FASB Addresses Reference Rate Reform
Background
On March 12, 2020, the FASB concluded its reference rate reform project and
issued ASU 2020-04.1
The Board undertook the reference rate reform project to address constituents’
concerns about certain accounting consequences that could result from the global
markets’ anticipated transition away from the use of the London Interbank
Offered Rate (LIBOR) and other interbank offered rates to alternative reference
rates. Constituents feared that, without new guidance and relief, entities’
application of contract modification and hedging requirements under U.S. GAAP to
modifications triggered by reference rate reform would be costly to implement
and result in financial reporting that did not faithfully represent management’s
intent or risk management activities. In addition, the FASB believes that such
accounting treatment would not provide decision-useful information to financial
statement users.
The relief provided by the ASU 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.
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ASC 815-15, Derivatives and Hedging: Embedded Derivatives.
The ASU 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 FASB is not acting alone in its efforts to address issues related to
reference rate reform. In 2019, the SEC staff issued a statement2 that provides additional guidance related to reference rate reform. For
more information about the staff’s statement, see Deloitte’s August 6, 2019,
Heads Up. The International Accounting Standards
Board is also addressing reference rate reform as part of its agenda.
Scope
The elective contract modification guidance in the ASU 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
The ASU 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 the
ASU.
Held-to-Maturity Debt Security Classification Relief
Under the ASU, an entity may make a one-time election to sell, or to transfer to
the available-for-sale or trading classifications (or both sell and transfer),
debt securities that both (1) reference an affected rate and (2) were classified
as held to maturity 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 35-163 and provide the disclosures required by ASC 320-10-50-10.
Contract Modification Relief
Scope
The elective guidance in the ASU 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
in the Codification’s contract modification subtopic 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
4
The modification can be made in anticipation of the reference
rate discontinuance (i.e., before the reference rate is
actually discontinued).
The ASU 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 following table 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.”
Contract Modification Expedients
The table below summarizes the optional expedients provided by the ASU 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 310-20-35-10.7
|
|
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 470-50-40-108 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 the ASU, 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;9 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.
Hedging Relief
Changes in Critical Terms
The ASU also 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.10
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Changing either the designated notional amount or proportion of the hedging instrument, the hedged item, or both to rebalance a fair value hedge.11
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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.
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Changing the method of assessing hedge effectiveness for cash flow hedges when (1) either the hedging instrument or the hedged item references an affected rate and (2) the new effectiveness assessment method is an optional expedient for cash flow hedges under ASC 848-50.12The entity would not be required to demonstrate that the new method is either an improved or preferable method under ASC 250.13 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 815-30.14
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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 assessment of effectiveness 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.
The ASU provides additional expedients for the different types of hedges. An
entity that elects to apply these expedients must update its hedge
documentation accordingly.
Fair Value Hedges
For existing hedges, an entity may 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.
Further, 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, 2022), 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, 2022).
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.
Cash Flow Hedges
If the designated hedged risk in a cash flow hedge of a forecasted
transaction is an 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.
The ASU 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).
Expedients for Assessing Cash Flow Hedge Effectiveness
As noted above, the ASU 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 that 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.
Expedients Related to Methods That Assume Perfect Hedge Effectiveness
The following table 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
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Conditions That May Be Disregarded
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|---|---|
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Shortcut method
|
|
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Assessment on the basis of an option’s terminal
value
|
|
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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 disregarding the criteria listed above), the entity may
assume that the hedge will be perfectly effective.
Expedients Related to Quantitative Methods
The ASU 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:
|
Expedients Related to a Qualitative Method
The ASU 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 the ASU’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 2017-1216 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
2022. Specifically, 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 in a qualifying cash flow
hedge is initially recognized in other comprehensive income
(OCI) in each reporting period. Amounts in accumulated OCI 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 observed 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.”
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).
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.
Effective Date and Transition
The optional amendments are effective for all entities as of March 12, 2020,
through December 31, 2022.
|
Type
|
Effective Date/Expiration Date
|
|---|---|
|
Contract modifications
|
|
|
Hedging relationships
|
|
|
Sale or transfer of held-to-maturity securities
|
The one-time election to sell or transfer eligible
held-to-maturity securities may be made at any time
after March 12, 2020, but no later than December 31,
2022.
|
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:
-
Changing critical terms of a hedging relationship.
-
Changing the method for assessing hedge effectiveness in a cash flow hedge if the optional expedient method elected is the simplified hedge accounting approach for private companies for initial or subsequent hedge effectiveness assessments.
-
Assuming that the occurrence of the hedged forecasted transaction for cash flow hedges is probable.
-
Assuming that the reference rate will not be replaced for the remainder of the hedging relationship when the entity is using a quantitative method to assess hedge effectiveness in a cash flow hedge, if both the hedged forecasted transaction and the hedging instrument reference an affected rate.
-
Allowing an entity to disregard certain criteria when applying the simplified hedge accounting approach for private companies for initial or subsequent hedge effectiveness assessments.
Footnotes
1
FASB Accounting Standards Update (ASU) No. 2020-04, Facilitation of
the Effects of Reference Rate Reform on Financial Reporting.
2
Staff Statement on LIBOR Transition.
3
FASB Accounting Standards Codification (ASC) Subtopic 320-10,
Investments — Debt and Equity Securities: Overall.
4
The modification can be made in anticipation of the reference
rate discontinuance (i.e., before the reference rate is
actually discontinued).
5
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.”
6
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.”
7
ASC Subtopic 310-20, Receivables:
Nonrefundable Fees and Other Costs.
8
ASC Subtopic 470-50, Debt: Modifications and
Extinguishments.
9
ASC Subtopic 944-310, Financial Services — Insurance:
Receivables.
10
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.
11
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 Subtopic 848-40,
Reference Rate Reform: Fair Value Hedges.
12
ASC Subtopic 848-50, Reference Rate Reform: Cash Flow
Hedges.
13
ASC Topic 250, Accounting for Changes and Error
Corrections.
14
ASC Subtopics 815-20, Derivatives and Hedging: Hedging
— General, and 815-30, Derivatives and
Hedging: Cash Flow Hedges.
15
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.
16
FASB Accounting Standards Update No. 2017-12, Targeted
Improvements to Accounting for Hedging
Activities.
17
Under the ASU, if any of the following
expedients are elected for hedging relationships
existing as of December 31, 2022, 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.”