Staying afloat during IBOR reform
Mark Spencer, Financial Services’ Accounting Advisory team lead at BDO, sets sail on the amendments issued by the International Accounting Standards Board (IASB) and Financial Reporting Council (FRC).
Hedging arrangements will be affected by Interest Rate Benchmark (IBOR) Reform (the “Reform”) as regulators have announced a transition away from IBOR to alternative risk-free rates, such as the Sterling Overnight Index Average (SONIA).
The full effects of this reform are yet to play out, impact
- classification and measurement of financial instruments,
- the measurement of their fair values and other accounting estimates where an IBOR features either as a contractual term or is used as a component of the discount rate in determining that estimate.
IBOR Reform brings about several potentially significant implications both during the period of uncertainly prior to IBORs ceasing (‘pre-replacement issues’) as well as when they cease (‘replacement issues’). Amendments recently published by the IASB and FRC focus solely on pre-replacement issues and were considered necessary to prevent certain hedge accounting relationships being discontinued as a direct result of the uncertainties created.
The IASB and FRC issued the amendments to the applicable financial reporting standards (International Accounting Standards IAS 39: Financial Instruments: Recognition and Measurement and IFRS 9 Financial Instruments in terms of IFRS and FRS 102 in terms of UK GAAP) to provide relief to certain hedge requirements on 26 September 2019 and 11 December 2019 respectively. The amendments issued by the IASB are ‘Interest Rate Benchmark Reform (Amendments to IFRS 9, IAS 39 and IFRS 7)’ and those issued by FRC are ‘Amendments to FRS 102 – Interest Rate Benchmark Reform’.
Under these amendments, entities applying hedge accounting are required to assume that the IBOR benchmark on which the hedged cash flows and cash flows of the hedging instrument are based, as well as their fair values, are not altered as a result of the Reform. The amendments do not provide relief from any other consequences arising from the Reform. Both sets of amendments are effective for accounting periods beginning on or after 1 January 2020.
These reliefs are mandatory for both existing and new hedge accounting relationships until the earlier of when the uncertainty regarding amounts and timings of cash flows arising from the Reform cease or hedge accounting relationship is discontinued.
If a hedge accounting relationship no longer meets the requirements for hedge accounting for reasons other than those specified by these amendments, then discontinuation of hedge accounting is still required.
So, what exactly do these ‘lifeboat’ issued provide relief for? The amendments, to varying degrees based on the underlying standard, provide relief for:
- Whether forecast transactions are highly probable
- Requirements relating to prospective assessments
- Requirements relating to retrospective assessments (under IAS 39)
- Assessment of risk components
- Assessment of macro hedges
The treatment of these reliefs are also clarified in terms of their application to group of items designated as the hedged item and the scope in terms of hedges of both interest rate and foreign exchange risk. The amendments also change existing disclosure requirements.
When assessing the first three items, the entity disregards the uncertainties arising around the hedging instruments and the hedged items due to the Reform.
Retrospective assessments are part of the set of qualifying criteria that must be adhered to in order to apply hedge accounting under IAS 39. The IASB’s amendments mean that an entity can continue to apply hedge accounting to a hedge accounting relationship even when the results of effectiveness testing are outside of the 80-125% range.
This is hugely helpful for entities applying hedge accounting as the fair value of the qualifying hedging instruments or hedged item, as result of the Reform, could fluctuate and become increasingly volatile with the adverse side-effect of them being more likely to be outside of this range. Nonetheless, the entity would measure the ineffectiveness arising and recognise this in profit or loss.
Under the amendments, entities are exempt from the disclosure requirements of paragraph 28(f) of IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors and paragraph 11 of Section 1 of FRS 102 upon the initial application of the amendments. Disclosures required are largely qualitative in nature, such as explanations of how the entity is managing its transition to alternative risk free rates and the significant assumptions or judgements the entity made in applying the relief to those hedge accounting relationships which fall within the scope of the amendments.
This is beneficial as, while the disclosures provide insight on the extent of hedge accounting relationships impacted by the Reform, they are not overly onerous.
In order to designate risk components in hedge accounting relationships, these need to be separately identifiable and reliably measurable. Under the amendments, a non-contractually specified risk component only needs to be separately identifiable at initial hedge designation and not on an on-going basis. Therefore, as long as a non-contractually specified IBOR risk component meets the separately identifiable requirement at inception of the hedge accounting relationship, hedge accounting is to be continued.
This is particularly important for entities, as they can continue to apply hedge accounting when the non-contractually specified risk component is no longer separately identifiable and reliably measurable at a later date as a result of a lack of liquidity in IBOR markets.
Scope of exemptions
The reliefs are clear in that their scope apply to hedge accounting relationships that are directly affected by uncertainties arising as result of the Reform with respect to the timing and amount of IBOR-based cash flows. This means that hedge accounting relationships that include instances where interest rate risk is not the only designated hedged risk are not precluded but the relief only applies to the IBOR-based cash flows.
The advantage of this is that the amendments are still to be applied to hedges of both interest rate risk and foreign exchange risk, which is common when a derivative such as a cross currency swap is used as a hedging instrument.
Group of Items
For a group of items designated as the hedged item, the end of application requirements applies to the designated group of hedged items as a whole. That is to say that they do not apply to each item separately.
This is particularly relevant for entities applying hedge accounting to a group of variable rate loans and means that the entity does not need to assess for each variable rate loan in the group whether the uncertainty regarding amounts and timings of cash flows arising from the Reform have ceased.
Under the amendments an entity only assesses whether a non-contractually specified risk component is separately identifiable at the time the hedged item is initially designated in the macro hedge. Once designated within a macro hedge, the separately identifiable requirement does not need to be reassessed for that same hedged item at subsequent re designations, i.e. this is not a continuous assessment.
This eliminates macro hedges potentially being discontinued in say, 12 months’ time, as a result of the risk component then no longer being separately identifiable.
About the author
Mark Spencer is Head of Financial Services’ Accounting Advisory team at BDO.