Interest rate benchmarks, such as the London Inter-Bank Offered Rate (LIBOR), play a key role in financial markets, underpinning trillions of lending and derivative transactions. However, work is underway in multiple jurisdictions to transition to Alternate Reference Rates (ARRs), with LIBOR expected to be discontinued in the UK after 2021. The transition from LIBOR to an ARR will give rise to wide ranging practical challenges and could affect financial reporting.
Financial reporting implications
The financial reporting implications are similar for both IFRS and UK GAAP reporters, with some likely to start taking effect before LIBOR is replaced. These pre-replacement issues relate to hedge accounting. In the absence of any relief in the accounting standards, the uncertainty arising from benchmark interest rate reform could result in hedge accounting needing to be discontinued. Widespread reclassification of amounts in cash flow hedge reserves to profit or loss and the cessation of fair value hedge accounting of fixed rate debt might then follow.
In September 2019, to avoid unnecessary disruption to existing hedge relationships during this period of uncertainty, the International Accounting Standards Board (IASB) published Interest Rate Benchmark Reform – Amendments to IFRS 9 Financial Instruments, IAS 39 Financial Instruments: Recognition and Measurement and IFRS 7 Financial Instruments: Disclosures.
The amendments are effective for annual periods beginning on or after 1 January 2020, with earlier application permitted, subject to EU endorsement. Given the tight timeframe, the endorsement process has been accelerated, with the aim that the amendments will be endorsed in time to apply for December 2019 year ends.
For cash flow hedges, the amendments require that an entity assume that hedged LIBOR-based cash flows will continue beyond the period when they could potentially be replaced by cash flows based on an alternative rate. This applies irrespective of whether LIBOR-based variability is contractual (eg, existing LIBOR-linked debt) or non-contractual (eg, a forecast debt issuance). Similarly, for fair value hedges, the amendments require that LIBOR risk continues to be treated as identifiable in the hedged item even if this ceases to be the case.
The amendments are to be applied retrospectively to hedge relationships that existed during the period in which an entity first applies the amendments and to gains or losses in the cash flow hedge reserve at the beginning of that period. Given the amendments ensure continuity of hedge accounting, early adoption is advisable. Where chosen, entities will need to clearly state that they have early adopted and in doing so, include the associated disclosures in their annual financial statements.
What about UK GAAP?
Similar amendments are in the process of being finalised by the Financial Reporting Council (FRC) for UK GAAP reporters. Under the proposed amendments to FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland, entities choosing to apply the recognition and measurement provisions of IAS 39 and/or IFRS 9 will be able to apply the IASB’s amendments to those standards. However, the amendments to IFRS 7 are not relevant to such entities as they follow the disclosure requirements of FRS 102 which are yet to be finalised. They are however, expected to be less substantial than those to the IFRS 7 disclosures.
Phase 2
The amendments discussed above do not address the financial reporting issues that may arise when an existing interest rate benchmark is actually replaced. For example, whether modification of a contract as a result of interest rate benchmark reform will result in derecognition. The IASB will be addressing these issues in a second phase of its project with an exposure draft expected in the first half of 2020. Equivalent proposals will then follow from the FRC. Given the potential disruption to hedge accounting when these modifications take place it may be advisable to defer making changes to contractual arrangements until it is clearer what further reliefs will be available.
About the author
Helen Shaw is a director at Deloitte
