reference rates, including for the purposes of margining, discounting, or contract price alignment. Therefore, after an entity stops applying the amendments, the entity should apply existing accounting requirements for contract modifications and hedging relationships.