FASB Proposes Delay in Shift from LIBOR

On April 20, 2022, the Financial Accounting Standards Board (FASB) proposed to defer the sunset date of rate reform rules by two years to December 31, 2024, a year after the new cessation date of the London Interbank Offered Rate (LIBOR). The proposal would also amend the definition of the Secured Overnight Financing Rate (SOFR) Swap Rate as part of efforts to stay aligned with market developments to shift from LIBOR to other rates.

Background

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 as early as 2003.

LIBOR, a daily calculation, was intended to represent the rate that banks pay to borrow money from each other. For years, it has served as the foundation for variable interest rate financial products. LIBOR has been used by banks to determine what rates to charge on various types of loans. It also may be incorporated into other contracts, including:

  • Leases,
  • Customer agreements,
  • Supply agreements,
  • Pension plans,
  • Insurance policies, and
  • Intercompany loans and receivables.

The transition from LIBOR presents challenges, in part, because 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 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.

Mounting concerns

After the cessation of LIBOR was announced, U.S. companies began raising 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. Stakeholders also said that 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, some hedging relationships may not qualify as “highly effective” during the rate reform transition period and may cause financial reporting outcomes that don’t reflect companies’ intended hedging strategies.

Implementation guidance

The FASB issued the following three accounting standards updates (ASUs) to address rate reform:

  1. ASU 2018-16, Derivatives and Hedging (Topic 815): Inclusion of the Secured Overnight Financing Rate (SOFR) Overnight Index Swap (OIS) Rate as a Benchmark Interest Rate for Hedge Accounting Purposes, which permitted the OIS rate based on the SOFR to be considered a U.S. benchmark interest rate for hedge accounting purposes,
  2. ASU 2020-04, Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting, which provided temporary optional relief to certain contract modification guidance and hedge accounting requirements, and
  3. ASU 2021-01, Reference Rate Reform (Topic 848): Scope, which expanded the scope of the relief to derivative instruments that don’t reference a rate expected to be discontinued but that have an interest rate for margining, discounting or contract price alignment that’s modified because of reference rate reform.

Recent proposal

In March 2021, the UK Financial Conduct Authority (FCA) announced that the intended cessation date of the overnight 1-, 3-, 6-, and 12-month tenors of U.S. dollar LIBOR would be June 30, 2023, which is beyond the current sunset date of Topic 848. The FASB responded by issuing Proposed ASU 2022-001, Reference Rate Reform (Topic 848) and Derivatives and Hedging (Topic 815) Deferral of the Sunset Date of Topic 848 and Amendments to the Definition of the Secured Overnight Financing Rate (SOFR) Overnight Index Swap Rate.

The proposal would defer the sunset date of Topic 848 from December 31, 2022, to December 31, 2024. This is one year after LIBOR’s new cessation date — beyond that date entities would no longer be permitted to apply the relief in Topic 848.

The proposal would also amend the definition of SOFR as part of efforts to stay aligned with market developments to shift from LIBOR to other rates. The definition would be amended to include SOFR term as a U.S. benchmark interest rate under Topic 815, Derivatives and Hedging. This change would enable any swap that is based on SOFR to use the fair value hedge accounting relief the board established four years ago. A swap refers to an exchange of a financial instrument between two parties.

Stay tuned

Companies have until July 6 to submit comments on Proposed ASU 2022-001. If finalized, the proposal will piggyback on three prior ASUs the FASB issued to address rate reform. Contact Hood & Strong to help transition variable-rate contracts that are still based on LIBOR.