8.2 Summary of ASU 2020-04
The relief provided by ASU 2020-04 is elective and applies “to all entities, subject to
meeting certain criteria, that have contracts, hedging relationships, and other
transactions that reference LIBOR or another reference rate expected to be discontinued
because of reference rate reform.” Optional expedients are provided for contract
modification accounting under the following Codification topics and subtopics:
- ASC 310, Receivables.
- ASC 470, Debt.
- ASC 840 or ASC 842, Leases.
- ASC 815-15, Derivatives and Hedging: Embedded Derivatives.
ASU 2020-04 also establishes (1) a general contract modification principle that entities
can apply in other areas that may be affected by reference rate reform and (2) certain
elective hedge accounting expedients.
The optional amendments in ASU 2020-04 are effective for all entities as
of March 12, 2020, through December 31, 2024.2 See Section 8.2.6 for
more information on the ASU’s effective and expiration dates.
8.2.1 Scope of ASC 848
The elective contract modification guidance in ASU 2020-04 applies to “contracts or
other transactions that reference [LIBOR] or a reference rate that is expected to be
discontinued as a result of reference rate reform” (an “affected rate”).
Connecting the Dots
ASU 2020-04 notes that an expectation that a reference rate will be
discontinued could be supported by:
-
A public statement or publication of information by or on behalf of the administrator of the relevant reference rate or by the regulatory supervisor for the administrator
-
Initiatives [undertaken] by a significant number of market participants or by market participants representing a significant number of transactions to move away from the reference rate
-
The production method for the calculation of the published reference rate [being] either:
- Fundamentally restructured
- Reliant on another rate that is expected to discontinue.
The Board chose to provide such guidance in lieu of providing a prescriptive
list of reference rates that fall within the scope of ASU 2020-04.
8.2.2 Contract Modification Relief
8.2.2.1 Scope
The elective guidance in ASU 2020-04 applies to modifications of contract terms
that will directly replace, or have the potential to replace, an affected rate
with another interest rate index, as well as certain contemporaneous
modifications of other contract terms related to the replacement of an affected
rate. As shown in the decision tree below, when contemporaneous modifications
are made, an entity’s eligibility to use the relief provided by ASC 848-20
(added by the ASU) depends on whether the contemporaneous modifications to the
other terms (1) could affect the amount or timing of contractual cash flows and
(2) are related to reference rate reform.
Eligibility
of Contemporaneous Contract Term Modifications for Relief Under the
ASU
3
The modification can be made in anticipation of the
reference rate discontinuance (i.e., before the reference rate is
actually discontinued).
ASU 2020-04 notes that changes in contract terms that are made to effect the
reference rate reform transition are considered related to the replacement of a
reference rate if they are not “the result of a business decision that is
separate from or in addition to changes to the terms of a contract to effect
that transition.” The table below provides examples of possible types of
modifications and indicates whether they generally would be considered related
to the replacement of a reference rate.
|
Related
|
Unrelated
|
|---|---|
|
Changes to:
| |
|
|
|
The addition of:
| |
|
|
|
The addition of or changes to:
| |
| |
|
The addition or removal of a:
| |
| |
|
Other:
| |
| |
The ASU further states that an entity should disregard circumstances in which
modified fallback terms include or have the potential to include a term
unrelated to reference rate reform if, when the fallback terms are added or
amended, the entity “determines that activation of the term unrelated to
reference rate reform is not probable of occurring if the fallback terms are
triggered.”
8.2.2.2 Contract Modification Expedients
The table below summarizes the optional expedients provided by ASU 2020-04 for
specific areas of the Codification that an entity could elect to apply to
qualifying contract modifications.
|
Codification Topic
|
Optional Expedients
|
|---|---|
|
Receivables (ASC 310)
|
Account for the modification as if it was only minor (and
not an extinguishment) in accordance with ASC
310-20-35-10.
|
|
Debt (ASC 470)
|
Account for the modification as if it was not substantial
(i.e., do not treat as an extinguishment).
In applying the 10 percent cash flow test in ASC
470-50-40-10 for any subsequent contract modifications
made within a year, entities should consider only terms
and provisions that were in effect immediately following
the election of the optional expedient.
|
|
Leases (ASC 840 or ASC 842)
|
The modification will not (1) trigger reassessment of
lease classification and the discount rate or (2)
require the entity to remeasure lease payments or
perform the other reassessments or remeasurements that
would otherwise be triggered by a modification under ASC
840 or ASC 842 when that modification is not accounted
for as a separate contract.
The modification of terms on which variable lease
payments depend will not cause the lessee to remeasure
the lease liability. The effects of such changes will
instead be recognized in profit or loss in the period in
which the obligation for those payments is incurred.
|
|
Embedded derivatives (ASC 815-15)
|
The modification of the contract terms will not cause an
entity to reconsider its conclusion about whether that
contract contains an embedded derivative that is clearly
and closely related to the economic characteristics and
risks of the host contract.
|
|
Other contracts
|
Account for the modification “as an event that does not
require contract remeasurement at the modification date
or reassessment of a previous accounting determination
required under the relevant Topic or Industry
Subtopic.”
|
Under ASU 2020-04, an entity that elects to apply an expedient under a particular
Codification topic, subtopic, or industry subtopic must apply that expedient to
all contract modifications that are within the scope of the ASU and are
accounted for under that topic, subtopic, or industry subtopic. For example, if
an entity applies the expedient to a qualifying modification under ASC 840 or
ASC 842, it would also apply that expedient to all other qualifying
modifications accounted for under those topics. Similarly, an insurer that
applies the expedient under ASC 310 would apply that expedient to all contract
modifications that are within the scope of the ASU and accounted for under the
insurance-specific receivable guidance in ASC 944-310; however, the insurer
would not be required to apply expedients to the other ASC 944 subtopics.
Further, an entity that determines that a contract modification does not qualify
for the optional relief under a given topic or industry subtopic would not be
precluded from applying the optional expedients to other qualifying contract
modifications.
8.2.3 Hedging Relief
8.2.3.1 Changes in Critical Terms
ASU 2020-04 allows entities to amend their formal designation and documentation
of hedging relationships in certain circumstances as a result of reference rate
reform. Under the ASU, if specified criteria are met, entities may change
certain critical terms of existing hedging relationships that are affected or
expected to be affected by reference rate reform, and these changes would not,
in and of themselves, cause an entity to dedesignate the hedging relationship.
An entity may elect to apply (1) expedients related to hedge accounting to each
individual hedging relationship (and not necessarily to other similar hedging
relationships) and (2) multiple optional expedients for a single hedging
relationship and in different reporting periods. The optional expedients include:
-
Changing certain critical terms of a designated hedging instrument, a hedged item, or a forecasted transaction in fair value, cash flow, or net investment hedges that are affected, or expected to be affected, by reference rate reform.6
-
Changing either the designated notional amount or proportion of the hedging instrument, the hedged item, or both to rebalance a fair value hedge.7
-
Changing the hedging instrument designation in fair value or cash flow hedges to combine two or more derivatives (or proportions thereof) and jointly designate them as the hedging instrument.
-
Changing the method of assessing hedge effectiveness for cash flow hedges when either the hedging instrument or the hedged item references an affected rate and the new effectiveness assessment method is an optional expedient for cash flow hedges under ASC 848-50. The entity would not be required to demonstrate that the new method is either an improved or preferable method under ASC 250. An entity may elect to apply this expedient for existing hedging relationships either on the date on which it opts to apply an optional expedient or when it ceases to apply an optional expedient and reverts to the guidance in ASC 815-20 and ASC 815-30.
-
For fair value, cash flow, or net investment hedges, (1) changing the systematic and rational method used to recognize in earnings the components excluded from the effectiveness assessment and, if elected, (2) recognizing in current earnings any change in fair value of the excluded component (resulting from changes to the hedging instrument’s contractual terms) in the same income statement line as the earnings effect of the hedged item.
When an entity elects to apply an expedient, it must update its hedge
documentation to note any changes. Hedge documentation must be updated no later
than when the entity performs its first hedge effectiveness assessment after the
change is made in accordance with ASC 815-20-25-3(b)(2)(iv)(02) and ASC
815-20-25-3A.
As noted in ASC 848-30-25-5, an entity may change the terms of a hedging
instrument, a hedged item, or a forecasted transaction that is “expected to be
affected by reference rate reform.” In other words, an entity may elect some of
the expedients before either the hedging instrument or the hedged item is
modified as a result of reference rate reform. In addition, an entity may apply
an expedient to update its hedge documentation for a single hedging relationship
multiple times as long as each update meets the criteria for one of the
expedients.
Example 8-1
Hedging First Interest Payments Received
Weekapaug Regional Bank has a pay-variable (one-month
LIBOR), receive-fixed interest rate swap hedging first
monthly receipts of one-month LIBOR interest payments on
$100 million of loans each month for changes in cash
flows attributable to changes in the contractually
specified interest rate (i.e., one-month LIBOR).
Weekapaug is no longer originating any loans that are
indexed to one-month LIBOR. Therefore, while it
currently has more than $100 million of one-month
LIBOR-based loans, it expects such loans to be gradually
replaced by loans that have monthly payments based on
SOFR rates.
Weekapaug decides to change the hedged item to first
monthly receipts of either one-month LIBOR interest
payments or SOFR interest payments that are received on
loans with monthly payment frequency on $100 million of
loans each month. It is allowed to amend its hedge
designation documentation for this change without
considering it a dedesignation of the hedging
relationship in accordance with ASC 848-30-25-3 because
the hedged forecasted transactions before the change are
within the scope of ASC 848-20-15-2 and 15-3 (i.e., they
are based on LIBOR).
Weekapaug is likely to further amend the critical terms
of the hedging relationship if any of the following occur:
- The interest rate swap is modified or replaced with a SOFR-based swap before its termination date.
- Weekapaug decides to remove receipts of one-month LIBOR interest payments from the hedged item because (1) it is probable that Weekapaug will have receipts of monthly SOFR interest payments on at least $100 million of loans each month for the remaining term of the hedging relationship or (2) it can no longer assert that it reasonably expects that the hedged transactions will include any LIBOR-based payments.
Each of the amendments described above would qualify for
the expedients in ASC 848 because they are related to
the discontinuance of LIBOR. Weekapaug could not change
the hedged item from SOFR interest payments to Bloomberg
Short-Term Bank Yield Index interest payments without
dedesignating the hedging relationship because that
change is not within the scope of ASC 848-20-15-2 and
15-3.
ASU 2020-04 provides additional expedients for the different
types of hedges. An entity that elects to apply these expedients must update its
hedge documentation accordingly.
8.2.3.2 Fair Value Hedges
For existing hedges, ASU 2020-04 allows an entity to change the designated
benchmark interest rate and the component of cash flows if (1) the rate
referenced by the hedging instrument changes or (2) the designation of the
hedging instrument is changed to a combination of derivatives. Further, (1) the
benchmark interest rate designated at hedge inception should be an affected
rate, (2) the newly designated rate should be an eligible benchmark interest
rate, and (3) the entity must expect that the hedging relationship will be
highly effective prospectively.
For existing hedges for which the shortcut method is applied,
when an entity assesses whether the hedging relationship continues to meet the
shortcut criteria, it can, for the remainder of the hedging relationship
(including for periods after December 31, 20248), disregard the requirements that (1) the formula for computing net
settlements under the interest rate swap is the same for each net settlement and
(2) the hedging relationship does not contain any atypical terms or terms that
would invalidate an assumption of perfect effectiveness.
Connecting the Dots
When an entity elects to change the designated benchmark
interest rate in an existing fair value hedging relationship, it must
revise the rate it uses to discount the hedged item’s cash flows to
reflect the change. It also can either (1) choose not to adjust the
cumulative fair value hedge basis adjustment associated with the hedged
item (that consists of cumulative hedging adjustments that existed
immediately before the date of change) or (2) adjust that basis
adjustment to reflect the replacement benchmark interest rate. To
implement its approach, the entity can further adjust either the
remaining designated cash flows or the revised benchmark interest rate
used to discount the hedged cash flows (by including a spread
adjustment). The method an entity uses to apply these approaches is not
prescribed by the ASU; however, it must be reasonable and be
consistently applied to similar hedges. The entity would use the revised
benchmark interest rate (including any applicable spread adjustment) and
the remaining revised cash flows for the designated term of the hedged
item (including periods after December 31, 2024).
When an entity chooses to update the cumulative basis adjustment to
reflect the new benchmark interest rate, it must recognize the
adjustment currently in earnings in the same income statement line as
the earnings effect of the hedged item.
8.2.3.3 Cash Flow Hedges
Under ASU 2020-04, if the designated hedged risk in a cash flow hedge of a
forecasted transaction is the affected rate, an entity can continue to assert
that the forecasted transaction’s occurrence is probable despite the entity’s
expectations about the reference rate’s discontinuance; however, the entity must
continue to assess whether it is probable that the underlying forecasted
transaction (e.g., future interest payments) will occur.
Further, if an entity applies the change in hedged risk guidance to a hedging
relationship affected by reference rate reform, it may determine that the
hedging relationship can continue by electing an optional expedient method to
assess hedge effectiveness.
ASU 2020-04 also notes that if a forecasted transaction in a hedged group of
forecasted transactions references an affected rate, the entity may disregard
the requirement that the group of individual transactions share the same risk
exposure for which they are designated as being hedged; however, the other
requirements for hedging a group of forecasted transactions still must be met
(e.g., forecasted purchases cannot be combined in a group with forecasted
sales).
8.2.3.3.1 Expedients for Assessing Cash Flow Hedge Effectiveness
As noted above, ASU 2020-04 allows entities to apply certain optional
expedients to change a cash flow hedging relationship’s critical terms in
certain circumstances. The ASU provides additional cash flow hedge
expedients that offer relief to entities when they perform effectiveness
assessments for new or existing cash flow hedging relationships in which
either the hedged forecasted transaction or the hedging instrument
references an affected rate. These expedients allow the entity to ignore
certain requirements that a hedging relationship would have otherwise been
required to satisfy to qualify for application of the specified method of
assessing hedge effectiveness. For existing hedging relationships, the
entity should apply the optional practical expedient prospectively from the
date on which it first applies the expedient. An entity would use the
expedient for both prospective and retrospective effectiveness assessments
(retrospective assessments would go back only to the date on which the
entity first applied the expedient). An entity that elects to apply an
expedient must also amend its hedge documentation to reflect its new
effectiveness assessment method.
8.2.3.3.1.1 Expedients Related to Methods That Assume Perfect Hedge Effectiveness
The table below lists conditions that an entity can disregard when it
qualifies for and applies the relevant expedient and performs initial or
subsequent assessments of hedge effectiveness by using an assessment
method that allows for an assumption of perfect hedge effectiveness.
|
Method of Assuming Perfect Hedge
Effectiveness
|
Conditions
That May Be Disregarded
|
|---|---|
|
Shortcut method
|
|
|
Assessment on the basis of an option’s terminal
value
|
|
|
Simplified hedge accounting approach
|
|
|
Change in variable cash flows method
|
|
|
Hypothetical derivative method
|
The
hypothetical derivative and the hedged items have
the same:
|
If a hedging relationship satisfies all the other criteria under the
specified method that would allow for an assumption of perfect hedge
effectiveness (after the criteria listed above are disregarded), the
entity may assume that the hedge will be perfectly effective.
8.2.3.3.1.2 Expedients Related to Quantitative Methods
ASU 2020-04 also permits
an entity to apply the following optional expedients for the specified
effectiveness assessment method when it performs either an initial or
subsequent quantitative assessment of cash flow hedge effectiveness:
|
Quantitative Method of Assessing Hedge
Effectiveness
|
Optional Expedients
|
|---|---|
|
|
|
Assessment on the basis of an option’s terminal
value
|
If either the hedging instrument
or hedged item references an affected rate, an
entity may adjust the critical terms of the
perfectly effective hypothetical derivative used
to assess effectiveness to match those of the
hedging instrument for:
|
8.2.3.3.1.3 Expedients Related to a Qualitative Method
ASU 2020-04 also provides expedients for circumstances in which an entity
performs subsequent effectiveness assessments by using a qualitative
method. Under the ASU, an entity may perform subsequent qualitative
effectiveness assessments when the entity performs its initial test of
hedge effectiveness by using either (1) one of the effectiveness
assessment methods in ASC 815-20 and ASC 815-30 or (2) an optional
expedient method. An entity that elects to apply this optional expedient
may disregard the criteria in ASC 815-20-35-2A through 35-2F that it
would otherwise have had to satisfy to qualify for the use of subsequent
qualitative assessments.
Under the ASU, to conclude that a hedging relationship continues to
qualify for subsequent qualitative effectiveness assessments, an entity
“shall verify and document whenever financial statements or earnings are
reported and at least every three months,” that the relationship
satisfies the following criteria:
-
Either the hedging instrument or the hedged forecasted transaction references an affected rate.
-
No changes have been made to the hedging instrument’s or forecasted transaction’s terms other than those that are permitted under the ASU (see the discussion above about modifications that are subject to the ASU).
-
The likelihood of the counterparty’s compliance with the hedging instrument’s contractual terms has been considered by the entity.
No other facts or circumstances need to be assessed.
An entity that determines that it can no longer qualitatively assert that
a hedging relationship is highly effective would need to quantitatively
assess the hedging relationship’s effectiveness; however, the entity
could elect to apply any expedient for a quantitative assessment method
if the hedging relationship is eligible for that expedient.
Connecting the Dots
In ASU 2020-04’s Background Information and Basis for
Conclusions, the Board acknowledges that the cash flow hedge
expedients provide a great deal of flexibility and that their
application could result in an entity’s applying hedge
accounting to a hedging relationship that is not highly
effective. In addition, for many hedges, application of the
expedients would essentially suspend the requirement to perform
subsequent hedge effectiveness assessments. The Board believes,
however, that new and existing cash flow hedges that will be
affected by reference rate reform should be allowed to continue
because they reflect the entity’s intended risk management
strategy.
Further, the Board believes that the flexibility
afforded by the expedients is counterbalanced by (1) its
requirement that entities adopt ASU 2017-12 before they can qualify for
most of the expedients (only certain expedients are available
for entities that have not yet adopted ASU 2017-12) and (2) the
fact that the relief is available only for a limited time and
will sunset at the end of 2024.10 Specifically, in a qualifying cash flow hedge under ASU
2017-12, the portion of the change in the fair value of the
hedging instrument that is included in the assessment of hedge
effectiveness is initially recognized in OCI in each reporting
period. Amounts in AOCI will ultimately be reclassified into
earnings in the same period or periods in which the hedged
transaction affects earnings and will be recognized in the same
income statement line as the earnings effect of the hedged item.
Because of this presentation requirement, the Board observes in
paragraph BC88 of ASU 2020-04 that “the results of an entity’s
hedging relationships are reflected in an income statement line
item that is typically an important metric for entities that
have significant interest rate risk hedging programs. Therefore,
in the Board’s view, the results of systematically entering into
drastically ineffective hedges would raise questions on the part
of users of financial statements.”
8.2.3.3.2 Losing Eligibility to Use an Expedient
An entity must cease using an expedient for assessing hedge effectiveness for
a cash flow hedge if any of the following conditions occur:
-
Neither the hedging instrument nor the hedged item references an affected rate.
-
The expedient guidance is superseded.
-
The entity chooses to cease application of the expedient.
When it stops using an expedient, the entity must revert to applying the
qualifying criteria and effectiveness assessment methods in ASC 815-20 and
ASC 815-30. A change in the effectiveness assessment method would not, in
and of itself, trigger a need to dedesignate the hedging relationship;
however, the entity would need to update its hedge documentation
accordingly. For continuing hedging relationships, the entity would apply
the new method of assessing effectiveness both prospectively and
retrospectively from the date of change (i.e., when the new assessment
method is first applied).
8.2.4 HTM Debt Security Classification Relief
Under ASU 2020-04, an entity may make a one-time election to sell, or to transfer to
the AFS or trading classifications (or both sell and transfer), debt securities that
both (1) reference an affected rate and (2) were classified as HTM before January 1,
2020. An entity that makes this election is not required to apply it to all debt
securities meeting these criteria. Such sales or transfers would not call into
question the entity’s previous assertions about its intent and ability to hold those
securities to maturity. An entity making such a transfer is required to apply the
measurement guidance governing transfers in ASC 320-10-35-10 through 35-16 and
provide the disclosures required by ASC 320-10-50-10.
8.2.5 Disclosures
Entities are required to disclose the nature of and reason for their elections to
apply expedients in each interim and annual financial statement period in the fiscal
year of adoption.
8.2.6 Effective Dates, Transition, and Expiration Dates
The optional amendments are effective for all entities as of March
12, 2020, through December 31, 2024.11 The table below summarizes the effective dates and expiration dates by
category of expedient.
|
Type of Expedient
|
Effective Date/Expiration Date
|
|---|---|
|
Contract modifications
|
|
|
Hedging relationships
|
|
|
Sale or transfer of HTM securities
|
|
Connecting the Dots
As indicated in ASC 848-10-65-1(c), only the following optional expedients
are available for entities that have not yet adopted ASU 2017-12:
-
Entities may change the “critical terms of a hedging relationship.”
-
Private companies may change the method for “assessing hedge effectiveness in a cash flow hedge . . . if the optional expedient method being elected is the simplified hedge accounting approach” for initial or subsequent hedge effectiveness assessments.
-
For cash flow hedges, entities may assume that the occurrence of the hedged forecasted transaction is probable.
-
When using a quantitative method to assess the effectiveness of cash flow hedges, entities may “assume that the reference rate will not be replaced for the remainder of the hedging relationships . . . if both the hedged forecasted transaction and the hedging instrument” reference an affected rate.
-
Private companies may disregard certain criteria when applying the simplified hedge accounting approach in initial or subsequent hedge effectiveness assessments.
Footnotes
2
As discussed in Section 8.1, on December 21, 2022, the
FASB issued ASU 2022-06 to defer the sunset date of ASC 848 until December 31,
2024. The ASU became effective upon issuance.
3
The modification can be made in anticipation of the
reference rate discontinuance (i.e., before the reference rate is
actually discontinued).
4
Under ASU 2020-04, the
“selection of a rate that is the last published
rate of an interest rate index that is
discontinued is not considered a stated fixed
rate.”
5
ASU 2020-04 provides that the
addition or removal of a prepayment or conversion
option is considered unrelated to the replacement
of a reference rate except for “the addition of a
prepayment option for which exercise is contingent
upon the replacement reference interest rate index
not being determinable in accordance with the
terms of the agreement.”
6
The expedient would also apply to hedging
instruments that are modified by (1) entering into a
derivative that fully offsets the original designated
hedging instrument and (2) contemporaneously entering into a
new derivative that has the modified contractual terms.
7
If the entity rebalances a fair value
hedging relationship by increasing or reducing the
designated portion of the hedged item, it must recognize the
cumulative effect of making that change as an adjustment to
the basis adjustment that would be recognized as a result of
changing the designated benchmark interest rate, in
accordance with ASC 848-40.
8
See footnote 2.
9
For a forecasted issuance or
purchase of fixed-rate debt in which the
designated hedged interest rate risk is a
benchmark interest rate, only the hedging
instrument must reference an affected rate.
10
See footnote 2.
11
See footnote 2.
12
See footnote 2.
13
See footnote 2.
14
Under ASU 2020-04, if any of
the following expedients are elected for hedging
relationships existing as of December 31, 2024
(see footnote 2), they will be retained through
the end of the hedging relationship:
- “An optional expedient to the systematic and rational method used to recognize in earnings the components excluded from the assessment of effectiveness.”
- “An optional expedient to the rate to discount cash flows associated with the hedged item and any adjustment to the cash flows for the designated term or the partial term of the designated hedged item in a fair value hedge.”
- “An optional expedient to not periodically evaluate [the specified] conditions in [ASC] 815-20-25-104(d) and (g) when using the shortcut method for a fair value hedge.”
15
See footnote 2.