Practical guide to Phase 2 amendments to IFRS 9, IAS 39, IFRS 7, IFRS 4 and IFRS 16 for interest rate benchmark (IBOR) reform: PwC In depth INT2020-06

Publication date: 09 Oct 2020

adobe_pdf_file_icon_32x32Practical guide to Phase 2 amendments to IFRS 9, IAS 39, IFRS 7, IFRS 4 and IFRS 16 for interest rate benchmark (IBOR) reform: PwC In depth INT2020-06

At a glance

The IASB has issued amendments to IFRS 9, IAS 39, IFRS 7, IFRS 4 and IFRS 16 that address issues arising during the reform of benchmark interest rates including the replacement of one benchmark rate with an alternative one. Given the pervasive nature of IBOR-based contracts, the amendments could affect companies in all industries. The amendments are effective from 1 January 2021. This publication provides guidance on how to apply the Phase 2 amendments to various contracts and hedge accounting relationships, including the interaction with the Phase 1 reliefs for hedge accounting.

Refer here for frequently asked questions relating to the Phase 2 amendments.


What’s inside:
  1. Key highlights
  2. Phase 2 amendments – Changes in the basis for determining contractual cash flows of financial assets and financial liabilities as a result of IBOR reform
  3. Phase 2 amendments to IFRS 4 for insurers
  4. Phase 2 amendments to IFRS 16, ‘Leases’
  5. Phase 2 amendments to IAS 39 and IFRS 9 hedge accounting
  6. Disclosures
  7. Effective date and transition

1. Key highlights

Publication date: 09 Oct 2020

Benchmark interest rates are a core component of global financial markets. Retail and commercial loans, corporate debt, derivatives and securitisation transactions all rely on these benchmark interest rates for pricing contracts and for hedging interest rates. 

The London Interbank Offered Rate (‘LIBOR’) is one of the most common series of benchmark interest rates, referenced by contracts measured in trillions of dollars across global currencies. Following the financial crisis, calls grew to reform the process used to generate LIBOR (including USD LIBOR, JPY LIBOR, CHF LIBOR and GBP LIBOR) and other benchmark interest rates.

As a result, the replacement of benchmark interest rates such as LIBOR and other interbank offered rates (‘IBORs’) has become a priority for global regulators. The Financial Stability Board’s July 2014 report ‘Reforming Major Interest Rate Benchmarks’ set out recommendations for the reform of certain benchmarks. As a result, many jurisdictions are in the process of transitioning to alternative benchmark rates. 

The reforms aim to achieve a shift away from individual quotes to observed transaction rates, and to increase the population on which those rates are based. Since the changes are market driven, there remains some uncertainty around their timing and precise nature. However, a summary of the position, at the time of writing (October 2020), for some of the most used benchmark rates is as follows:

IBOR_In_depth_img_11

* €STR is expected to co-exist with local IBOR in a multi-rate environment. The phase-in of all EURIBOR banks to the hybrid methodology for EURIBOR was completed in November 2019 and, at the time of writing (October 2020), the final recommendations on EURIBOR provisions and fallback benchmarks for cash and derivatives are expected in Q1 2021.

Who might IBOR replacement affect and how?

Financial institutions are likely to be most heavily affected by IBOR replacement, given the significant extent of their direct exposure to IBOR-linked financial instruments. However, IBOR reform might also be a significant issue for corporates with IBOR-based debt funding, or with fixed-rate funding that is hedged using IBOR-based derivatives, and for lessees with lease payments that are indexed to an IBOR rate. 

Even if an entity does not have any contracts referencing an IBOR, it might still use an IBOR in constructing certain discount rates used in financial reporting, such as in calculating an asset’s ‘value in use’ when assessing it for impairment or fair values in accordance with IFRS 13, and so it might still be affected by these changes. 

The impacts of IBOR replacement are potentially wide-ranging, and they are likely to include all of risk management, legal, IT and financial reporting. This publication focuses on only one aspect of the reforms, namely the implications for financial reporting under IFRS. For publications on the latest developments in IBOR replacement, and for further reading on other aspects of IBOR replacement, visit our LIBOR reference rate and reform insights page.

What is the impact of the Phase 2 amendments?

The IASB has undertaken a two-phase project to consider what, if any, reliefs to give from the effects of IBOR reform. The Phase 1 amendments, issued in September 2019, provided temporary reliefs from applying specific hedge accounting requirements to relationships affected by IBOR reform. The Phase 2 amendments that were issued in August 2020 address issues that arise during the reform of an interest rate benchmark rate, including the replacement of one benchmark rate with an alternative one.

The key reliefs provided by the Phase 2 amendments are as follows:

  • Changes to contractual cash flows. When changing the basis for determining contractual cash flows for financial assets and liabilities (including lease liabilities), the reliefs have the effect that the changes that are required by an interest rate benchmark reform (that is, are necessary as a direct consequence of IBOR reform and are economically equivalent) will not result in an immediate gain or loss in the income statement.
  • Hedge accounting. The hedge accounting reliefs will allow most IAS 39 or IFRS 9 hedge relationships that are directly affected by IBOR reform to continue. However, additional ineffectiveness might need to be recorded.

This publication provides a detailed explanation of each of these reliefs – see Sections 2 to 6.

2. Phase 2 amendments – Changes in the basis for determining contractual cash flows of financial assets and financial liabilities as a result of IBOR reform

Publication date: 09 Oct 2020

The basis for determining the contractual cash flows of financial assets or financial liabilities to which the amortised cost measurement applies can change as a result of IBOR reform. 

Such changes can be due to: 

  • an amendment to the contractual terms specified at initial recognition (for example, if the contract is amended to replace the benchmark rate with an alternative one);
  • a change that was not considered or contemplated in the contractual terms at initial recognition (for example, if the method of calculating the benchmark rate is changed, even though the contractual terms are not); or 
  • the activation of an existing contractual term (for example, triggering of an existing fallback clause in a contract). 

[IFRS 9 para 5.4.5]. [IFRS 9 para 5.4.6].

The Phase 2 amendments provide a practical expedient to account for these changes in the basis for determining contractual cash flows as a result of interest rate benchmark reform.

Under the practical expedient, entities will account for these changes by updating the effective interest rate using the guidance in paragraph B5.4.5 of IFRS 9 without the recognition of an immediate gain or loss. This practical expedient applies only to such a change and only to the extent that it is necessary as a direct consequence of interest rate benchmark reform, and the new basis is economically equivalent to the previous basis. [IFRS 9 para 5.4.7]. The Phase 2 amendments provide a number of examples of what is considered to be ‘economically equivalent’. [IFRS 9 para 5.4.8].

Without the practical expedient, an entity would need to consider whether these changes result in the derecognition of the financial asset or financial liability. If the changes did not result in derecognition, an entity would have had to apply either paragraph 5.4.3 or B5.4.6 of IFRS 9 to the changes. This would mean recalculating the carrying amounts and recognising a gain or loss immediately in the income statement, while continuing to recognise interest income or expense using the original effective interest rate. [IFRS 9 paras BC5.302–BC5.305]. 

If there are changes in addition to those required by IBOR reform, an entity will first apply the practical expedient and then apply the other applicable requirements in IFRS 9 to the additional changes to which the practical expedient does not apply. [IFRS 9 para 5.4.9].

The following flowchart illustrates the typical steps that an entity will follow when applying the practical expedient:

IBOR_In_depth_img_2


As part of the Phase 2 amendments, the IASB considered other IFRS 9 classification and measurement issues in the context of IBOR reform and concluded that the standard provides an adequate basis to determine the required accounting. These matters include:

  • Derecognition: Derecognition of financial assets and financial liabilities and the recognition of the resulting gain or loss following a substantial modification because of IBOR reform.
  • Business model: Whether changes in the basis for determining contractual cash flows resulting from the reform affects an entity’s business model for managing financial assets following the derecognition of a financial asset.
  • SPPI: Whether the interest component of the contractual cash flows of a financial asset referenced to an alternative benchmark rate meets the criteria for solely payments of principal and interest (SPPI).
  • Expected credit losses: The recognition of the expected credit losses for a new financial asset following a substantial modification as a result of the reform.
  • Embedded derivatives: Whether an entity must reassess whether an embedded derivative is required to be separated from a financial liability host contract, and whether the practical expedient applies to hybrid financial liabilities that have been separated into a host contract and an embedded derivative.

[IFRS 9 paras BC5.319–BC5.320].

FAQ 2.1 – What does ‘necessary as a direct consequence of interest rate benchmark reform’ mean?
FAQ 2.2 – What does ‘economically equivalent’ mean?

3. Phase 2 amendments to IFRS 4 for insurers

Publication date: 09 Oct 2020

IFRS 4 permits insurers to continue to apply IAS 39, instead of adopting IFRS 9, if their activities are ‘predominantly connected with insurance’ and IFRS 9 has not previously been applied. This temporary exemption to apply IAS 39 will cease to be applicable when IFRS 17 becomes effective on 1 January 2023.

The Phase 2 amendments will require insurers that are applying the temporary exemption from IFRS 9 (that is, they are still applying IAS 39) to also apply the same practical expedient as under IFRS 9 for changes in the basis for determining contractual cash flows of financial assets and financial liabilities as a result of IBOR reform. [IFRS 4 paras 20R, 20S].

The practical expedient is discussed further in ‘Section 2. Phase 2 amendments - Changes in the basis for determining contractual cash flows of financial assets and financial liabilities as a result of reform’.

4. Phase 2 amendments to IFRS 16, ‘Leases’

Publication date: 09 Oct 2020

Some leases might include variable lease payments that are referenced to a benchmark interest rate subject to IBOR reform. IFRS 16 requires lessees to include these variable lease payments in the measurement of their lease liabilities. [IFRS 16 para BC267C].

IFRS 16 has been amended to include a practical expedient, for all leases that are modified, to change the basis for determining future lease payments as a result of IBOR reform. As a practical expedient, a lessee will remeasure the lease liability by discounting the revised lease payments using a discount rate that reflects the change in the interest rate. This practical expedient applies only if the lease modification is necessary as a direct consequence of IBOR reform, and the new basis for determining the lease payments is economically equivalent to the previous basis. [IFRS 16 para 105]. 

If lease modifications are made in addition to those required by IBOR reform, an entity will be required to apply applicable IFRS 16 requirements to account for all lease modifications made at the same time, including those required by IBOR reform. [IFRS 16 para 106].

The IASB decided not to amend requirements for lease modifications from a lessor's perspective. For finance lease modifications, the Board noted that a lessor would be required to apply IFRS 9 to those modifications. As a result, a finance lessor would be required to apply the practical expedient relief for modifications required by the reform (see ‘Section 2. Phase 2 Amendments - Changes in the basis for determining contractual cash flows of financial assets and financial liabilities as a result of reform’). In addition, the Board noted that, for operating leases, lessors should follow the modification guidance in IFRS 16. [IFRS 16 para BC267J].

5. Phase 2 amendments to IAS 39 and IFRS 9 hedge accounting

Publication date: 09 Oct 2020

The Phase 2 amendments address replacement issues (that is, where changes are made to hedging relationships as a result of the transition to alternative benchmark rates). The Phase 2 amendments require an entity to amend the hedging relationship, to reflect the changes required by IBOR reform, where the uncertainty arising from the reform is no longer present with respect to the hedged risk or the timing and the amount of IBOR-based cash flows of the hedging item or of the hedging instrument. As a result, hedge relationships within the scope of the Phase 1 reliefs will also be within the scope of the Phase 2 amendments, with the exception of the separately identifiable requirement which will also apply to new hedge designations. [IFRS 9 para BC6.604]. [IAS 39 para BC296].

5. Phase 2 amendments to IAS 39 and IFRS 9 hedge accounting - 5.1 Summary of the Phase 1 reliefs

Publication date: 09 Oct 2020

The Phase 1 amendments provided temporary relief from applying specific hedge accounting requirements to hedging relationships directly affected by IBOR reform. 

The following table summarises the key Phase 1 reliefs, including when each of the reliefs prospectively ceases to apply:


Key relief

End of relief

‘Highly probable’ requirement

Cash flow hedge accounting under both IFRS 9 and IAS 39 requires the future hedged cash flows to be ‘highly probable’. 

The relief requires an entity to assume that the interest rate on which the hedged cash flows are based does not change as a result of the reform. Hence, where the cash flows might change as a result of benchmark reform, the reliefs allow the hedge relationship not to fail because of the reform.

Ceases to apply to a hedged item at the earlier of (a) when there is no longer uncertainty arising from IBOR reform over the timing and amount of IBOR-based cash flows of hedged item, and (b) when the hedging relationship is discontinued. 

Prospective assessments 

Both IAS 39 and IFRS 9 require a forward-looking prospective assessment in order to apply hedge accounting. IAS 39 requires the hedge to be expected to be highly effective, whereas IFRS 9 requires there to be an economic relationship between the hedged item and the hedging instrument. 

Under the relief, an entity assumes that the interest rate benchmark on which the cash flows of the hedged item, hedging instrument or hedged risk are based is not altered by IBOR reform.

Ceases to apply to:

  • a hedged item at the earlier of (a) when there is no longer uncertainty arising from IBOR reform with respect to the hedged risk or over the timing and amount of IBOR-based cash flows, and (b) when the hedging relationship is discontinued. 
  • a hedging instrument at the earlier of (a) when there is no longer uncertainty arising from IBOR reform over the timing and amount of IBOR-based cash flows, and (b) when the hedging relationship is discontinued. 

IAS 39 retrospective effectiveness test exception

IBOR reform might cause a hedge to fall outside the required 80–125% range. 

The relief provides an exception to the retrospective effectiveness test, such that a hedge is not discontinued during the period of IBOR-related uncertainty solely because the retrospective effectiveness falls outside this required 80–125% range. 

Ceases to apply at the earlier of (a) when there is no longer uncertainty arising from IBOR reform with respect to the hedged risk and the timing and amount of IBOR-based cash flows of the hedged item or of the hedging instrument, and (b) when the hedging relationship is discontinued.

See updated end of relief date as part of the Phase 2 amendments in ‘Section 5.2 End of Phase 1 reliefs provided by the Phase 2 amendments’. 

Recycling of the cash flow hedging reserve

Under IAS 39 and IFRS 9, entities are required to recycle a cash flow hedge reserve if the hedged cash flows are no longer expected to occur. The relief requires an entity to assume that the interest rate on which the hedged cash flows are based does not change as a result of the reform.

Cease to apply at the earlier of (a) when there is no longer uncertainty arising from IBOR reform over the timing and amount of IBOR-based future cash flows of the hedged item, and (b) when the entire amount in the cash flow reserve for the discontinued hedge has been recycled to profit or loss.

Risk components

In some hedges, the hedged item or hedged risk is a non-contractually specified IBOR risk component. In order for hedge accounting to be applied, both IAS 39 and IFRS 9 require the designated risk component to be separately identifiable and reliably measurable. 

Under the relief, the risk component only needs to be separately identifiable at initial hedge designation, and not on an ongoing basis. In the context of a macro hedge, where an entity frequently resets a hedging relationship, the relief applies from when a hedged item was initially designated within that hedging relationship.

The Phase 1 amendments did not provide an end date for the risk components relief. 

See end of relief date as part of the Phase 2 amendments in ‘Section 5.2 End of Phase 1 reliefs provided by the Phase 2 amendments’.


[IFRS 9 paras 6.8.4–6.8.12]. [IAS 39 paras 102D–102N].

5. Phase 2 amendments to IAS 39 and IFRS 9 hedge accounting - 5.2 End of Phase 1 reliefs provided by the Phase 2 amendments

Publication date: 09 Oct 2020

Non-contractually specified risk components in hedging relationships 

The Phase 2 amendments provide an end date for the Phase 1 relief for non-contractually specified risk components (IFRS 9) and non-contractually specified risk portions (IAS 39) relief. These are referred to as ‘non-contractually specified risk components’ in this publication. The relief will prospectively cease to apply at the earlier of (a) when changes required by the reform are made to the non-contractually specified risk component, or (b) when the hedging relationship is discontinued. [IFRS 9 para 6.8.13]. [IAS 39 para 102O].

Retrospective effectiveness assessment (IAS 39 only)

The reliefs from the retrospective effectiveness assessment, for IAS 39 only, end under the Phase 1 amendments at the earlier of (a) when the uncertainty arising from IBOR reform is no longer present with respect to the hedged risk and the timing and amount of the cash flows of the hedged item or the hedging instrument, and (b) when the hedging relationship is discontinued. 

The Phase 2 amendments extend the end of the relief to the earlier of (a) when the uncertainty arising from IBOR reform is no longer present with respect to the hedged risk and the timing and amount of the cash flows of the hedged item and the hedging instrument, and (b) when the hedging relationship is discontinued. [IAS 39 para 102M].

5. Phase 2 amendments to IAS 39 and IFRS 9 hedge accounting - 5.3 Amendments to the formal designation of hedge relationships

Publication date: 09 Oct 2020

Temporary exception for changes made to the hedge designation and hedge documentation

When an entity ceases to apply the Phase 1 reliefs (see summary of the reliefs in Section 5.1 above), the Phase 2 amendments require an entity to make changes to the formal designation of the hedge relationship, to reflect the changes that are required by IBOR reform. Similar to the practical expedient for changes in the basis of contractual cash flows of financial assets and financial liabilities, the change needs to be required by interest rate benchmark reform, which means the following two conditions need to be met: the change is necessary as a direct consequence of interest rate benchmark reform, and the new basis is economically equivalent to the previous basis. The hedge designation shall, in this context, be amended only to make one or more of the following changes: 

  • designating an alternative benchmark rate as a hedged risk;
  • amending the description of the hedged item (including the description of the designated portion of the cash flows or fair value being hedged); 
  • amending the description of the hedging instrument; or
  • amending the description of how the entity will assess hedge effectiveness (IAS 39 only).

[IFRS 9 para 6.9.1]. [IAS 39 para 102P].

The hedge designation will be required to be amended by the end of the reporting period during which a change required by IBOR reform is made to the hedged risk, hedged item or hedging instrument. Amending the formal designation of a hedging relationship, as required by this temporary exception, is not the discontinuation of the hedge relationship nor the designation of a new hedging relationship. [IFRS 9 para 6.9.4]. [IAS 39 para 102S].

FAQ 5.3.1 – When is there no longer uncertainty arising from IBOR reform?
FAQ 5.3.2 – Can regression analysis be used for effectiveness testing immediately after transition to a new benchmark (IAS 39)?

Amending the description of the hedging instrument 

An entity should also amend the hedge designation relating to the hedging instrument if the following three conditions are met: 

  • the entity makes a change required by IBOR reform using an approach other than changing the basis for determining the contractual cash flows of the hedging instrument; 
  • the original hedging instrument (for example, the derivative) is not derecognised; and 
  • the approach is economically equivalent to changing the basis for determining the contractual cash flows of the original hedging instrument. 

[IFRS 9 para 6.9.2]. [IAS 39 para 102Q].

FAQ 5.3.3 – Which alternative methods of transitioning derivatives will fall into the reliefs? 

Additional changes other than those required by IBOR reform

If additional changes other than those required by IBOR reform are made, an entity will first apply the applicable IAS 39 or IFRS 9 hedge accounting requirements to determine if the changes result in the discontinuance of hedge accounting. If the changes do not result in the discontinuance of hedge accounting, the entity will amend the designation of the hedge relationship using the temporary exception. [IFRS 9 para 6.9.5]. [IAS 39 para 102T].

Amendments to the formal designation of hedge relationships at different times

The Phase 1 reliefs (see a summary of the reliefs in Section 5.1 above) might cease to apply at different times. When applying the temporary exception to amend the formal designation, an entity might be required to:

  • amend the formal designation of different hedging relationships at different times, or
  • amend the formal designation of a specific hedging relationship more than once (for example, due to changes to the hedging instrument or the hedged item).

[IFRS 9 para 6.9.3]. [IAS 39 para 102R].

An entity amending the hedge designation should apply the accounting reliefs related to cash flow hedging, group of items and risk components, as applicable. [IFRS 9 para 6.9.3]. [IAS 39 para 102R]. These accounting reliefs are discussed in Sections 5.4 to 5.6 below.

5. Phase 2 amendments to IAS 39 and IFRS 9 hedge accounting - 5.4 Accounting for qualifying hedge relationships

Publication date: 09 Oct 2020

No exception for the measurement of hedged items or hedging instruments

An entity will apply the existing requirements in IAS 39 or IFRS 9 for qualifying fair value and cash flow hedging relationships to account for any changes in the fair value of the hedged item or hedging instrument. 

[IFRS 9 paras 6.5.8, 6.5.11, 6.9.3]. [IAS 39 paras 89, 96, 102R].

The IASB has not provided any exception to the measurement of hedged items or hedging instruments. This is because such an exception would be inconsistent with the decision not to change the requirements to measure and recognise hedge ineffectiveness. 

Due to the economically equivalent requirement, the IASB also does not expect that there will be a significant change in fair value arising from the remeasurement of the hedged item or hedging instrument. 

FAQ 5.4.1 – How does an entity update the hypothetical derivative in a cash flow hedge at the date of transition to an alternative benchmark interest rate?
FAQ 5.4.2 – Does the simultaneous amendment of a hedging instrument and hedged risk to reflect a new benchmark rate for a fair value hedge relationship result in an immediate gain or loss recognised in profit or loss?

No exception for the recognition and measurement of ineffectiveness

There is no exception for the recognition and measurement of hedge ineffectiveness. The IAS 39 and IFRS 9 hedge accounting requirements will need to be applied, and any resulting ineffectiveness recognised in the income statement. [IFRS 9 paras BC6.626–BC6.627]. [IAS 39 paras BC319–BC320]. In the IASB’s view, this reflects the economic effects of the amendments to the formal designation of a hedging relationship. The Board further noted that the temporary exception to amend the description of the hedged item enables an entity to change the hedging relationship in a way that minimises the change in fair value on the remeasurement of the hedged item or hedging instrument. [IFRS 9 para BC6.624]. [IAS 39 para BC317]. 

Temporary exception for amounts accumulated in the cash flow hedge reserve

At the point when an entity amends the description of a hedged item under the temporary exception to amend the hedge designation and documentation (see ‘Section 5.3 Amendments to the formal designation of hedge relationships’ above), the amounts accumulated in the cash flow hedge reserve are deemed to be based on the alternative benchmark rate on which the hedged future cash flows are determined. [IFRS 9 para 6.9.7]. [IAS 39 para 102W].

The Phase 2 amendments also provide for a similar temporary exception for discontinued cash flow hedges when the benchmark interest rate on which the hedged future cash flows were based has changed, as required by IBOR reform, where the amount accumulated in the cash flow hedge reserve for that hedging relationship shall be deemed to be based on the alternative benchmark rate on which the hedged future cash flows will be based. [IFRS 9 para 6.9.8]. [IAS 39 para 102X]. 

Temporary exception for the retrospective effectiveness test (IAS 39 only)

For the purposes of assessing retrospective effectiveness of a hedge relationship on a cumulative basis, an entity may elect, on an individual hedging relationship basis, to reset to zero the cumulative fair value changes of the hedged item and hedging instrument when ceasing to apply the retrospective effectiveness assessment relief provided by the Phase 1 amendments (see summary of the Phase 1 reliefs in Section 5.1 above). [IAS 39 para 102V].


PwC Observation

The Phase 1 IAS 39 retrospective effectiveness test relief provides an exception to the retrospective effectiveness test such that a hedge is not discontinued during the period of IBOR-related uncertainty solely because the retrospective effectiveness falls outside this required 80–125% range. When this Phase 1 relief ceases to apply, an entity will be required to assess the retrospective effectiveness of the hedge relationship. If this assessment is done on a cumulative basis, the hedging relationship might fail the retrospective test. The IASB noted that this would be inconsistent with the objective of Phase 1. The Phase 2 amendments therefore allow entities that carry out the assessment on a cumulative basis to elect either to reset or to not reset the cumulative fair value hedged item and hedging instrument to zero. 

The IASB allowed a choice to reset because, in some cases, if an entity were to reset to zero, it might cause the hedging relationship to fail the retrospective test. For example, a hedging relationship might fall outside the 80–125% range if there is market volatility during the initial period after the transition to the alternative benchmark rate, and the entity were to reset to zero. [IAS 39 paras BC322–BC324].

5. Phase 2 amendments to IAS 39 and IFRS 9 hedge accounting - 5.5 Accounting for hedges of groups of items

Publication date: 09 Oct 2020

When applying the ‘changes to hedge designations and hedge documentation’ temporary exception (see ‘Section 5.3 Amendments to the formal designation of hedge relationships’ above) to groups of items, hedged items are allocated to sub-groups based on the benchmark rate being hedged, and the benchmark rate for each sub-group is designated as the hedged risk. As a result, some items in the group could be changed at different times. [IFRS 9 para 6.9.9]. [IAS 39 para 102Y].

Each sub-group will be required to be assessed separately, to determine whether it meets the requirements for an eligible hedged item. [IFRS 9 para 6.6.1]. [IAS 39 paras 78, 83]. Hedge accounting will be discontinued prospectively, for the hedging relationship in its entirety, if any sub-group fails to meet the eligible hedged item requirements. An entity should also account for the ineffectiveness related to the hedging relationship in its entirety. [IFRS 9 para 6.9.10]. [IAS 39 para 102Z].

5. Phase 2 amendments to IAS 39 and IFRS 9 hedge accounting - 5.6 Designation of risk components and portions

Publication date: 09 Oct 2020

An alternative benchmark rate designated as a non-contractually specified risk component that is not separately identifiable, at the date when it is designated, will be deemed to have met the requirements at that date if the entity reasonably expects that it will meet the requirements within a period of 24 months. The 24-month period will: 

  • apply to each alternative benchmark rate separately (on a rate-by-rate basis); and
  • begin from the date when the entity designates the alternative benchmark rate as a non-contractually specified risk component for the first time. 

[IFRS 9 para 6.9.11]. [IAS 39 para 102Z1].

The non-contractually specified risk component will, however, be required to be reliably measurable. 

If, at a later date, the entity reasonably expects that the alternative benchmark rate will not be separately identifiable within the 24-month period, it will cease to apply the temporary exception and prospectively discontinue hedge accounting from the date of that reassessment. [IFRS 9 para 6.9.12]. [IAS 39 para 102Z2].

This relief will similarly apply to new hedging relationships where the alternative benchmark rate is not separately identifiable at the date when the non-contractually specified risk component is designated. [IFRS 9 para 6.9.13]. [IAS 39 para 102Z3].

6. Disclosures

Publication date: 09 Oct 2020

The objective of the disclosures required by the Phase 2 amendments is to enable users of financial statements to understand the effect of IBOR reform on an entity’s financial instruments and risk management strategy. An entity needs to disclose information about the nature and extent of risks arising from IBOR reform to which the entity is exposed, how the entity manages those risks, and the entity’s progress in completing the transition to alternative benchmark rates and how it is managing that transition. [IFRS 7 para 24I].

To meet these objectives, the Phase 2 amendments require disclosure of:

  • how the entity is managing the transition to alternative benchmark rates, its progress and the risks to which it is exposed arising from financial instruments because of the transition; 
  • disaggregated by significant interest rate benchmark subject to IBOR reform, quantitative information about financial instruments that have yet to transition to an alternative benchmark rate at the end of the reporting period, showing separately non-derivative financial assets and liabilities, and derivatives; and 
  • if the risks identified have resulted in any changes to an entity’s risk management strategy, a description of these changes.

[IFRS 7 para 24J].

7. Effective date and transition

Publication date: 09 Oct 2020

Effective date

The amendments should be applied for annual periods beginning on or after 1 January 2021. Earlier application is permitted. [IFRS 9 para 7.1.9]. [IAS 39 para 108H]. [IFRS 7 para 44GG]. [IFRS 4 para 50]. [IFRS 16 App C para C1B].

Transitional requirements for the amendments to IFRS 9, IAS 39, IFRS 4 and IFRS 16

The amendments to IFRS 9, IAS 39, IFRS 4 and IFRS 16 are to be applied retrospectively. However, the amendments provide relief from restating comparative information. An entity may restate prior periods if, and only if, it is possible to do so without the use of hindsight.

If an entity does not restate prior periods, it recognises any difference between the previous carrying amount and the carrying amount at the beginning of the annual reporting period that includes the date of initial application of the Phase 2 amendments in the opening retained earnings (or other component of equity, as appropriate) of the reporting period that includes the date of initial application of the amendments. [IFRS 9 para 7.2.46]. [IAS 39 para 108K]. [IFRS 4 para 51]. [IFRS 16 App C paras C20C, C20D].

Transitional requirements for the amendments to IFRS 7

The amendments to IFRS 7 apply when an entity applies the Phase 2 amendments to IFRS 9, IAS 39, IFRS 4 and IFRS 16. In the reporting period when an entity first applies the Phase 2 amendments, it is not required to present that quantitative information required by paragraph 28(f) of IAS 8. [IFRS 7 paras 44GG, 44HH].

Reinstating discontinued hedges

An entity is prohibited from designating a new hedge accounting relationship in prior periods. However, discontinued hedging relationships are required to be reinstated if, and only if, the following two conditions are met: 

  • the hedge relationship was discontinued solely due to changes required by IBOR reform (and would not have been discontinued if the Phase 2 reliefs had been available); and 
  • at the date of initial application, the discontinued hedging relationship continues to meet all qualifying criteria for hedge accounting (after taking the Phase 2 reliefs into account).

[IFRS 9 para 7.2.44]. [IAS 39 para 108I].

If an entity reinstates a discontinued hedging relationship, the 24-month period for a non-contractually specified risk component begins from the date of initial application of the Phase 2 amendments (see ‘Section 5.6 Designation of risk components and portions’). [IFRS 9 para 7.2.45]. [IAS 39 para 108J].

PwC Observation

We expect that entities planning on making IBOR-related amendments to contracts in 2020 will choose to early adopt the Phase 2 amendments as soon as possible (subject to any local endorsement requirements). 

If an entity adopts the amendments in 2021 and adoption has a measurement impact, either due to the reinstatement of hedges previously discontinued due to uncertainty arising from IBOR reform, or due to reversal of previous modification gains / losses for changes in the basis of determining contractual cash flows to the extent that it was required by IBOR reform, then in 2020 the entity will already have had to:

  • identify those hedges affected and compute the accounting entries to discontinue the hedge accounting for 2020, prior to reinstatement in the following year;
  • identify those financial instruments that have been modified and compute the modification gain / loss; and
  • disclose, under paragraph 30(b) of IAS 8, the possible impact of adopting these amendments in 2021, which would generally be expected to be reasonably estimable by continuing to apply the previous hedge accounting (for 1 above) or using the new cash settlements to compute the paragraph B5.4.5 accounting (for 2 above).

This would result in a significant amount of work being performed in 2020, solely to be undone on adoption in 2021. Early adoption would therefore result in less disruption from an accounting perspective.


Authored by:

Marie Kling
Partner
Email: marie.kling@pwc.com

Scott Bandura
Partner
Email: scott.bandura@pwc.com

Mark Randall
Director
Email: mark.b.randall@pwc.com

Frances Coldham
Senior Manager
Email: frances.coldham@pwc.com

Elizabeth Dicks
Senior Manager
Email: elizabeth.a.dicks@pwc.com

Illustrative text - FAQ 2.1 – What does ‘necessary as a direct consequence of interest rate benchmark reform’ mean?

Publication date: 09 Oct 2020

Question

Several IBOR reliefs are conditional on changes to the basis for determining contractual cash flows being necessary as a ‘direct consequence’ of interest rate benchmark reform, or on the changes being ‘required by interest rate benchmark reform’ (which itself requires them to be a ‘direct consequence’ as set out in paragraph 5.4.7(a) of IFRS 9).

Which changes to the basis for determining contractual cash flows are necessary as a ‘direct consequence’ of interest rate benchmark reform?

Answer

IFRS does not give specific examples of changes that are a direct consequence of interest rate benchmark reform. Therefore, some judgement might be required. The necessary changes might also vary depending on the type of contract (for example, a loan, a derivative or a lease). However, the following are examples of changes that would generally be a direct consequence of interest rate benchmark reform:

  • change from the existing IBOR-based benchmark rate to an alternative benchmark rate*;
  • change to the fixed spread to reflect the basis difference between the existing IBOR-based benchmark rate and the new alternative benchmark rate;
  • changes to the calculation methodology of the applicable interest rate (for example, where the new methodology calculates the interest rate as a daily compounded average of an overnight benchmark rate, rather than simply a quoted rate);
  • changes to the reset period, reset dates, day count convention, number of days between coupon payments or payment dates that arise from the change to the alternative benchmark rate;
  • insertion of a fallback clause covering any of the above items;
  • changes to pre-existing prepayment or cancellation options where they refer to the existing IBOR-based benchmark rate in determining the amount(s) payable;
  • changes to pre-existing interest rate caps or floors where they reference the existing IBOR-based benchmark rate; and
  • removal of an existing ‘fallback’ clause.

* The replacement benchmark rate could be any reasonable alternative to the original IBOR rate for that change to be considered a ‘direct consequence’ of IBOR reform (for example, a move from GBP LIBOR to the Bank of England base rate would be considered a ‘direct consequence’ of IBOR reform, as would a move from GBP LIBOR to SONIA). Furthermore, the replacement benchmark rate does not need to have the same term as the original IBOR rate if there is insufficient liquidity in that term in the replacement benchmark rate. For example, for a 3-month IBOR contract, the replacement would not need to be a 3-month alternative benchmark rate to be a ‘direct consequence’ if that term is not available or not sufficiently liquid at the point of changing the contract. Conversely, moving to a 5-year alternative benchmark rate from a 3-month IBOR rate would not be expected to be a reasonable alternative if a liquid overnight alternative benchmark rate were also available (that is, it would not be viewed as a direct consequence of benchmark reform). 

The following changes would generally not be a direct consequence of interest rate benchmark reform:

  • changes to the notional amount or maturity date;
  • changes to the structure of the instrument (for example, changing a term loan to a revolving loan facility);
  • addition of a new, or removal of an existing, interest rate cap or floor;
  • addition of a new, or removal of an existing, prepayment or conversion option;
  • changes to include an underlying reference rate that is unrelated to the interest rate benchmark, such as payments that are indexed to the price of a commodity;
  • change of the counterparty to a party unrelated to the original counterparty; or
  • change to the currency of the contract.

Illustrative text - FAQ 2.2 – What does ‘economically equivalent’ mean?

Publication date: 09 Oct 2020

Question

Several IBOR reliefs are conditional on the new basis for determining cash flows being ‘economically equivalent’ to the previous basis, or on the changes being ‘required by interest rate benchmark reform’ (which itself requires them to be ‘economically equivalent’ as set out in paragraph 5.4.7(b) of IFRS 9).

How should the term ‘economically equivalent’ be interpreted?

Answer

Applicable guidance

Examples of changes that are economically equivalent to the previous basis (that is, the basis immediately preceding the change) are provided in paragraph 5.4.8 of IFRS 9 as follows:

“(a) the replacement of an existing interest rate benchmark used to determine the contractual cash flows of a financial asset or financial liability with an alternative benchmark rate - or the implementation of such a reform of an interest rate benchmark by altering the method used to calculate the interest rate benchmark - with the addition of a fixed spread necessary to compensate for the basis difference between the existing interest rate benchmark and the alternative benchmark rate;

(b) changes to the reset period, reset dates or the number of days between coupon payment dates in order to implement the reform of an interest rate benchmark; and

(c) the addition of a fallback provision to the contractual terms of a financial asset or financial liability to enable any change described in (a) and (b) above to be implemented.”

However, no further guidance is provided and so judgement will be required. 

Possible approaches

Some analysis is expected in order to demonstrate economic equivalence. A sensible starting point for such analysis would be understanding the basis that the parties used to determine the changes required to the original contract. A new interest rate and credit spread should not automatically be considered ‘economically equivalent’ just because it has been recommended by a regulator, regulator-sponsored IBOR working group, industry body or similar organisation. However, where such a recommendation results from widespread consultation with counterparties of contracts affected by the change, and reflects their consensus view, it would be unusual if such changes were not then ‘economically equivalent’. 

There is no requirement for economic equivalence to be demonstrated or assessed by comparing the fair value of an instrument immediately before and after the change. However, a comparison of fair values is one approach that could be used, in particular where – as well as the benchmark rate and fixed spread changing – other substantive changes are also made which might not be captured by the other approaches discussed below. 

To assess whether the fixed spread adjustment is appropriate compensation for the basis difference between the existing interest rate benchmark and the alternative benchmark rate, so that together these changes are ‘economically equivalent’, we consider that the following approaches (which are not exhaustive) could be used as comparisons to the actual adjustment made to the fixed spread:

  • Forward spread approach – A spread adjustment based on the market observed forward spread between the existing IBOR rate and the replacement benchmark rate at the time of the change, over the expected remaining life of the instrument.
  • Historical spread approach – A spread adjustment based on the observed historical mean / median difference between the existing IBOR rate and the replacement benchmark rate at the time of the change, over a suitable historical period.
  • Spot approach – The spread adjustment required so that the first interest payment post-change (that is, based on the replacement benchmark rate) equals the amount that would have been calculated using the existing IBOR-based rate.
  • Swap adjustment approach (applicable only to debt instruments) – The spread adjustment that would be made when changing the IBOR rate of a fixed to floating interest rate swap whose critical terms match those of the debt instrument, so that, if the holder were hedged with that swap (and the swap were changed to the replacement benchmark rate at the same time as the debt instrument), the holder would have no net impact from the changes.

Whatever approach is used might have limitations, depending on the specific features of the instrument and other circumstances. Therefore, it is important to understand these and develop an approach that appropriately takes account of them. An example of such a limitation is the use of the ‘Spot approach’ to assess an instrument that has other features such as a cap or floor, which such an approach would not take account of.

Illustrative text - FAQ 5.3.1 – When is there no longer uncertainty arising from IBOR reform?

Publication date: 09 Oct 2020

The IBOR reform Phase 1 amendments provide various hedge accounting reliefs together with end of relief conditions, as summarised in ‘Section 5.1 Summary of the Phase 1 reliefs'. The reliefs cease to apply at the earlier of:

  • when the hedge relationship is discontinued (or, for the relief in respect of reclassifying the cash flow hedge reserve, when the entire amount accumulated in the reserve has been reclassified); and
  • when one or more of the following applies, depending on the relief (the various combinations of these conditions that apply to each relief are summarised in ‘Section 5.1 Summary of the Phase 1 reliefs'):
    • when the uncertainty arising from interest rate benchmark reform is no longer present with respect to the hedged risk; 
    • when the uncertainty arising from interest rate benchmark reform is no longer present with respect to the timing and amount of interest rate benchmark-based cash flows of the hedging instrument; and/or
    • when the uncertainty arising from interest rate benchmark reform is no longer present with respect to the timing and amount of the interest rate benchmark-based cash flows of the hedged item.

Question 1

When is there no longer uncertainty arising from interest rate benchmark reform with respect to the hedged risk?

Answer

IFRS 9 and IAS 39 do not provide specific guidance on when uncertainty is no longer present in respect of the hedged risk. Therefore, judgement is required.

For a cash flow hedge, where the hedged risk is defined in terms of the hedged item’s floating-rate cash flows (for example, the variability in cash flows arising on a specified debt instrument due to changes in 3-month GBP LIBOR), uncertainty in the hedged risk arises from uncertainty as to when and how the debt instrument’s IBOR cash flows will change to the new benchmark rate. Therefore, an appropriate approach is to consider that the uncertainty has been eliminated from the hedged risk when the uncertainty is no longer present with respect to the timing and amount of the interest rate benchmark-based cash flows of the hedged item. This is discussed further in question 2 below.

For a fair value hedge, where the hedged item is typically a fixed-rate instrument and the hedged risk is defined as a non-contractually specified risk component (for example, the change in fair value of a specified fixed-rate debt instrument with respect to changes in 3-month GBP LIBOR), the source of the uncertainty is less clear. The uncertainty does not arise from the amount or timing of the hedged item’s cash flows, since the cash flows are fixed. Neither is the uncertainty in the hedged risk necessarily linked to the uncertainty of the timing and amount of the cash flows of the hedging instrument. More generally, uncertainty in the hedged risk due to IBOR reform would be expected to increase as time passes, as market participants transition to the new benchmark rate(s) and as market liquidity in the original IBOR rate declines. In this sense, the uncertainty will not be removed until the documented hedged risk is updated to reference the new benchmark rate, as required by paragraph 6.9.1 of IFRS 9 / paragraph 102P of IAS 39.  

Given that there is no further guidance on when to make this change to the hedged risk, and because there is otherwise a potentially circular analysis (whereby the documented hedged risk can only be updated when there is no longer uncertainty, but uncertainty can only cease when the documented hedged risk is updated), we consider that an appropriate approach is to consider the range of dates during which it is possible to designate the new benchmark rate as the hedged risk.

Considering the earliest possible date, the Phase 2 relief provided by paragraph 6.9.11 of IFRS 9 / paragraph 102Z1 of IAS 39 permits a non-contractually specified risk component to be designated as a hedged risk if it is not currently separately identifiable, but where there is a reasonable expectation that it will be separately identifiable within 24 months of the designation date. There is no relief provided in respect of the ‘reliably measurable’ requirement. Therefore, the earliest date that the hedged risk can be updated to reference the new benchmark is when the new benchmark rate is reliably measurable and there is a reasonable expectation that it will be separately identifiable within 24 months. 

Considering the latest possible date by which the hedged risk can be updated, once both i) the hedging instrument has been amended to the alternative benchmark rate and its uncertainty ceases, and ii) the alternative benchmark rate risk component in the hedged item is separately identifiable and reliably measurable, there are no further IBOR-related actions or events to occur. Therefore, we consider that this should be the latest date by which the hedged risk should be updated.

We consider that there is a period between these two dates during which the hedged risk should be changed. When deciding at which point in this period to update the hedged risk, and therefore remove uncertainty, an entity might want to consider which hedged risk best reflects the economics of its scenario and minimises ineffectiveness in the relationship. For example, whilst the separately identifiable and reliably measurable criteria might be met for the new benchmark rate risk component before the hedging instrument is amended, updating the hedged risk might increase the hedge ineffectiveness at this time, and so an entity might choose not to update the hedged risk until the derivative has subsequently been amended.

Question 2

When is there no longer uncertainty arising from interest rate benchmark reform (‘IBOR reform’) with respect to the timing and amount of interest rate benchmark cash flows for a hedging instrument or a hedged item?

Answer

For this uncertainty to be eliminated, an instrument would generally need to be amended to specify the timing and amount of cash flows based on the alternative benchmark rate, along with any spread adjustment between the IBOR-based benchmark rate and the alternative benchmark rate. However, it is possible that an instrument might have been amended to include a reference to the alternative benchmark rate, whilst not eliminating the uncertainty. Therefore, the facts and circumstances of any scenario will need to be considered.

Below are scenarios based on those provided in paragraphs BC 6.588 to BC 6.593 of IFRS 9 and paragraphs BC 274 to BC 279 of IAS 39 that illustrate different aspects relating to uncertainty of the timing and/or amount of cash flows.

Scenario A

A contract is amended to include a clause that specifies:

  • the date the interest rate benchmark will be replaced by an alternative benchmark rate; and
  • the alternative benchmark rate on which the cash flows will be based and the relevant spread adjustment between the interest rate benchmark and the alternative benchmark rate. 

An example would be “GBP LIBOR will be replaced with SONIA + 1.5% on 30 June 2021”. 

In this case, the uncertainty regarding the timing and the amount of cash flows for this contract is eliminated when the contract is amended to include this clause.

Scenario B

A contract is amended to include a clause that states modifications of contractual cash flows will occur due to the reform but that specifies neither the date that the interest rate benchmark will be replaced nor the alternative benchmark rate on which the amended cash flows will be based. An example would be “GBP LIBOR will be replaced with an alternative benchmark rate and appropriate spread adjustment at a date to be mutually agreed by the parties to the contract”.

In this case, the uncertainty regarding the timing and the amount of cash flows for this contract has not been eliminated by amending the contract to include this clause. 

Scenario C

A contract is amended to include a clause which states that conditions specifying the amount and timing of interest rate benchmark based cash flows will be determined by a central authority at some point in the future, but the clause does not specify those conditions. An example would be “GBP LIBOR will be replaced by the replacement rate determined by the Central Bank X when that replacement rate becomes effective”.

In this case, the uncertainty regarding the timing and the amount of the interest rate benchmark-based cash flows for this contract has not been eliminated by including this clause in the contract. Uncertainty regarding both the timing and the amount of cash flows for this contract will be present until the central authority specifies when the replacement of the benchmark will become effective, and what the alternative benchmark rate and any related spread adjustment will be. 

Scenario D

A contract is amended to include a clause in anticipation of the reform that specifies the date the interest rate benchmark will be replaced and any spread adjustment between the interest rate benchmark and the alternative benchmark rate will be determined. However, the amendment does not specify the alternative benchmark rate, or the spread adjustment between the interest rate benchmark and the alternative benchmark rate, on which the cash flows will be based. An example would be “GBP LIBOR will be replaced with an alternative benchmark rate on 30 June 2021. Any spread adjustment between GBP LIBOR and the alternative benchmark rate will be determined on 30 June 2021”.

In this scenario, by amending the contract to include this clause, uncertainty regarding the timing has been eliminated, but uncertainty about the amount remains.

Scenario E

A contract is amended to include a clause in anticipation of the reform that specifies the alternative benchmark rate on which the cash flows will be based and the spread adjustment between the interest rate benchmark and the alternative benchmark rate, but does not specify the date from which the amendment to the contract will become effective. An example would be “GBP LIBOR will be replaced with SONIA + 1.5% to take effect from a date to be mutually agreed”.

In this scenario, by amending the contract to include this clause, uncertainty about the amount has been eliminated, but uncertainty with respect to timing remains. 

Scenario F

In preparation for the reform, a central authority in its capacity as the administrator of an interest rate benchmark undertakes a multi-step process to replace an interest rate benchmark with an alternative benchmark rate. The objective of the reform is to cease the publication of the current interest rate benchmark and replace it with an alternative benchmark rate. As part of the reform, the administrator introduces an interim benchmark rate and determines a fixed spread adjustment based on the difference between the interim benchmark rate and the current interest rate benchmark. An example would be the reform of EONIA, where a first step set EONIA equal to €STR plus 0.085% until the end of 2021, but where a second step of the rate’s reform then remained.

Uncertainty about the timing or the amount of the alternative benchmark rate-based cash flows will not be eliminated during the interim period, because the interim benchmark rate (including the fixed spread adjustment determined by the administrator) represents only an interim step in progressing the reform, but it does not represent the alternative benchmark rate (or any related spread adjustment agreed between the parties to the contract). There is no uncertainty about the timing or amount of cash flows on contracts which mature before the end of the interim period, although uncertainty remains for contracts with longer maturities.

Illustrative text - FAQ 5.3.2 – Can regression analysis be used for effectiveness testing immediately after transition to a new benchmark (IAS 39)?

Publication date: 09 Oct 2020

Question

Can regression analysis be used for effectiveness testing immediately after transition to a new benchmark under IAS 39?

Answer

It depends. 

Immediately after transition of a market to a new benchmark rate, there might be insufficient historical data points for the new benchmark rate in order to perform a valid regression analysis to support effectiveness of a hedging relationship, because the new benchmark has only existed for a limited period of time. 

When modifying the hedge documentation to change the hedged risk to the new benchmark (under the Phase 2 reliefs), we believe – based on paragraph 102P of IAS 39 – that it would be acceptable to document that an alternative method of effectiveness assessment is to be used until there are sufficient data points available for a statistically valid regression analysis, at which point the method of effectiveness assessment would revert to regression. Where there are insufficient data points to compute a valid regression, such a temporary change to the effectiveness method could be viewed as reflecting the changes to the effectiveness assessment methodology required as a result of benchmark reform. The documentation of the method of assessing effectiveness should be specific enough to determine objectively when the method of assessing effectiveness reverts to regression. 

Illustrative text - FAQ 5.3.3 – Which alternative methods of transitioning derivatives will fall into the reliefs?

Publication date: 09 Oct 2020

Question

In many cases, IBOR-based derivatives designated in hedge accounting relationships will transition to alternative benchmark interest rates by modifying the referenced interest rate benchmark in the original derivative contract. This is referred to as ‘changing the basis for determining the contractual cash flows of the hedging instrument’ in paragraph 6.9.2 of IFRS 9 and paragraph 102Q of IAS 39.

However, some derivatives might be transitioned in other ways. The Phase 2 hedging reliefs might still be applied to hedge relationships involving these derivatives, but only where the additional criteria in paragraph 6.9.2 of IFRS 9 and paragraph 102Q of IAS 39 are met. Those criteria are that:

  • the original hedging instrument (for example, the derivative) is not derecognised; and 
  • the approach is economically equivalent to changing the basis for determining the contractual cash flows of the original hedging instrument.

How will these criteria apply, in practice, to different alternative methods of transitioning derivatives?

Answer

Summary 

Four possible alternative approaches are described and discussed in paragraph BC 6.620 of IFRS 9 and paragraph BC 312 of IAS 39. These are set out below, along with a summary of whether the conditions are met (which is discussed in more detail in the following analysis):


Approach

Economically equivalent?

Original hedging instrument not derecognised?

Phase 2 reliefs can be applied?

#1 Close-out and replace on the same terms (that is, off-market terms)

An entity applying this approach would enter into two new derivatives with the same counterparty. These two would be (i) a new derivative that is equal and offsetting to the original derivative (so that both contracts are based on the interest rate benchmark to be replaced), and (ii) a new alternative benchmark-based derivative with the same terms as the original derivative, so that its fair value at initial recognition is equivalent to the fair value – on that date – of the original derivative (that is, the new derivative is off-market).

Yes

Yes

Yes

#2 Close-out and replace on substantially different terms (for example, on-market terms)

An entity applying this approach would terminate (close-out) the existing interest rate benchmark-based derivative with a cash settlement. The entity then enters into a new on-market alternative benchmark rate derivative with substantially different terms, so that the new derivative has a fair value of zero at initial recognition.

No

n/a

No

#3 Add a new basis swap

An entity applying this approach would retain the original IBOR-based derivative but enter into a basis swap that swaps the existing interest rate benchmark for the alternative benchmark rate. The combination of the two derivatives is equivalent to modifying the contractual terms of the original derivative to replace the interest rate benchmark with an alternative benchmark rate.

It depends

n/a

It depends

#4 Novating to a new counterparty

An entity applying this approach would novate the original IBOR-based derivative to a new counterparty and subsequently change the contractual cash flows on the novated derivative to replace the interest rate benchmark with an alternative benchmark rate.

n/a

No

No

In the analysis below, which includes explanations provided in paragraph BC 6.620 of IFRS 9 and paragraph BC 312 of IAS 39 as well as supplemental analysis, an approach has only been included in the analysis where that is relevant to the overall conclusion of whether or not the Phase 2 reliefs can be applied. So, for example, the ‘economically equivalent’ condition is not analysed for approach #4, given that the derecognition condition is not met, with the result that, regardless of the ‘economically equivalent’ analysis, the Phase 2 reliefs could not be applied.

Analysis – economically equivalent

Approach #1 – Since the terms of the new alternative benchmark rate derivative are not substantially different from those of the original IBOR-based derivative, this is considered to be ‘economically equivalent’. In particular, the credit spread continues to reflect the credit spread in the original derivative, rather than a current market credit spread. 

Approach #2 – The terms of the new alternative benchmark rate derivative are substantially different from the terms of the original IBOR-based derivative, for the purposes of assessing ‘economically equivalent’, as they are ‘on-market’. Therefore, the new alternative benchmark rate derivative is not considered ‘economically equivalent’ to the original derivative. 

Approach #3 – In principle, the combination of the original IBOR-based derivative and an IBOR versus alternative benchmark rate basis swap could achieve an outcome economically equivalent to amending the original IBOR-based derivative. However, the IASB observed that, in practice, basis swaps are generally entered into on an aggregated basis to economically hedge an entity’s net exposure to basis risk (that is, across a portfolio), rather than on an individual derivative basis. The IASB, therefore, noted that for this approach to be consistent with the changes required by the reform, the basis swap must be coupled or linked with the original derivative (that is, it must be done on an individual derivative basis). This is because a change to the basis for determining the contractual cash flows of a hedging instrument is made to an individual instrument and, to achieve the same outcome, the basis swap would need to be coupled with an individual derivative. For this reason, whilst possible, whether or not this approach would meet the ‘economically equivalent’ condition will depend on how it is implemented in practice.

Analysis – derecognition

The analysis below assumes that an entity has not previously adopted accounting policies relating to derecognition of derivatives or similar instruments that conflict with the views set out below. Where an entity has adopted different policies, the derecognition analysis might differ, as might the conclusion as to whether or not the Phase 2 reliefs can be applied. Furthermore, given the lack of guidance on derivative derecognition in IFRS, the analysis below is only one possible analysis and is not intended to be prescriptive.

Approach #1 – Two possible variants of this approach are that i) the two IBOR-based derivatives that economically offset each other are cancelled against each other and legally extinguished, and ii) the two IBOR-based derivatives remain in place, so that the original IBOR-based derivative is ‘closed out’ only economically, and not legally. These two variants are considered separately below.

Analysis if the two IBOR-based derivatives are not legally cancelled

  • If the two IBOR-based derivatives are not cancelled, with the result that three derivatives exist, the original IBOR-based derivative has not legally expired, and so an acceptable view is that the original derivative is not derecognised.

Analysis if the two IBOR-based derivatives are legally cancelled

  • If the two IBOR-based derivatives are cancelled against each other and legally extinguished, from a legal point of view alone the original derivative could be viewed as derecognised under paragraph 3.2.3 of IFRS 9 (for financial assets) and paragraph 3.3.1 of IFRS 9 (for financial liabilities), as the original contract has expired or been extinguished.
  • However, whilst IFRS 9 has no explicit guidance on financial asset modifications, a sensible approach is to apply a similar approach to financial liabilities. The guidance on financial liabilities addresses the situation where there is an exchange of instruments between existing counterparties, so that legally the original instrument is cancelled. It requires the issuer to nonetheless continue recognising the original (legally expired) instrument for accounting purposes where the terms of the two instruments are not substantially different, as per paragraph 3.3.2 of IFRS 9.
  • On the basis that all that differs between the original IBOR-based derivative and the new alternative benchmark rate derivative is i) the different floating benchmark interest rate, and ii) the fixed spread, which is adjusted to compensate for the benchmark rate change on an economically equivalent basis, an acceptable view is that the terms are not substantially different from a quantitative standpoint.
  • The objective of IBOR reform is for contracts to use more robust floating interest rates, with a suitably similar alternative floating rate replacing the original IBOR floating rate of interest. Therefore, whilst there might be detailed underlying differences between the original and new interest rates (such as amount of credit risk inherent in the rate, or reference period / methodology for interest calculation), an acceptable view is that the terms are not substantially different from a qualitative standpoint.
  • Therefore, an acceptable view is that the original derivative is not derecognised.

The above conclusions are also consistent with the statement in paragraph BC 6.620 of IFRS 9 and paragraph BC 312 of IAS 39 that the original derivative has not been derecognised and that the terms of the alternative benchmark rate derivative are not substantially different from that of the original derivative.

Approach #4 – In this specific context, paragraph BC 6.620(d) of IFRS 9 and paragraph BC 312(d) of IAS 39 state that novation of a derivative would result in the derecognition of the original derivative.

Illustrative text - FAQ 5.4.1 – How does an entity update the hypothetical derivative in a cash flow hedge at the date of transition to an alternative benchmark interest rate?

Publication date: 09 Oct 2020

Question

How should the hypothetical derivative in a cash flow hedge be updated at the date of transition to an alternative benchmark interest rate, and what is the impact on the cash flow hedge reserve, given the Phase 2 amendments of IFRS 9/IAS 39?

Illustration

An entity has designated a non-collateralised pay fixed / receive GBP LIBOR interest rate swap as a hedging instrument in a cash flow hedge of the interest rate risk of a floating-rate GBP LIBOR borrowing. As a direct consequence of IBOR reforms, the following contractual changes are made to the swap and the floating-rate loan:

It is assumed in this illustration that:

  • the floating rates in the interest rate swap and the loan change from GBP LIBOR to SONIA, both at the same time;
  • when the GBP LIBOR reference rate of the borrowing changes to the alternative benchmark rate (in this example, SONIA), an additional spread is added to the floating rate of the borrowing; 
  • the interest rate swap changes to a SONIA swap under two possible scenarios (laid out as solutions 1 and 2 below); and
  • the hedge documentation is being amended to reflect the new hedged risk, hedging instrument and hedged item.

In solution 1, the fixed rate of the interest rate swap (hedging instrument) is adjusted.

In solution 2, the fixed rate of the interest rate swap (hedging instrument) remains unchanged but there is cash compensation for the rate differential.

In both solutions, the changes to the hedged item and the hedging instrument are considered to be done on an economically equivalent basis.

Answer

Under the Phase 2 amendments, the entity will continue to apply the existing requirements in IAS 39 or IFRS 9 for qualifying cash flow hedging relationships, to account for any changes in the fair value of the hedged item or hedging instrument. [IFRS 9 para 6.5.8]. [IFRS 9 para 6.5.11]. [IFRS 9 para 6.9.3]. [IAS 39 para 89].[IAS 39 para 96].[IAS 39 para 102R]. 

There is also no exception for the recognition and measurement of hedge ineffectiveness. The IAS 39 and IFRS 9 hedge accounting requirements will need to be applied, and any resulting ineffectiveness recognised in the income statement (subject to the normal ‘lower of’ test). [IFRS 9 para BC6.626]. [IFRS 9 para BC6.627]. [IAS 39 para BC319]. [IAS 39 para BC320].

The IASB noted that amending the formal designation of a hedging relationship could lead to changes in the hedged item and, as a result, an entity might need to change the hypothetical derivative to calculate the change in the value of the hedged item to measure hedge ineffectiveness. [IFRS 9 para BC6.632]. [IAS 39 para BC329].

The IASB noted that, when calculating the change in fair value of the hedged item for the purposes of measuring hedge ineffectiveness, the hypothetical derivative will replicate the hedged risk and the hedged cash flows of the hedged item. As a result, the hypothetical derivative will not be amended and measured based on the alternative benchmark rate if the hedged item has not yet transitioned to the alternative benchmark rate (in this case, SONIA). [IFRS 9 para BC6.644]. [IAS 39 para BC341].

Solution 1 – the fixed rate of the interest rate swap (hedging instrument) is adjusted

The borrowing and interest rate swap have the following characteristics before and after the change from 3-month GBP LIBOR to SONIA:


Borrowing

Interest rate swap


Floating rate

Floating rate

Fixed rate

Fair value

GBP

Before change

3-month GBP LIBOR

3-month GBP LIBOR

3%

–1,000,000

After change

SONIA+1%

SONIA

2%

–1,000,000

The lower fixed rate of the interest rate swap is deferred compensation for the lower floating-rate payments on the derivative. As a result, the fair value of the interest rate swap will remain unchanged. 

The hypothetical derivative fair value as at the date of the transition to the alternative rate (that is, when the floating-rate loan transitions to SONIA) is based on the expected future cash flows and assumptions that market participants will use, as required by IFRS 13. Because hedge accounting is applied prospectively, it is appropriate not to redefine the hypothetical derivative ‘as if’ the hedged risk had always been the new alternative benchmark rate. In other words, the terms on which the hypothetical derivative is constructed must mirror the terms of the hedged item.

The hypothetical derivative will therefore be changed from ‘pay 3-month GBP LIBOR, receive a fixed rate of 3%’ to ‘pay SONIA, receive a fixed rate of 2%’ (assuming that credit risk is excluded from the hedge relationship), and it will have a fair value at the date of the change of GBP -1,000,000. Because the change is made on an economically equivalent basis, it is assumed for the purposes of this example that the fair value of the hypothetical derivative remains the same. Therefore, after application of the ‘lower of’ test, the entity will not recognise any ineffectiveness at the date of the change, assuming that there are no other sources of ineffectiveness in the relationship.

Solution 2 – the fixed rate of the interest rate swap (hedging instrument) remains unchanged and as a result there is cash compensation for the rate differential

The borrowing and interest rate swap have the following characteristics before and after the change from 3-month GBP LIBOR to SONIA, where one-off cash compensation of GBP300,000 is received on the derivative:


Borrowing

Interest rate swap


Floating rate

Floating rate

Fixed rate

Fair value 

GBP

Before change

3-month GBP LIBOR

3-month GBP LIBOR

3%

–1,000,000

After change

SONIA+1%

SONIA

3%

–1,300,000*

* Fair value immediately after the cash compensation of GBP300,000 has been received.

The changes to the derivative represent a partial settlement of the derivative that do not result in derecognition. Since the derivative remains off-market, this differs from the ‘close-out and replace on substantially different terms’ fact pattern that triggers derecognition of the derivative, as illustrated in the Basis of Conclusions to the amendments. [IFRS 9 para BC6.620]. [IAS 39 para BC312].

The change to the benchmark rate and its impact on expected future cash flows of the borrowing are compensated by an increase in the spread equal to the difference in the spread between SONIA and 3-month LIBOR. However, because a similar spread was not added to the interest rate swap, upfront cash compensation is provided by the derivative counterparty to maintain economic equivalence for both parties to the derivative. 

As a result of the change to the loan, the hypothetical derivative representing the risk being hedged will be updated, and it will be equivalent to how it was defined in solution 1 above. The one-off cash compensation of GBP300,000 will offset the increase in the fair value of the interest rate swap. The cash compensation does not relate to the hedged risk (that is, the SONIA floating interest rate), and so it is not part of the hedging relationship. This partial settlement of the derivative is not itself a fair value change (that is, it is a cash settlement of part of the fair value). Therefore, it can be excluded from the ‘lower of’ test and from the 80–125% retrospective effectiveness test under IAS 39. 

Illustrative text - FAQ 5.4.2 – Does the simultaneous amendment of a hedging instrument and hedged risk to reflect a new benchmark rate for a fair value hedge relationship result in an immediate gain or loss recognised in profit or loss?

Publication date: 09 Oct 2020

No, in this scenario a gain or loss should not usually arise, assuming that the hedging relationship was perfectly effective prior to the amendment of the hedged risk and hedging instrument. 

In a typical fair value hedging relationship, the hedged item is a fixed-rate bond and the hedging instrument is a fixed for IBOR floating swap. On initial designation of the hedging relationship, the hedged risk might be identified as an IBOR risk component of the fixed-rate bond. Subsequently, the interest rate swap might transition to a new benchmark rate (‘the New Benchmark’) as a result of IBOR reform. For the purposes of this FAQ, we assume that, at the time when the interest rate swap transitions to the New Benchmark, the hedged risk is also amended in the documentation to reflect the New Benchmark risk component of the fixed-rate bond (that is, it meets the conditions for the risk component being expected to be separately identifiable within 24 months, as discussed in ‘Section 5.6 Designation of risk components and portions’, and it is reliably measurable). See ‘FAQ 5.3.1 – When is there no longer uncertainty arising from IBOR reform? Question 1 Fair value hedge’.

As discussed in ‘Section 5.3 Amendments to the formal designation of hedge relationships’ , the scope of the Phase 2 reliefs contemplates changes to hedging instruments required as a result of benchmark reform (that is, changes that are a direct consequence of benchmark reform and meet the economically equivalent criterion). Economic equivalence may be demonstrated through various approaches, as discussed in ‘FAQ 2.2 – What does ‘economically equivalent’ mean?’. As a result, an immediate difference in the measurement of the hedged risk component (that is, the change in fair value attributable to the hedged risk) would not be expected. The IASB noted, in paragraph BC6.626 of IFRS 9, that a significant change in fair value arising from the remeasurement of the hedged item indicates that changes were not made on an economically equivalent basis.

We believe that an entity should follow a hedge effectiveness approach consistent with what had been previously documented, and therefore no gain or loss would arise at the time when the documented hedged risk is amended. For example, the ‘fixed credit spread’ method addresses a mismatch at inception of a hedging relationship, whereby the contractual rate on the hedged item is typically higher than the prevailing swap rate. This is dealt with by modelling the hedged item using the contractual rate and applying an implied fixed credit spread to the discount curve, such that the fair value of the hedged item at inception equals its principal. The implied fixed credit spread remains constant over the life of the hedge relationship. 

It would follow that, when an entity remeasures the hedged item based on the alternative benchmark rate, it would also update the fixed credit spread, resulting in no change to the basis adjustment and no gain or loss. There are other methods used in practice which might also lead to a similar outcome (for example, adjustments to the cash flows versus the spread). 

Where other sources of ineffectiveness were present in the hedging relationship (such as a mismatch in timing between the hedging instrument and the risk component), ineffectiveness would need to be measured and recognised in profit or loss. 

 
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