The slow death of a critical benchmark interest rate will produce a series of compliance headaches for companies stretching over the next few years.
Rocked by allegations of manipulation and fraud, the London InterBank Offered Rate, or LIBOR, is the benchmark interest rate underlying hundreds of trillions of dollars in various forms of variable debt throughout the global economy. The International Swaps and Derivatives Association says the total notional exposure across derivatives, bonds, loans, and other instruments is estimated at $370 trillion.
The Financial Conduct Authority, the U.K. regulator that oversees the maintenance of LIBOR, said it will no longer compel financial institutions to report information that forms the basis for LIBOR past 2021, leaving markets and regulators globally to determine new means of benchmarking financial products. U.S. authorities formed the Alternative Reference Rate Committee to establish a new approach, which so far has produced a rate called the “secured overnight finance rate.”
Although it is early in the establishment of SOFR, the new reference rate is widely expected to replace LIBOR in the United States. Banks are just beginning to establish new contracts based on SOFR as well as the long, slow process of transitioning trillions of dollars worth of existing contracts. Operating companies outside of financial services are just beginning to understand what the transition will mean for them.
“This change from LIBOR to a new benchmark rate is going to have implications for companies, depending on the nature of the company, both from an operational standpoint as well as from an accounting and financial reporting standpoint,” says Mahesh Narayanasami, a principal with KPMG. “LIBOR has been around for a very long time, and it’s embedded in a number of contracts, particularly loan arrangements, securities, and derivatives, such as interest rate swaps.”
Companies will need to review contracts indexed to LIBOR and determine how they will transition to a new benchmark, first determining whether the transition is already contemplated in the contract or will be subject to negotiation. “This is a very impactful change in the reference rate, and I’m hoping it won’t result in any significant financial impact, but that remains to be seen,” says Adam Gilbert, global regulatory leader at PwC.
“Accounting for derivative contracts may be the biggest issue,” says Narayanasami. Financial institutions are significant users of derivative instruments for trading and hedging purposes, but plenty of corporates manage risk exposures using derivatives as well, he says. A transition to a new benchmark will affect the valuation for balance sheet purposes, but it also affects hedge accounting compliance, which is a complex area of Generally Accepted Accounting Principles.
Under current interpretations of GAAP, the transition from LIBOR to a different benchmark rate could cause problems for a company’s hedge accounting, said Jonathan Howard, a senior consultation partner at Deloitte & Touche. Companies could face questions, for example, about whether their hedges are effective and, therefore, eligible for hedge accounting, he says.
“Discount rates used in fair-value measurements are sometimes based on LIBOR. That will change the way you construct curves for valuations. The rates, the models, the processes all would have to be adjusted, and systems changes might need to be made.”
Tim Kviz, National Assurance Partner, BDO USA
Companies could also face some uncertainty about whether a change in the underlying benchmark represents a modification, says Howard, which has serious implications that could disqualify a particular transaction from hedge accounting. The consequences of losing hedge accounting include onerous fair-value exercises and potential income statement volatility.
The Financial Accounting Standards Board has already made one adjustment to hedge accounting rules to allow for a seamless transition from LIBOR to SOFR and has taken up a project to consider other rule changes that might be necessary. Staff at the Securities and Exchange Commission have also indicated they will not object to some common-sense interpretations to get companies through a transition.
“It would be a travesty if the SEC told people they can’t get hedge accounting any more when we all expect the FASB is going to deal with this in a reasonable and rational manner,” said Howard. “We don’t want to start having accounting that doesn’t make sense for something that’s likely going to happen in a couple of years. This probably navigates a soft landing for everybody.”
Debt arrangements represent another big area for companies to explore, says Tim Kviz, a national assurance partner at audit firm BDO USA. Anywhere a company has issued floating-rate debt, it is likely indexed to LIBOR. “If it extends beyond LIBOR, hopefully there’s text in the agreement to address a transition,” he says. “If not, you’ll need to renegotiate.”
The transition is not as simple as swapping out a new rate for an old one, says Kviz. While LIBOR is a rate banks use to lend among themselves, SOFR is a secured overnight rate. Credit risk is embedded in LIBOR, but not in SOFR, he says. “There’s going to have to be some negotiation for the credit spread that was implicit in LIBOR,” he says. “That will take some time.”
SEC on LIBOR and hedge accounting
In existing cash-flow hedge relationships of variable rate debt instruments where the hedged item is documented as LIBOR-based interest payments, stakeholders have raised two questions:
“The first question related to whether the LIBOR-based interest payments identified in cash flow hedge documentation are probable of occurring. In order to apply hedge accounting, the forecasted transaction being hedged (in this case, the LIBOR-based interest payments) has to be probable of occurring. The stakeholder requested the staff’s view on whether registrants could continue to assert that cash flow hedges where the hedged item is documented as LIBOR-based interest payments are probable of occurring for variable rate debt whose terms extend beyond the anticipated transition away from LIBOR. The stakeholder shared its view that hedge documentation involving LIBOR-based cash flows implicitly considers the rate that would replace LIBOR, thereby allowing an entity to continue to assert that the hedged item is probable of occurring. The staff did not object to this view.
“The second question was whether and how the expected transition away from LIBOR would impact the assessment of hedge effectiveness of a cash-flow hedge of LIBOR-based variable-rate debt. In order to apply hedge accounting, a hedge must be assessed as highly effective both on a prospective and retrospective basis. The stakeholder shared its view that, as part of its assessment of hedge effectiveness, an entity could consider an expectation that anticipated changes to LIBOR will impact both the hedged item (e.g., forecasted interest payments on debt) as well as the hedging instrument (e.g., interest rate swap). The stakeholder further asserted that in light of this expectation, the anticipated transition away from LIBOR in and of itself would not impact the effectiveness of the hedge. The staff did not object to this view.”
As companies go through that exercise, they’ll need to determine if changes in debt arrangements represent modifications or something more significant under accounting standards, says Howard. If the changes become significant enough, companies may need to regard the transition as ending one debt arrangement and beginning a new one.
Under accounting rules, that means taking the old loan off the balance sheet at its carrying amount and adding the new loan at fair value, with changes reported through earnings. “That’s for debtors and lenders, and it will need to be dealt with,” says Howard. “It will probably be dealt with as modifications, but it’s something to watch for.”
The movement away from LIBOR could affect other areas of accounting and financial reporting as well, says Kviz. “Discount rates used in fair-value measurements are sometimes based on LIBOR,” he says. “That will change the way you construct curves for valuations. The rates, the models, the processes all would have to be adjusted, and systems changes might need to be made.”
Although the transition to a new benchmark rate is not set in stone, companies need to start identifying where they have instruments that reference LIBOR so they can begin to take stock of what will need to be done, says Gilbert. “Raise awareness about this,” he says. “Get organized from the front office to the back.”
Companies will need to engage corporate support functions like finance, controllers, and risk managers to perform an impact analysis and identify how to proceed, says Gilbert. Communication with investors, clients, and customers may be critical, and some companies may want to work with industry peers or regulators as well.
“You can’t wait until LIBOR goes away to make changes,” he says. Alternative reference rates are emerging, and financial products are already starting to change. “All of this is starting to happen, and firms need to get on it.”
The SEC has indicated it expects companies to begin taking stock and disclosing expected effects to investors, says Howard. “Take a look at your debt arrangements and have a better understanding, even if you don’t know what will happen with your arrangements,” he says. “It’s good to have this on your radar.”