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Reference rate reform refers to the global transition away from referencing rates such as the London Interbank Offered Rate (LIBOR) and toward new reference rates that are more observable or transaction-based (e.g., the Secured Overnight Financing Rate or SOFR). The ICE Benchmark Administration Limited (IBA) has ceased publishing LIBOR settings other than one, three, and six-months USD LIBOR settings, and the three-month GBP LIBOR setting. For the settings that are still being published as of the date of this article, IBA is using an unrepresentative synthetic methodology, which will no longer be representative of the underlying market that LIBOR was intended to measure, per Article 23D Benchmarks Regulation issued by the UK Financial Conduct Authority (FCA).
The FCA intends for the three-month GBP LIBOR settings and one-, three-, and six-month USD LIBOR settings to cease being published by the IBA on March 28, 2024, and Sept. 30, 2024, respectively.
Why should reference rate reform matter to organizations?
Historically, LIBOR has been widely used as an interest rate benchmark (i.e., reference rate). The move away from LIBOR is therefore a significant change for both financial markets and many organizations. LIBOR rates have frequently been referenced in many types of arrangements such as debt agreements with variable rates of interest, derivative instruments (e.g., the variable leg of an interest rate swap), and lease agreements with variable rents. As reference rates such as LIBOR are replaced with new ones such as SOFR, organizations may modify existing contracts to effect the transition to new reference rates. Such modifications could be initiated by, for example, an organization’s lender or an organization may decide there is a compelling economic reason to proactively consider changing contractual terms. Accordingly, the impact of reference rate reform isn’t limited to a particular industry or type of organization, as it could affect any contract that contains a reference rate subject to reform.
Financial Accounting Standards Board’s (FASB) response
Under U.S. GAAP, accounting for contractual modifications can be complex and time-consuming. Generally speaking, accounting for a contractual modification involves identifying the type of modification and then applying the appropriate accounting recognition. Reference rate reform, therefore, has the potential for accounting and financial reporting consequences and could create a volume of incremental work for organizations that may already be wrestling with managing their workforces. To address this, the FASB issued ASU 2020-04, Reference Rate Reform (Topic 848), Facilitation of the Effects of Reference Rate Reform on Financial Reporting (the ASU), which codifies Topic 848 (the Topic). This ASU provides “optional guidance for a limited period of time to ease the potential burden in accounting for (or recognizing the effects of) reference rate reform on financial reporting.” The relief provided under this Topic, however, is only available for a limited period of time. The FASB has extended the sunset date of Topic 848 to Dec. 31, 2024, allowing organizations more time to elect and apply the optional guidance.
The guidance in Topic 848 provides optional expedients for the treatment of modifications of contracts that reference LIBOR or a reference rate that is expected to be discontinued due to reference rate reform. Those optional expedients, however, are not available for contracts with modifications not related to reference rate replacement that change, or have the potential to change, cash flow timing or amounts, even when they are made contemporaneously with the replacement of a reference rate.
The new guidance, if elected, provides the following for qualifying contracts:
- Simplified accounting analyses under current GAAP for contract modifications, as described in greater detail below
- Simplified assessment and hedge documentation relief for the continuance of hedge accounting for hedging relationships affected by reference rate replacement
- One-time election to sell or transfer debt securities classified as held to maturity that reference a rate affected by reference rate reform
Optional expedient: Contract modifications due to Reference Rate Reform
Certain contracts accounted for under Topic 310 – Receivables, Topic 470 – Debt, Topic 842 – Leases, and ASC 815-15 – Derivatives and Hedging – Embedded Derivatives that are modified due to reference rate reform may be within the scope of this Topic if certain criteria are met. Contracts eligible for relief under this Topic are those with terms that have been modified to make a change related to the replacement of a reference rate (e.g., LIBOR) that has been or is expected to be discontinued. This could be a simple assessment if the only modification to the contract is to, for example, change the reference rate from LIBOR to SOFR. However, there could be other changes to a contract that are not clearly related to reference rate replacement. Such a contractual change could further be made contemporaneously with another change that is related to reference rate replacement. For example, an organization may amend an outstanding debt agreement to change the contractually referenced rate due to reference rate reform and, contemporaneously therewith, modify the spread adjustment. Those changes add complexity to an organization’s assessment of whether a contractual modification is eligible for the optional expedients made available under this Topic. In the previous example, the organization would determine whether the modification to the spread adjustment is intended to be compensation for the difference in reference rates and, if so, would conclude that the modification is within the scope of the Topic. To assist organizations with these assessments, the Topic includes example changes in contractual terms that are related to reference rate replacement.
If the optional expedients are elected, qualifying modifications related to reference rate replacement made to contracts within the scope of Topic 310 – Receivables and Topic 470 – Debt should be accounted for prospectively in accordance with the guidance in those respective topics. Similarly, qualifying reference rate replacement related modifications to contracts within the scope of Topic 842 – Leases do not require reassessment and remeasurement if the optional expedients are elected.
Finally, electing the optional expedients for qualifying modifications to contracts within the scope of ASC 815-15 – Embedded Derivatives would not require an entity to reassess its original conclusion as to whether the contracts contain an embedded derivative that is clearly and closely related to the host. It should be noted that determining whether a modification is related to reference rate replacement in accordance with this Topic is critical because the optional expedients are only available to those contracts containing modifications that are related to reference rate replacement.
This Topic also provides optional expedients when hedging relationships are impacted by reference rate reform. Generally speaking, election of the optional expedients simplifies how an organization would handle the impact of modifications related to reference rate replacement on designated hedging relationships. For example, the optional expedients simplify an organization’s assessment of hedge effectiveness and hedge documentation requirements associated with a change in the hedged item(s) and/or hedging instrument due to reference rate reform.
Held to maturity debt securities
This Topic also includes a one-time election allowing an organization to sell debt securities classified as held to maturity and that reference a rate (e.g., LIBOR) expected to be discontinued, or reclassify such securities from held to maturity to either available for sale or trading. Because held to maturity classification is restrictive, this one-time election would allow an organization to sell and/or reclassify these securities without calling into question their previous classification, nor would it affect the classification of debt securities that remained classified as held to maturity. As this election is one-time, it will be elected concurrently for all qualifying debt securities classified as held to maturity. Organizations should carefully consider this one-time election.
What do you do now?
The ASU was effective upon issuance and is applicable to contracts within scope of the Topic that are modified between March 12, 2020, and Dec. 31, 2024. In addition, the one-time election available for debt securities that are classified as held to maturity must be made any time after March 12, 2020, but no later than Dec. 31, 2024. Now is the time to identify contracts that reference LIBOR or other reference rates that have been discontinued or will be discontinued. As these contracts are modified, organizations need to determine whether any of the optional expedients are available to those contract modifications. This could be simple or complex depending on the type of modification and how many terms within the contract were modified.
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