Adam Deller explains the likely consequences for cashflow hedge accounting from the looming reform of interest rate benchmarks such as Libor
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This article was first published in the September 2019 International edition of Accounting and Business magazine.
Interest rate benchmarks are undergoing significant reform right now. Following cases of attempted market manipulation of some of these benchmarks, the G20 forum of the major global economies asked the Financial Stability Board to undertake a fundamental review.
The standard benchmarks include the interbank offered rates (the interest rates at which banks lend to and borrow from each other) of Libor (London Interbank Offered Rate), Euribor (Euro Interbank Offered Rate) and Tibor (Tokyo Interbank Offered Rate). They are interest reference rates that represent the cost of obtaining unsecured funding, in a particular combination of currency and maturity, and in a particular interbank term lending market.
Libor, the world’s most influential interest rate benchmark, is expected to come to an end in the near future. The UK Financial Conduct Authority, which regulates Libor, has required banks to keep submitting their borrowing rates to the Libor administrators until the end of 2021, at which point the rate is expected to fall away.
Libor’s looming cessation has caused great uncertainty in the market, and shifting many contracts to alternative benchmarks will cause significant disruption. David Ramsden, the Bank of England’s deputy governor for markets and banking, recently told banks to stop adding to their post-2021 Libor exposures. He also rather worryingly noted that in some ways the task is even bigger than preparing for Brexit, which suggests that a potentially long and bumpy road lies ahead.
The International Accounting Standards Board (IASB) has released an exposure draft inviting comment on its proposed amendments to IFRS 9, Financial Instruments, and IAS 39, Financial Instruments: Recognition and Measurement. It notes that the doubt surrounding potential future interest rate benchmarks has a particular effect on hedge accounting and identifies two major groups of issues that could have implications for financial reporting:
- issues affecting financial reporting in the period before the replacement of an existing interest rate benchmark (pre-replacement issues)
- issues that might affect financial reporting when an existing interest rate benchmark is replaced with an alternative interest rate (replacement issues).
The IASB’s exposure draft addresses only the pre-replacement issues. It focuses on how the current uncertainty could impact the financial reporting treatment of items currently shown in the financial statements of entities. The issues that may arise following the replacement of existing benchmarks are not currently being looked at, as they will depend on the alternative selected.
The exposure draft focuses on cashflow hedges. As the interest rate benchmark reform takes place, contractual cashflows of hedged items and hedging instruments based on an existing interest rate benchmark will change. As it is unclear what decisions will be made about the alternative interest rates, uncertainties will exist about the timing and the amount of these cashflows.
The uncertainties over the interest rate benchmarks could affect an entity’s ability to meet specific forward-looking hedge accounting requirements. This in turn could mean that an entity could be required to discontinue hedge accounting for hedging relationships that would otherwise qualify for hedge accounting.
Currently, under cashflow hedge accounting rules, the gains or losses on the hedging instrument are held in a cashflow hedge reserve in other comprehensive income. These are only released to the statement of profit or loss as the hedged item occurs. To apply the cashflow hedge accounting rules, the forecast transaction that is designated as the hedged item must be a highly probable event.
Once an entity discontinues hedge accounting, the changes in the fair value of the hedging instrument before discontinuation are recognised in profit or loss, instead of the cashflow hedge reserve in other comprehensive income.
A couple of problems arise here. The first is that the hedged item must be highly probable. If an entity designates as the hedge item cashflows that are contractually linked to an interest rate benchmark, and these are expected to occur after the reform has taken place, then these cashflows may no longer meet the requirement of high probability. As a result, the entity would currently have to discontinue hedge accounting.
The IASB believes that discontinuing hedge accounting solely due to these uncertainties would not provide useful information to users of financial statements. It is therefore proposing exceptions to specific accounting requirements of IFRS 9 and IAS 39 to make an assumption that the interest rate benchmark on which the hedged cashflows are based is not altered as a result of the reform. This means that the uncertainty is removed from considerations of the economic relationship between the hedged items and hedging instrument, in addition to the assessment of the hedge being highly effective.
The purpose of these exceptions is to prevent entities from being forced to discontinue hedge accounting as a result of the uncertainty that exists over the interest rate benchmarks; entities may still be required to discontinue hedge accounting if other requirements are not met. To offer further guidance, the IASB has provided some examples – see box on previous page.
The second problem arises when identifying a risk component as the hedged item in a hedging relationship. Both IFRS 9 and IAS 39 allow entities to designate only changes in the cashflows or fair value of an item attributable to a specific risk or risks. An entity issuing a five-year floating-rate debt instrument that bears interest at three-month Libor +1% could designate either the entire debt instrument or the three-month Libor risk component as the hedged item. The key issue is that for the risk component to be eligible for hedge accounting, it must be separately identifiable and reliably measurable.
The IASB has noted that the outcome of the reform could affect an entity’s assessment of whether a non-contractually specified Libor component is separately identifiable, as it may not qualify as a hedged item. If this was the case, an entity would have to discontinue hedge accounting. The IASB has decided that this would not be a useful outcome, and has therefore extended the exemptions to this scenario so that the discontinuation of hedge accounting is not required.
An important change to note is that the IASB has not allowed this exemption for new arrangements. This means that if the risk component is not separately identifiable at the inception of the hedging arrangement, then it cannot be designated as the hedged item. The IASB believes this situation is very different from allowing continued hedge accounting for components that met the requirement at the inception of the arrangement but may no longer do so following the reform.
Feedback to the suggested changes has been mainly positive, with commenters largely agreeing with the IASB’s proposals. Most have noted the urgency required for this project and would like the IASB to issue the amendments quickly. A large number of respondents also believe the IASB needs to consider the replacement issues as a priority, as they see this as very important.
The most contentious issue is that the IASB is proposing that the exceptions should not apply to retrospective assessments of effectiveness in accordance with IAS 39, as the IASB believes these relationships are based on the actual results of the hedging relationships. This approach is disputed by a large number of commenters, from accounting institutes to large practitioners, who believe the uncertainty has already impacted these rates and could lead to excess discontinuing of hedge accounting.
The IASB is proposing that these exceptions will apply for a limited period only and cease when the uncertainty arising from interest rate benchmark reform is no longer present. The amendments would have an effective date of annual reporting periods beginning on or after 1 January 2020, with earlier application permitted, and would be applied retrospectively.
Adam Deller is a financial reporting specialist and lecturer.
CPD technical article
"Many believe the Libor uncertainty has already hit rates and could lead to excess discontinuing of hedge accounting"