To compensate counterparties for the time value of money, many contracts reference interest rate indices (reference rates). For example, a debt instrument may have a coupon that periodically resets based upon the then-current reference rate. The London Interbank Offered Rate (LIBOR) has been one of the most commonly used reference rates in the global financial markets. In July 2017, the United Kingdom’s Financial Conduct Authority announced that it would no longer persuade or compel banks to submit LIBOR as of the end of 2021. In November 2020, the ICE Benchmark Administration (the administrator to LIBOR) announced its consults on its intention to cease the publication of the one week and two month US dollar (USD) LIBOR settings as well as all non-USD LIBOR settings immediately following the LIBOR publication on December 31, 2021, and the remaining USD LIBOR settings immediately following the LIBOR publication on June 30, 2023. Concerns about the sustainability of LIBOR and other interbank offered rates (IBORs) globally has led to an effort to identify alternative reference rates, as it is currently expected that non-USD LIBOR settings will cease to exist beyond 2021 while USD LIBOR settings are expected to cease to exist beyond June 2023. In the United States, the Alternative Reference Rates Committee (ARRC) convened by the Federal Reserve identified the Secured Overnight Financing Rate (SOFR) as its preferred alternative reference rate to US dollar LIBOR.
The shift away from the most widely used interest rate benchmarks to alternative reference rates is a significant change for the global financial markets. The impact of this change is not limited to financial services companies; it will impact all companies. IBOR rates are frequently used in financial instruments, such as debt agreements, investments, and derivatives, but may also be present in leases, compensation arrangements, and contracts with customers. Preparing for the impact of IBOR reform is likely to be a significant effort and will require a multidisciplinary team to identity where IBOR is used and negotiate changes to arrangements. Many institutions are already working to insert provisions frequently referred to as “fallback language” into new or existing agreements. These provisions specify how a replacement rate will be identified (and other terms, such as how the spread above the reference rate will be changed) once a trigger event (such as LIBOR no longer being quoted) occurs. Industry working groups continue to develop standard fallback terms for a number of financial instruments that they are recommending entities adopt.
From an accounting perspective, IBOR reform has the potential to create challenges when accounting for contract modifications and hedging relationships. For example, there may be a significant volume of contracts that will need to be modified and then assessed to determine whether the modification results in the establishment of a new contract or a continuation of the existing contract for accounting purposes. In addition, modifications related to reference rate reform to derivatives or hedged items involved in hedging relationships could result in de-designations of otherwise highly effective hedges.
As a result, on March 12, 2020, the FASB issued ASU 2020-04
, Reference Rate Reform (Topic 848), Facilitation of the Effects of Reference Rate Reform on Financial Reporting
(the “ASU”). This ASU, which introduces ASC 848
to the Codification, provides relief that, if elected, will require less accounting analysis and less accounting recognition for modifications related to reference rate reform. The ASU provides specific guidance relating to instruments subject to ASC 310
, ASC 470
, ASC 840
or ASC 842
, and ASC 815
, Derivatives and Hedging
. It also includes a principle that provides relief from contract modification requirements in other guidance not explicitly addressed.
A number of reporting entities are looking to amend agreements in preparation for reference rate reform in the short-term. As a result, the guidance was effective for all reporting entities immediately upon issuance on March 12, 2020, and a reporting entity could have elected to apply the optional expedients in the guidance from the beginning of the interim period that includes the effective date upon issuance. However, a reporting entity is not required to adopt the guidance upon issuance and can elect to apply the optional expedients prospectively in a reporting period subsequent to March 12, 2020. The relief is designed to be temporary, and as a result, this guidance cannot be applied subsequent to December 31, 2022, except for certain optional expedients elected for hedging relationships (see REF 4.1.4
for additional information).
In January 2021, the FASB issued ASU 2021-01
, Reference Rate Reform (Topic 848): Scope,
to clarify the scope of ASC 848
to include derivatives that are affected by a change in the interest rate used for margining, discounting, or contract price alignment that do not also reference LIBOR or another reference rate that is expected to be discontinued as a result of reference rate reform. Similar to ASU 2020-04
, the guidance is effective for all reporting entities immediately upon issuance on January 7, 2021. A reporting entity may elect to apply the guidance retrospectively as of any date from the beginning of an interim period that includes or is subsequent to March 12, 2020, or prospectively to any new modifications within an interim period including or subsequent to January 7, 2021 (see REF 4.1.1
and REF 4.1.2
for additional information).