Many companies pay interest on variable rate loans, based on the London Interbank Offered Rate (LIBOR). But, by 2021, LIBOR will have been phased out in response to a series of scandals, where regulators uncovered collusion between banks to manipulate LIBOR to profit on the financial instruments supported by LIBOR.
How will the shift away from LIBOR affect companies’ financial statements? The Financial Accounting Standards Board (FASB) is evaluating that question and urging private companies to do the same.
Today, LIBOR is the most common reference rate in the global financial markets. In its simplest form, LIBOR provides a theoretical rate that a major bank might charge a competitor to borrow funds overnight. It can also be thought of as the risk-free cost of borrowing.
The Federal Reserve estimates that LIBOR underpins about $200 trillion of transactions, including short-term loans, derivatives and other contracts. That’s roughly 10 times the gross domestic product (GDP) of the United States.
Of that total, more than $35 trillion won’t mature by the end of 2021, when LIBOR will be phased out. Many contracts don’t have fallback language when LIBOR is no longer available, or they have fallback language that assumes LIBOR will be only temporarily unavailable. When the rate is discontinued, it could convert floating rate contracts to fixed rate contracts.
A possible alternative to LIBOR comes from the Federal Reserve Bank of New York. The Secured Overnight Financing Rate (SOFR) addresses the shortcomings of LIBOR by using interest rates associated with repurchasing agreements, which involves a large volume of overnight lending activity.
These repurchasing agreements are real-world (not theoretical) transactions, secured by U.S. government securities, such as Treasury bills and bonds. So, SOFR closely approximates the risk-free rate.
Swapping SOFR for LIBOR minimizes the potential for market manipulation because, with SOFR, the Federal Reserve, not a corporation, assumes responsibility for its aggregation and reporting. By comparison, individual companies assume responsibility for aggregation and reporting of LIBOR.
By late summer or early fall, the FASB plans to issue a proposal aimed at addressing the effects of reference rate reform, including the shift away from LIBOR and other reference rates, on financial reporting. The FASB plans to move quickly to issue a proposal for public comment.
Although the details aren’t yet set in stone, the FASB has agreed that changes in a contract’s reference rate, such as LIBOR, would be accounted for as a contribution of that contract, provided it met certain criteria. In addition, the changes will be principles-based and specify that LIBOR qualifies in the scope of the modifications. If finalized, the relief guidance would need to be applied prospectively, and would end as of January 1, 2023.
“The overall goal of the whole project is to not have the accounting complexity get in the way of the transition from LIBOR or any other IBORs,” said FASB Acting Technical Director Shayne Kuhaneck. “We didn’t specify the rate that you had to shift to — so if you’re shifting to SOFR or you’re shifting to some other rate, as long as you meet the criteria, you would … be afforded the relief for the contract modification.”
Private companies typically lag behind public companies in adopting new accounting rules. However, in this case, the FASB said that the accounting relief would be applicable to private companies at the same time as public companies (next year). That’s because the changes are driven by regulatory reform that’s outside of the FASB’s control.
Contact Keith Klodnick at kklodnick@cohencpa.com or a member of your Cohen & Company service team to discuss this topic further.
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.