Laboring Over LIBOR

Nancy Miller, CPA Controller - UOP, Honeywell International Inc.
Navigating the Ins and Outs of Corporate Finance

The most widely used interest rate benchmark in the world, the London Interbank Offered Rate (LIBOR), will be replaced by the end of 2021. This benchmark is instrumental in global contracts representing hundreds of trillions of dollars. Are we ready for this transition?

LIBOR’s discontinuation poses risks and challenges for organizations worldwide because so many financial instruments are linked to it. As most market participants never anticipated LIBOR’s discontinuation, many financial transactions provide no contractual fallbacks or contain provisions that may not effectively cover this particular scenario. Given these gaps and the risks to the financial system, the State of New York and the European Union have both recently adopted measures to migrate certain contracts to their respective regulators’ recommended replacement benchmark in an effort to reduce the uncertainty surrounding LIBOR’s cessation.

In addition to ongoing legislative work, the Financial Accounting Standards Board (FASB) has begun to clarify accounting guidance to facilitate the transition of corporate floating-rate transactions from the LIBOR reference rate in Topic 848, “Reference Rate Reform.” The new topic incudes Accounting Standards Update (ASU) 2020-04, “Facilitation of the Effects of Reference Rate Reform on Financial Reporting,” and ASU 2021-01, “Reference Rate Reform: Scope,” which clarifies some scope issues related to hedge accounting.

LIBOR is not just an issue for commercial banks. References to LIBOR occur in many longterm contracts with a financing element, including contracts with customers and suppliers, operating and financing leases, and hedging arrangements. For example, the transition provisions in ASC 842, “Leases,” specified that many of the practical expedients could only be applied as long as the lease is not modified. Modifications to replace LIBOR with another reference rate could have triggered a significant change in lease accounting. Fortunately, the FASB has provided an optional expedient for lease modifications so that the LIBOR transition can be addressed without needing to reassess lease classification and the discount rate, remeasure lease payments, or perform other reevaluations. The change in the reference rate will continue to be accounted for as variable rent. However, one cannot pick and choose: The optional expedient must be applied to all eligible leases.

The impact of the transition on derivatives will largely focus on interest rate hedges for loans with a variable interest rate tied to LIBOR. There are two major requirements for hedge accounting: documentation and effectiveness assessment. The requirements for documentation are very specific and are listed at the inception of the hedge relationship, including documenting the nature of the hedged risk, identifying the hedging instrument, defining the hedged item, and stating how effectiveness assessment requirements will be met. For interest rate hedge designations, the underlying interest rate is key to all these documentation requirements and to performing the associated effectiveness assessment testing.

Many existing hedges will simply continue as they had been accounted for historically under the finalized ASC 848, as there are meaningful reliefs from the strict criteria for using the “critical terms matched” and “shortcut” methods for hedge accounting. Hedgers will be able to hedge benchmark rates where long-haul effectiveness testing is used. With the flexibility currently built into the guidance, current LIBOR hedgers will be able to adjust documentation at the time the relief is applied. This period of relief will end in 2022.

As for a LIBOR alternative, the FASB has added the Secured Overnight Financing Rate (SOFR) to the list of eligible benchmark rates. However, transitioning from the term structure of LIBOR, a forward-looking rate with an embedded credit component, to SOFR, an overnight risk-free rate, requires operational changes by market participants. End-users are accustomed to calculating LIBOR-based cash flows well in advance of payment due to LIBOR’s term structure. There is insufficient liquidity in futures and over-the-counter derivatives markets to facilitate the development of meaningful SOFR-based forward curves as SOFR still remains an overnight rate. End-users will need to negotiate SOFR-based financial instruments and adopt systems and processes that mitigate the risks of SOFR’s daily volatility.

The impact of the LIBOR discontinuation and transition to alternative reference rates can hardly be overstated. There are still many moving parts and significant uncertainty as to the passage of legislative solutions. Those who do their homework and act decisively are likely to gain a strategic advantage and significant financial rewards—while those who choose to ignore the impending change are likely to face grave consequences.

This column was co-authored with John Hepp, Ph.D., clinical assistant professor of accountancy in the University of Illinois Gies College of Business.