FASB Issues Proposal to Refine the Scope of ASC 848 in Response to Reference Rate Reform
On October 29, 2020, the FASB issued a proposed ASU1 that would refine the scope of ASC 8482 and clarify some of its guidance as part of the Board’s monitoring of global
reference rate reform activities. The proposed amendments would permit entities to
elect certain optional expedients and exceptions when accounting for derivative
contracts and certain hedging relationships affected by changes in the interest
rates used for discounting cash flows, for computing variation margin settlements,
and for calculating price alignment interest (PAI3) in connection with reference rate reform activities underway in global
financial markets (the “discounting transition”).
Comments on the proposed ASU are due by November 13, 2020. For ease
of reference, the proposal’s questions for respondents are reproduced in the
appendix of this Heads Up.
Background
Global market participants are undertaking efforts to transition from using or
referencing the London Interbank Offered Rate (LIBOR) and other interbank
offered rates to using or referencing alternative reference rates. Such efforts
have included changes made by certain central clearing parties (CCPs) to the
interest rates used for discounting and for variation margin settlements and
PAI. For example, on July 24, 2020, the Chicago Mercantile Exchange (CME)
changed the interest rate used in certain euro contracts for discounting and PAI
from the Euro Overnight Index Average (EONIA) to the Euro Short-Term Rate
(ESTR). In addition, on October 16, 2020, it changed the interest rate used in
U.S. dollar contracts for discounting and PAI from the daily Effective Federal
Funds Rate (EFFR) to the Secured Overnight Financing Rate (SOFR).4 Interest rate transitions such as the CME’s changes do not necessarily
replace reference rates that are expected to be discontinued (e.g., the daily
EFFR is not expected to be discontinued), and they are not limited to contracts
that reference a rate that is expected to be discontinued (e.g., the CME’s
interest rate transition applies to all U.S. dollar interest rate products, not
only those that reference LIBOR or another rate that is expected to be
discontinued). The CME’s interest rate transitions, for example, are intended to
increase the trading volume in alternative reference rates (e.g., ESTR and
SOFR).
The discounting transition may also affect collateralized bilateral derivative
transactions, not all of which are indexed to a rate that will be discontinued
as a result of reference rate reform. The proposed ASU is intended to reduce
diversity in practice related to accounting for (1) modifications to the terms
of affected derivatives and (2) existing hedging relationships in which the
affected derivatives are designated as hedging instruments.
This Heads Up should be read alongside Deloitte’s March 23, 2020,
Heads Up.
Main Provisions of the Proposed Amendments
Scope (ASC 848-10)
The FASB acknowledges that not all derivative contracts subject to the
discounting transition reference LIBOR or other interbank offered rates that
are expected to be discontinued. For example, the discounting transition
will affect derivative contracts that currently reference and will continue
to reference other interest rates (e.g., EFFR, SOFR, the Securities Industry
and Financial Markets Association (SIFMA) Municipal Swap Rate). However, the
current scope of ASC 848 does not include such contracts. As stated in
paragraph BC9 of the proposed ASU, ASC 848 was intended to provide relief
related to “contracts and transactions that reference LIBOR or a reference
rate that is expected to be discontinued as a result of reference rate
reform.” Accordingly, the proposed amendments would expand the scope of ASC
848 to include all affected derivatives and give market participants the
ability to apply certain aspects of the contract modification and hedge
accounting expedients to derivative contracts affected by the discounting
transition.
Contract Modification (ASC 848-20)
ASU 848-20-35-1 currently indicates that an entity that elects to use a
contract modification expedient under a particular Codification topic,
subtopic, or industry subtopic must apply that expedient to all contract
modifications accounted for under that guidance. The proposed ASU would
provide an exception to those requirements that permits an entity to also
elect to apply the expedient to all other derivative contract modifications
related to reference rate reform on a different date (i.e., when other
modifications are made).
Connecting the Dots
ASC 848-20-35-4 and ASC 848-20-55-2 can be applied to derivative
contracts affected by the discounting transition. That is, an entity
can conclude that a contract previously determined to be a
derivative in accordance with ASC 815 continues to meet the
definition of a derivative and not a hybrid instrument in situations
in which the terms of the contract change as a result of the
discounting transition. Further, in accordance with ASC 815-10-45-11
through 45-15, an entity does not need to reassess whether the
contract includes a financing element.
Hedging — General (ASC 848-30)
The proposed ASU would permit an entity to elect certain hedging relief if it
has designated a derivative as a hedging instrument in a hedging
relationship and the terms of the derivative (e.g., discount rate) have
changed as a result of the discounting transition.
Connecting the Dots
In situations in which a derivative is designated as a hedging
instrument in a hedging relationship and the interest rate used for
discounting cash flows to calculate variation margin settlements and
PAI has changed as a result of the discounting transition, questions
have arisen about whether the change was made to critical terms of
the hedging relationship. The proposed ASU clarifies that ASC
848-30-25-7 continues to apply to the affected derivative; that is,
a change in the interest rate as a result of the discounting
transition would not be considered a change to the critical terms of
a hedging relationship. An entity can continue to apply hedge
accounting without dedesignating the existing hedging
relationship.
A cash settlement (or equivalent) may be exchanged to
neutralize the change in the fair value of a derivative affected by the
discounting transition. If such a derivative is designated as a hedging
instrument in a cash flow hedging relationship, that cash settlement may
create a mismatch between the fair value of the hedging instrument and the
amount deferred in accumulated other comprehensive income (AOCI).
An entity that assesses hedge effectiveness of a cash flow
hedge relationship by using a method that allows an assumption of perfect
hedge effectiveness would be permitted under the proposal to elect the
relevant optional expedients and subsequently apply the original
effectiveness assessment method under which it continues to assume that the
hedge is perfectly effective after the discounting transition.
Alternatively, the entity can elect to change to any applicable quantitative
method of assessing the effectiveness of a cash flow hedge in ASC 815-20 and
ASC 815-30 without dedesignating the hedging relationship.
The proposed ASU would require an entity that originally
applied a quantitative or qualitative method in accordance with ASC 815-20
and ASC 815-30 to continue to apply the same method when performing its
subsequent effectiveness assessment of a cash flow hedge relationship that
was affected by the discounting transition. In addition, the entity would be
able to use a reasonable approach to adjust the amount recorded in AOCI for
the cash settlement (or equivalent) as a result of the discounting
transition. Any adjustment to AOCI would be recognized in the income
statement in the same manner as other reclassifications out of AOCI related
to the hedging relationship.
Connecting the Dots
The proposed ASU and ASC 848 do not specify the method an entity
should use to adjust the amount in AOCI for the cash settlement (or
equivalent) as a result of the discounting transition, only that
such method should be reasonable. However, an entity should apply
its elected method consistently to similar hedges. An entity that
does not elect to adjust the amount recorded in AOCI as a result of
the discounting transition should ensure that all such amounts are
reclassified into earnings when the hedged transaction affects
earnings or when it is probable that the hedged transaction will no
longer occur.
In fair value hedging relationships for which the shortcut method is used, a
receipt or payment of a cash settlement (or equivalent) as a result of the
discounting transition may also cause a mismatch in the cumulative change in
fair value of the hedging instrument (e.g., an interest rate swap) and the
cumulative-basis adjustments applied to the hedged item (e.g., fixed-rate
debt hedged for changes in fair value because of changes in LIBOR). That is,
the cumulative-basis adjustments will not be naturally unwound as
settlements occur on the hedging instrument. The proposed ASU addresses this
issue by adding an optional expedient that would permit an entity to use a
reasonable approach to adjust the cumulative-basis adjustment for the amount
equal to the fair value change in the hedging instrument (i.e., a cash
settlement or equivalent) as a result of the discounting transition. An
entity could also elect, as an optional expedient, to continue to apply the
shortcut method when assessing the effectiveness of the hedging relationship
affected by the discounting transition.
In connection with the discounting transition, an entity may receive a series
of basis swaps (e.g., EFFR for SOFR) simultaneously with a payment or
receipt of a cash settlement (or equivalent). The proposed ASU would allow
the entity to add one or more, or proportions of, basis swaps to a
derivative designed as a hedging instrument in a hedging relationship
without having to dedesignate the hedging relationship if the hedging
instrument is affected by, and those basis swaps are received as a result
of, the discounting transition. Subsequent removal of one or more, or
proportions of, basis swaps that were added to the designated hedging
instrument would also not result in dedesignation of the hedging
relationship.
Connecting the Dots
The proposed ASU does not otherwise specifically address the
subsequent accounting for basis swaps, which are separate
freestanding derivatives subject to ASC 815.
Fair Value Hedges (ASC 848-40)
The proposed ASU would allow an entity to change the designated benchmark
interest rate in a fair value hedge relationship if a designated derivative
is affected by the discounting transition.
As discussed above, the proposed amendment to ASC 848-30-25-10 allows an
entity to continue to apply the shortcut method when subsequently assessing
effectiveness of a fair value hedging relationship affected by the
discounting transition. This optional expedient will be available until the
remainder of the original hedging relationship that includes periods after
December 31, 2022. However, if an entity also elects the expedient that
permits it to add one or more, or proportions of, basis swaps received as a
result of the discounting transition to an existing hedging relationship for
which the shortcut method is applied, the proposed ASU would not permit the
entity to continue to apply the shortcut method after December 31, 2022. In
other words, the entity must cease the application of the shortcut method
after December 31, 2022, and change to another effectiveness assessment
method in ASC 815-20 and ASC 815-25.
Connecting the Dots
The election to apply any of the expedients discussed would not
result in dedesignation of the existing fair value hedge
relationship, but the entity would be required to update the hedge
documentation to identify the elections.
Cash Flow Hedges (ASC 848-50)
If a derivative that is affected by the discounting transition is already
designated in a cash flow hedging relationship using a hedge effectiveness
assessment method under which perfect effectiveness was assumed, the
proposal would allow an entity to continue to do either of the following:
- Apply the corresponding optional expedient to assume perfect effectiveness in accordance with the expedients previously provided by ASU 2020-04.5
- Change its effectiveness approach to a quantitative method in accordance with ASC 815-20 and ASC 815-30.
Regardless of which alternative it selects, an entity can make its election
without dedesignating the hedging relationship.
Provisions That Were Not Directly Amended but Can Be Applied to the Affected Derivatives
The proposed ASU would not amend certain optional expedients and exceptions in
ASC 848. However, the FASB clarifies in the proposed ASU that an entity would
apply the optional expedients and exceptions described in the table below
(reproduced from the proposed ASU) to derivative contracts that are affected by
the discounting transition.
Codification Subtopic
|
Provisions That Apply to Derivatives Affected by the
Discounting Transition That Were Not Directly
Amended
|
---|---|
Reference Rate Reform — Contract Modifications
(848-20)
|
|
Hedging — General (848-30)
|
|
Fair Value Hedges (848-40)
|
|
Cash Flow Hedges (848-50)
|
|
Effective Date and Transition
The amendments in the proposed ASU would be effective, once finalized, for all
entities as follows:
Type
|
Effective Date and Expiration Date
|
---|---|
Contract modifications
|
Entities would use either of the following approaches to
apply the amendments to modifications to the terms of
the derivatives affected by the discounting transition:
|
Hedging relationships6
|
Entities would apply the amendments to either of the
following types of eligible hedging relationships
affected by the discounting transition:
|
The amendments do not apply to (1) contract modifications made or new hedging
relationships entered into after December 31, 2022, or (2) existing hedging
relationships evaluated for periods after December 31, 2022, unless an entity
elects to apply certain optional expedients that permit the accounting effects
to be retained through the end of the hedging relationships that extend beyond
December 31, 2022. Under those optional expedients, an entity would:
- Use a reasonable approach to modify the fair value hedge basis adjustment in a fair value hedge accounted for under the shortcut method.
- No longer periodically evaluate the conditions in ASC 815-20-25-104(d) and (g) when using the shortcut method for a fair value hedge. However, the entity’s application of the shortcut method would cease after December 31, 2022, if the entity elects the optional expedient to add one or more, or a proportion of, basis swaps to a fair value hedging relationship as a result of the discounting transition.
- Use a reasonable approach to adjust the amount recorded in AOCI for a cash flow hedge affected by a receipt or payment of a cash settlement (or equivalent) as a result of the discounting transition.
- Continue to use a subsequent assessment method under which perfect effectiveness is assumed in accordance with ASC 848-50-35-4 through 35-9 for a cash flow hedge if the entity elected the practical expedient that permits it to use a reasonable approach to adjust the amount recorded in AOCI as a result of the discounting transition.
Connecting the Dots
Under the proposed ASU, any private company that has not
yet adopted ASU 2017-127 is only allowed to elect the expedient permitting it to change the
method designated for use in assessing the effectiveness of a hedging
relationship if it elects the optional expedient under which it may
apply “the simplified hedge accounting approach for eligible private
companies or for subsequent hedge effectiveness in paragraph
848-50-35-7” after the discounting transition.
Appendix — Questions for Respondents
The proposed ASU’s questions for respondents are reproduced below for
reference.
Question 1 — Scope Refinement: Do you agree that the scope of Topic 848
should be refined to include contracts that do not reference a rate expected to
be discontinued as a result of reference rate reform but that are affected by
the discounting transition? Why or why not?
Question 2 — Operability: The Board is proposing amendments in this Update
to the expedients and exceptions in Topic 848 to capture the incremental
consequences of the proposed scope refinement and tailor the existing guidance
to derivative instruments affected by the discounting transition. Are those
proposed amendments complete and operable? If not, what suggestions do you have
and why?
Question 3 — Effective Date and Transition: Do you agree with the proposed
effective date and transition guidance? Why or why not?
Question 4 — Ongoing Monitoring: Are there other accounting consequences
related to reference rate reform that the Board should consider?
Footnotes
1
FASB Proposed Accounting Standards Update (ASU),
Reference Rate Reform (Topic 848): Scope Refinement.
2
For titles of FASB Accounting Standards Codification
(ASC or the “Codification”) references, see Deloitte’s “Titles of Topics and Subtopics
in the FASB Accounting Standards
Codification.”
3
PAI is also referred to as the price alignment amount (PAA)
by the London Clearing House, and price alignment (PA) by the Chicago
Mercantile Exchange.
4
See the CME’s “SOFR Discounting Transition Process for Cleared
Swaps,” August 2020.
5
FASB Accounting Standards Update No.
2020-04, Reference Rate Reform (Topic 848): Facilitation
of the Effects of Reference Rate Reform on Financial
Reporting.
6
Once finalized, the guidance in the proposed ASU
would require any private company that is not a
financial institution as described in ASC
942-320-50-1 and any not-for-profit entity (except
for a not-for-profit entity that has issued, or is
a conduit bond obligor for, securities that are
traded, listed, or quoted on an exchange or an
over-the-counter market) and that adopts any of
the proposed amendments related to a hedging
relationship to update its hedge documentation
before the next interim (if applicable) or annual
financial statements are available to be issued.
All other entities would be required to update
their hedge documentation no later than when those
entities perform the first quarterly hedge
effectiveness assessment after making any
elections in the proposed ASU for that hedging
relationship.
7
FASB Accounting Standards Update No. 2017-12,
Derivatives and Hedging (Topic 815): Targeted
Improvements to Accounting for Hedging Activities.