The London Interbank Offer Rate (LIBOR) is the current interest benchmark for bonds, loans, derivatives and securitizations worldwide. However, LIBOR will be phased out at the end of 2021, which means financial institutions, lessors, and many other companies that currently rely on LIBOR will need to modify their agreements that reference LIBOR and replace them with a suitable alternative reference rate.
Read on to discover more about how the loss of LIBOR might affect your company and what to do about it.
Key Changes in ASU 2020-04 & 2021-01
When FASB issued Accounting Standards Update (ASU) 2020-04 on March 12, 2020, it provided optional expedients and exceptions for applying U.S. GAAP to contract modifications, hedging relationships and other transactions affected by the transition away from LIBOR.
The operational impact of the modifications required by the transition to an alternative reference rate is likely to be significant. Accordingly, the FASB focused on granting certain relief specific to contract modifications:
- Modifications to contracts within the scope of ASC Topics 310, Receivables, and 470, Debt, may be accounted for as a continuation of the existing contract (i.e., by prospectively adjusting the effective interest rate).
- Modifications to contracts within the scope of ASC Topics 840 and 842, Leases, may be accounted for as a continuation of the existing contracts with no reassessments of the lease classification and the discount rate (e.g., the incremental borrowing rate) or remeasurements of lease payments that otherwise would be required under those Topics for modifications not accounted for as separate contracts.
- Contract modifications do not require reassessment of whether embedded derivatives are considered clearly and closely related to the host contract under Subtopic 815-15, Derivatives and Hedging-Embedded Derivatives.
- For other Topics or industry Subtopics, the amendments also include a general principle that entities may consider in-scope contract modifications as events that do not require contract remeasurement or reassessment of previous accounting determinations.
However, the FASB has stipulated certain requirements in order to qualify for the contract modification expedients. For example, other terms being concurrently modified need to be related to the replacement of a reference rate and because of reference rate reform.
All elected expedients are required to be consistently applied to all eligible contract modifications within a given Codification Topic or industry Subtopic.
In addition to the contract modification expedients, the FASB has also provided expedients related to the application of hedge accounting. Prior to the expedients, a change in reference rate could potentially nullify the ability to qualify for hedge accounting treatment pursuant to ASC 815. Accordingly, the FASB provided a number of expedients and exceptions that impact the application of hedge accounting that are designed to allow entities to sustain their historical hedge accounting in light of the reference rate reform.
Effective Date and Transition
The amendments in this Update are effective for all entities as of March 12, 2020
through Dec. 31, 2022.
An entity may elect to apply the amendments for contract modifications by Topic
or Industry Subtopic as of any date from the beginning of an interim period that
includes or is subsequent to March 12, 2020, or prospectively from a date within
an interim period that includes or is subsequent to March 12, 2020, up to the date
that the financial statements are available to be issued. Once elected for a Topic
or an Industry Subtopic, the amendments in this Update must be applied
prospectively for all eligible contract modifications for that Topic or Industry
An entity may elect to apply the amendments in this Update to eligible hedging
relationships existing as of the beginning of the interim period that includes March
12, 2020 and 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 existing as of the beginning of the interim period that includes March
12, 2020, any adjustments as a result of those elections must be reflected as of
the beginning of that interim period and recognized in accordance with the
guidance in Reference Rate Reform Subtopics 848-30, 848-40, and 848-50 (as
applicable). If an entity elects to apply any of the amendments for a new hedging
relationship entered into between the beginning of the interim period that includes
March 12, 2020, any adjustments as a result of those elections must be reflected as of the beginning of the hedging relationship and recognized in accordance with the guidance in Reference Rate Reform Subtopics 848-30, 848-40, and 848-50 (as applicable).
For private companies that are not financial institutions as described in paragraph
942-320-50-1 and not-for-profit entities (except for not-for-profit entities that have
issued, or are a conduit bond obligor for, securities that are traded, listed, or quoted
on an exchange or an over-the-counter market), an entity must update its hedge
documentation noting the changes made before the next interim (if applicable) or
annual financial statements are available to be issued. All other entities must update their hedge documentation noting the changes made no later than when the entity performs its first quarterly assessment of effectiveness after the election.
The amendments in this Update do not apply to contract modifications made after
Dec. 31, 2022, new hedging relationships entered into after Dec. 31, 2022, and hedging relationships evaluated for periods after Dec. 31, 2022, except for hedging relationships existing as of Dec. 31, 2022, that apply the following optional expedients that are retained through the end of the hedging relationship (including for periods evaluated after Dec. 31, 2022):
- An optional expedient to the systematic and rational method used to
recognize in earnings the components excluded from the assessment of effectiveness
- An optional expedient to the rate to discount cash flows associated with
the hedged item and any adjustment to the cash flows for the designated
term or the partial term of the designated hedged item in a fair value
An optional expedient to not periodically evaluate certain conditions when
using the shortcut method for a fair value hedge.
If an entity has not adopted the amendments in ASU No. 2017-12, Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities, the entity may elect only the following optional expedients for hedge accounting:
- An optional expedient allowing changes in critical terms of a hedging
- An optional expedient allowing a change in the method designated for
use in assessing hedge effectiveness in a cash flow hedge, if the optional
expedient method being elected is the simplified hedge accounting
approach for eligible private companies for initial hedge effectiveness or
for subsequent hedge effectiveness
- An optional expedient allowing the entity to assume that the hedged
forecasted transaction in a cash flow hedge is probable of occurring
- An optional expedient allowing the entity to assume that the reference
rate will not be replaced for the remainder of the hedging relationships for
initial and subsequent hedge effectiveness when the entity is using any
of the methods for assessing and measuring hedge effectiveness in a
cash flow hedge on a quantitative basis and if both the hedged forecasted
transaction and the hedging instrument have an eligible reference rate
- An optional expedient allowing the entity to disregard certain
requirements of the simplified hedge accounting approach for eligible private companies for initial hedge effectiveness or for subsequent hedge
effectiveness in a cash flow hedge.
In January 2021, the FASB issued ASU 2021-01 to provide additional clarification pertaining to certain optional expedients and exceptions in Topic 848 for contract modifications and hedge accounting applying to derivatives that are affected by the discounting transition. This change broadened Topic 848 to include derivatives instruments that use an interest rate for margining, discounting, or contract price alignment that is modified as a result of reference rate reform. This guidance was effective upon issuance for all reporting entities.
Where Can I Learn More?
For more information on how the latest accounting changes to reference rates could affect your business, contact us.
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