LIBOR. The London Interbank Offered Rate. This is the reference rate underlying trillions of dollars of loans, derivatives and other financial instruments. However, after 2021, banks will no longer be required to report the information used to determine LIBOR. Reference rate reform has come about and with it the need to modify contracts that are currently based on LIBOR.
The reform poses many operational challenges, starting with an assessment of how to account for contracts subject to the changes and the costs of applying relevant accounting standards. Not to mention that the volume of contracts subject to modification is daunting. Furthermore, for investment companies, there are concerns about earnings volatility should contracts require modification. Does the modification result in the termination of one contract (resulting in realized gain and portfolio turnover) and establishment of a new contract?
So why change at all? While LIBOR is the most widely used reference rate between banks, it lacks observability and is not transaction based, and therefore is vulnerable to manipulation by those banks that establish the rate. Below are the recent developments in reference rate reform.
1. FASB Issues a Proposed ASU Offering Relief to Certain Contracts
In response to stakeholder concerns that have been voiced, the FASB issued a proposed Accounting Standards Update (ASU) last month, which would provide relief to certain contracts. For contracts meeting the following criteria, the proposed ASU would allow for the modified contract to be accounted for as a continuation of the existing contract, rather than termination of the existing contract and establishment of a new contract. Those contracts that would fall in scope of the proposed ASU are:
Those that reference LIBOR or a reference rate that is expected to be discontinued as a result of reference rate reform; and
Those in which the modifications change, or have the potential to change, the amount and timing of contractual cash flows related to the replacement of the reference rate (such as changes in the spread adjustment, reset periods or dates, day count conventions, etc.)
In contrast, contracts do not fall within the scope of the proposed ASU if there are potential changes to cash flows that are not the result of a change in the reference rate, such as changes to notional amount, maturity date, etc.
If issued, the ASU would be effective upon issuance and would apply to contract modifications through December 31, 2022. And the option to adopt the relief is on an all or nothing basis, meaning an entity cannot elect to apply the guidance to certain contracts that fall in scope and not others. An entity would need to apply the relief to all contracts that fall in scope and would otherwise be accounted for under the same codification topic of U.S. GAAP.
2. The Alternative Reference Rate Committee (ARRC) Issues a Practical Implementation Checklist
The Alternative Reference Rates Committee (ARRC) is a group of private market participants convened by the Federal Reserve Board and the New York Fed to help ensure a successful transition from U.S. dollar LIBOR to a more robust reference rate. In late September 2019, the committee issued a practical implementation checklist to help entities with the transition, and includes topics such as accounting and reporting, IT and operational readiness, risk management, exposure management, communication strategy and others. View the complete checklist.
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Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.