End of LIBOR: How all industries, not just banks, can prepare

The change affects any company that has borrowed money through rate-referenced debt or has an agreement that references the London Interbank Offered Rate.
By Mark D. Mishler, CPA

End of LIBOR: How all industries, not just banks, can prepare
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Financial institutions and other industries globally are working to replace the London Interbank Offered Rate (LIBOR). By the end of 2021, LIBOR is expected to be phased out, which necessitates adopting a new interest reference rate, not just for new loan agreements but also for existing loans. Banks, such as JP Morgan, were issuing new debt linked to the Secured Overnight Financing Rate (SOFR) in the fourth quarter of 2019.

Standard setters, too, are involved. In October 2018, FASB issued Accounting Standards Update (ASU) No. 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.

On Nov. 13, 2019, FASB approved temporary, optional guidance designed to ease the potential burden in accounting for, or recognizing the effects of, reference-rate reform on financial reporting. This became ASU No. 2020-04Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting, issued on March 12, 2020.

The guidance permits preparers to account for changes in the reference rate for certain contracts as a continuation of that contract rather than as a new contract. The guidance also permits preparers to preserve their organizations' hedge accounting when updating hedging strategies in response to reference-rate reform when contracts reference LIBOR or another rate that is being discontinued as a result of reference-rate reform.

Banks and financial institutions realize the magnitude of this change and are leading the way for transition planning, but this is not only a banking issue. Manufacturers and other nonfinancial companies need to pay attention and address this issue.

The LIBOR phaseout affects any company that has borrowed money through rate-referenced debt or has any agreement or contract (including forwards and futures) that references LIBOR. Rate-referenced interest contracts include asset-backed securities, floating-rate notes, preferred stock, and derivatives and hedges (see the sidebar, "Hedges May Become Ineffective"). Furthermore, the impact exists beyond companies to consumers. For example, rate-referenced interest also affects mortgages, automobile loans, credit cards, student loans, etc.

WHY IS THIS CHANGE OCCURRING?

LIBOR is a frequent interest rate reference that has been used in both lending and borrowing contracts since the mid-1980s. LIBOR is published daily and is calculated from hypothetical borrowing transactions submitted by a few banks. Because the transactions are hypothetical (not market-based) and may have few submissions (not an active market), LIBOR is not fully supported by an active market of observable transactions by market participants. These same terms are also used in FASB ASC Topic 820, Fair Value Measurement. In Topic 820, LIBOR may be a lowly level three in the fair value hierarchy.

The LIBOR manipulation scandal of 2008, where one banker manipulated LIBOR lower — the opposite direction expected during a credit squeeze — showed that LIBOR lacked observable market inputs. This realization caused many to question LIBOR as a reliable interest rate benchmark. In 2017 in the United States, the Alternative Reference Rates Committee (ARRC), convened by the Federal Reserve Board, officially endorsed the Secured Overnight Financing Rate (SOFR) as the preferred benchmark interest reference rate replacing LIBOR.

SOFR's price is based on borrowing rates for overnight U.S. Treasury repurchase agreements, or repos.

SOFR ISN'T SO GOOD EITHER

The repo market is influenced by the concentration of large banks in the market. Large banks act as intermediaries between the Federal Reserve and smaller financial institutions. If these large banks hold on to cash to meet their own needs instead of lending to smaller banks, this may crowd out liquidity to smaller banks and cause repo (and SOFR) rate volatility to increase and interest rates to skyrocket.

This volatility and rate boost occurred in mid-September 2019. SOFR rose to 5.25%, from its stable rate of slightly over 2%. Companies need interest rates supported by stable markets that behave in predictable ways.

SOFR is a preferred alternate interest rate benchmark, not a required rate. Thus, contracts incorporating interest reference rates may use other rates. ASU 2018-16 added the SOFR Overnight Index Swap (OIS) rate to other benchmark interest rates it already recognized that may be designated as the hedged risk in hedges of fixed-rate financial instruments. Examples of other benchmark interest rates are:

  • Direct Treasury obligations of the U.S. government;
  • The LIBOR swap rate;
  • The OIS rate based on the effective federal funds rate;
  • The Securities Industry and Financial Markets Association (SIFMA) municipal swap rate; and
  • The prime rate.

WHAT NONFINANCIAL COMPANIES SHOULD BE DOING NOW

Companies need to identify and inventory all contracts that contain interest reference rates to perform an impact assessment of LIBOR discontinuation. Contracts need to be evaluated, and mitigation, if any, needs to be completed for existing contracts. This evaluation and risk mitigation may span several reporting periods. Companies should consider disclosing the status of company efforts to date and the significant matters yet to be addressed.

Several exposures are discussed below.

Loan term adjustments

An interest-reference-rate transition may affect whether the loan term adjustment is a new loan or a loan modification. The accounting is different for each. ASC Subtopic 470-50, Debt Modifications and Extinguishments, provides this guidance.

The primary issue is whether the existing debt is extinguished, and the post-term-adjusted debt is considered distinct from the pre-term-adjusted debt. Loan modifications receive prospective accounting by changing the interest rate with no gain or loss recognized; however, loan extinguishments may result in a gain or loss recognition.

ASU 2020-04 will temporarily ease accounting for and recognizing the effects of interest-reference-rate reform on contracts and hedging relationships. The relief would expire Jan. 1, 2023, a year following the expected LIBOR phaseout, but FASB is monitoring closely to see if the sunset date needs to be extended given the coronavirus pandemic.

Under certain conditions, FASB considers changes in a contract's interest reference rate a contract continuation. This viewpoint greatly simplifies accounting because companies would not need to perform the complex evaluation about whether the cash flows would change by more than 10%, which would require accounting for a new contract. This accounting relief impacts loans, leases, and other contracts affected by interest-reference-rate reform away from LIBOR.

ASU 2020-04 would also simplify a hedge effectiveness assessment by allowing hedging relationships that are affected by interest-reference-rate reform away from LIBOR to continue. This relief application would be optional on a hedge-by-hedge basis.

The relief applies to contracts or hedging relationships with a LIBOR interest reference rate. It would also apply if another interest reference rate were to phase out as a result of interest-reference-rate reform.

Debt covenant changes

Debt contracts may need to be renegotiated. Some debt contracts may contain interest-reference-rate "fallback" clauses that specify how to calculate reference-rate difference impacts. Examples are valuing debt or interest rate spreads affecting cash flow.

Debt covenants usually consist of non-interest-rate financial metrics and would not be directly impacted by a different reference interest rate. A different reference rate could, however, result in higher interest expense that may indirectly impact debt covenants, such as a times-interest-earned covenant.

Interest rate hedges

An interest-reference-rate change may affect interest rate hedges. If a hedged item's underlying interest reference rate changes, then the hedge may become ineffective, which could change the accounting. If the hedge's underlying interest reference rate changes, then the hedge may need to be accounted for as a termination.

ASC Topic 815, Derivatives and Hedging, requires discontinuing hedge accounting for terminated hedges, and a benchmark interest rate change could terminate the hedge. Also, a cash flow hedge requires that the transaction occurrence be probable. If the LIBOR replacement made the hedge occurrence less probable, this too could discontinue hedge accounting. Finally, a change in benchmark interest rates could impact the required hedge effectiveness documentation, especially if the benchmark interest rate had insignificant market volume or market participants. Any of these situations would increase income volatility.

Operational function impacts

An interest-reference-rate change may impact several operational functions such as treasury lending, legal, and accounting. This will result in policy and procedure changes for credit underwriting, asset and liability management, interest rate risk, and accounting.

Internal control updates

Internal controls need to be updated along with accounting and financial processes. This includes debt compliance, inputs used in valuation models, and potential income tax consequences.

Operating management will need to understand the differences between LIBOR and SOFR (or other benchmark interest rates) as well as how this affects contract negotiations and interest cost calculation.

Valuation models may include an interest reference rate, and a rate change may impact discount rates. Examples are leases, financial instrument investments, and goodwill.

IT updates

There may be other business consequences from discontinuing LIBOR, such as to strategy, products, processes, and information systems. For example, companies should ensure that information technology systems can incorporate new financial instruments and rates with features that differ from LIBOR.

Depending on existing LIBOR exposure, prudent risk management may necessitate establishing a task force to assess the impact of financial, operational, legal, technology, and other risks.

Communication with stakeholders

Companies need to communicate with stakeholders the potential accounting and financial changes from a transition from LIBOR to SOFR. These include a potential jump in borrowing costs, hedge ineffectiveness, and interest rate risk management.

CHECKLIST FOR ADOPTING SOFR

In October 2019, the ARRC published a practical implementation checklist for adopting SOFR. The checklist applies to all public and private companies.

Use this checklist as a starting point when developing a transition plan. As the transition plan matures, the checklist should be customized to the entity's specific needs and risk management guidelines from the board of directors.

  • Establish program governance: Implement a robust program governance and management framework and define and prioritize program objectives.
  • Develop transition management program: Establish an enterprisewide program to evaluate and mitigate risk for transitioning away from LIBOR.
  • Implement communication strategy: Develop a strategy to proactively engage, educate, and consistently communicate with internal and external stakeholders.
  • Identify and validate exposure: Quantify and develop a process for monitoring LIBOR-linked exposure, and construct capabilities to value and price SOFR-based products.
  • Develop product strategy: Develop a strategy for redesigning/transitioning an existing portfolio of LIBOR-based products into new SOFR-linked products.
  • Manage risks: Identify key transition risks and mitigating actions to address those risks and establish a process for ongoing risk management and the role of key control functions.
  • Assess contractual remediation impact and design plan: Review existing LIBOR-related contracts to determine the impact of fallbacks, define a prioritization strategy for remediation, and incorporate recommended fallback language developed by the ARRC and the International Swaps and Derivatives Association for new contracts that reference LIBOR.
  • Develop an operational and technology readiness plan: Develop a plan to address large-scale operating model, data, and technology implications, including assessing LIBOR usage, implementing capabilities to incorporate/build new rate financial products, supporting fallback processing technology, and building testing plans.
  • Plan for accounting and reporting adjustments: Identify impacts to accounting standards along with related reporting considerations.
  • Assess taxation and regulatory issues: Determine tax and regulatory implications and any required reporting considerations.

Hedges may become ineffective

Companies utilize interest rate swaps to reduce their risk exposure to asset and liability fair value changes or to cash flow risk exposure due to interest rate fluctuations. FASB ASC Topic 815, Derivatives and Hedging, requires hedge effectiveness between the hedge and the hedged item, which is generally achieved when both have the same amount, term, and interest rate. Hedges could become ineffective if the interest reference rate changed on either the hedged item (debt) or the hedge (interest rate swap). For example, both instruments are initially based on LIBOR, and then the debt changes to SOFR.


About the author

Mark D. Mishler, CPA, CMA, is a principal at CFO Resource Management in Morristown, N.J., and an adjunct professor of accounting, finance, and management at Seton Hall University in South Orange, N.J., and Rutgers University in New Brunswick, N.J.

To comment on this article or to suggest an idea for another article, contact Sabine Vollmer, a JofA senior editor, at Sabine.Vollmer@aicpa-cima.com or 919-402-2304.


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