FASB Issues Proposed Standard Related to Reference Rate Reform
For many years, the London Interbank Offered Rate (LIBOR) has functioned as the bedrock of financial contracts. Since the LIBOR Rigging Scandal of 2014, however, the writing has been on the wall-LIBOR is on its way out. Regulators around the world have worked to identify alternative reference rates that are more observable or transaction-based and thus, less susceptible to manipulation.
Since these rates are central to so many contracts and hedge transactions, questions have been raised regarding the challenge of accounting for these transactions. To address these concerns, the Financial Accounting Standards Board (FASB) issued a proposed Accounting Standards Update (ASU or Update) on Sept. 5, 2019 entitled Reference Rate Reform (Topic 848): Facilitation of the Effects of Reference Rate Reform on Financial Reporting.
This new standard will have a huge impact on a wide range of contracts including debt agreements, lease agreements and derivative instruments. These will all need to be modified to replace references to discontinued rates with the modified rates.
Under current generally accepted accounting principles (GAAP), the changes caused by reference rate reform would be considered a contract modification. As such, they would all need to be evaluated to determine if the modifications result in a new contract or the continuation of an existing contract. Due to the overarching effect of this reform, this would affect a significant volume of contracts and other arrangements and would be burdensome to all those affected.
In response, FASB issued the proposed Update, providing temporary, optional practical expedients and exceptions to enable a smoother transition to the new reference rates. These optional expedients and exceptions to GAAP apply to contracts, hedging relationships, and other transactions affected by reference rate reform under certain conditions. They would also only apply to contracts and hedging relationships that reference LIBOR or other reference rates expected to be discontinued.
The following optional expedients in the proposed amendment are as follows:
- Modifications of contracts within the scopes of Topic 210, Receivables and Topic 470, Debt, would be accounted for by prospectively adjusting the effective interest rate in the agreement.
- Modifications of contracts within the scope of Topic 842, Leases, would be accounted for as a continuation of the existing contract with no reassessments or remeasurements that otherwise would be required under that Topic.
- Modifications of contracts would not require a reassessment under Subtopic 815-15, Derivatives and Hedging-Embedded Derivatives, of whether an embedded derivative should be accounted for as a separate instrument.
The amendments also include a general principle that would apply to the Accounting Standards Codification (ASC) topics and subtopics, permitting entities to:
- Consider modification of contracts due to reference rate reform to be a continuation of these contracts
- Not reassess previous determinations
To be considered valid, the optional expedient that’s selected would need to be applied consistently across all contract modifications under a topic, subtopic or industry subtopic within the ASC. There are also a variety of optional expedients and some exceptions for various types of hedging transactions included in the proposed Update.
The amendments proposed in this Update would be effective for all entities upon the issuance of a final ASU and will remain in force upon adoption through to Dec. 31, 2022. The proposed amendments would not apply to contract modifications made and hedging relationships entered into or evaluated after Dec. 31, 2022.
The comment period for the proposed Update ended on Oct.7 and on Nov. 13, 2019 the FASB approved the proposed Update and instructed the FASB staff prepare the final ASU for issuance. The final ASU is expected to be issued in the first quarter of 2020.
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