The effect on hedge accounting of the reform of LIBOR and other similar rates PwC In brief INT2019-07
What is the issue?
At a glance
The reform of LIBOR and other similar rates (‘IBOR reform’) will affect virtually all companies in all industries. Whilst the reforms are expected to happen over several years, there are potential impacts on financial reporting in the short term, in particular for hedge accounting.
The IASB has published an Exposure Draft ‘Interest Rate Benchmark Reform: Proposed amendments to IFRS 9 and IAS 39’. These proposed amendments would enable hedge accounting to continue for certain hedges that might otherwise need to be discontinued due to uncertainties arising from IBOR reform. The comment period for the Exposure Draft ends on 17 June 2019 with the IASB aiming to finalise the amendments by the end of 2019.
Following the financial crisis, the replacement of benchmark interest rates such as LIBOR and other inter-bank offered rates (‘IBORs’) has become a priority for global regulators. Many uncertainties remain but the roadmap to replacement is becoming clearer. Given the pervasive nature of IBOR-based contracts among both financial institutions and corporates, there are significant potential impacts of these changes on financial reporting under IFRS.
The IASB has a two-stage project to consider what, if any, reliefs to give from the effects of IBOR reform. The first stage considers reliefs to hedge accounting in the period before the reforms are enacted, and has led to the Exposure Draft described in this In brief. In the second stage, the IASB will consider possible reliefs relevant at the time when the reforms occur.
The Exposure Draft proposes amendments to IFRS 9 and IAS 39, to enable hedge accounting to continue for certain hedges that might otherwise need to be discontinued due to uncertainties arising from IBOR reform. More specifically, the Exposure Draft proposes that:
- the 'highly probable' requirement should be amended such that, when assessing the likelihood that a forecast transaction will occur, an entity would assume that IBOR-based contractual terms are not altered as a result of IBOR reform;
- the prospective hedge effectiveness assessment should be amended such that an entity would assume that the IBOR-based contractual cash flows from the hedging instrument and the hedged item are not altered as a result of IBOR reform; and
- an entity would continue hedge accounting where a non-contractually specified IBOR risk component met the separately identifiable requirement at the inception of the hedging relationship, even if it does not meet that requirement at a later date.
It is proposed that the reliefs above would be mandatory, to address concerns around arbitrary discontinuation of hedge accounting (‘cherry picking’) and to be consistent with IFRS 9’s prohibition on voluntary discontinuation of hedge accounting. They would apply to both existing and new hedges.
The Exposure Draft proposes that the reliefs should stop being applied at the earlier of when the uncertainty regarding the timing and amount of the resulting cash flows is no longer present, on the one hand, and the discontinuation of the hedge relationship on the other.
What is the impact and for whom?
The proposed amendments will have an impact in all jurisdictions that have decided that there is a need for IBOR reform. They will affect companies in all industries that have applied hedge accounting for IBOR-related hedges, such as hedges of loans, bonds and borrowings with instruments such as interest rate swaps, interest rate options, FRAs and cross-currency swaps. More detail is given below.
Highly probable requirement
Cash flow hedge accounting under both IFRS 9 and IAS 39 requires the future hedged cash flows to be ‘highly probable’. Where these cash flows depend on an IBOR (for example, future LIBOR-based interest payments on issued debt hedged with an interest rate swap), the question arises as to whether they can be considered ‘highly probable’ beyond the date at which the relevant IBOR is expected to cease being published. Under the proposed amendments, an entity would assume that the current IBOR-based cash flows remain unchanged as a result of IBOR reform, and so the highly probable requirement would still be met.
Prospective assessments (economic relationship and highly effective hedge)
Both IFRS 9 and IAS 39 require a forward-looking prospective assessment in order to apply hedge accounting. IFRS 9 requires there to be an economic relationship between the hedged item and the hedging instrument, whereas IAS 39 requires the hedge to be expected to be highly effective. Given the uncertainties arising from IBOR reform, including when IBORs will be replaced and with what rate(s), this might become difficult to demonstrate. Under the proposed relief, an entity would assume that the IBOR-based contractual cash flows of the hedging instrument and hedged item remain unchanged as a result of IBOR reform when making the prospective assessment. However, no relief is proposed from measuring and recognising all ineffectiveness (including that arising from IBOR reform) in the normal way; nor from discontinuing a hedge where, under IAS 39, it exceeds the 80–125% threshold in the retrospective effectiveness assessment.
In some hedges, the hedged item or hedged risk is a non-contractually specified IBOR risk component. An example is a fair value hedge of fixed-rate debt where the designated hedged risk is changes in the fair value of the debt attributable to changes in an IBOR. In order for hedge accounting to be applied, both IFRS 9 and IAS 39 require the designated risk component to be separately identifiable. Given the uncertainties arising from IBOR reform, this might cease to be the case. Under the proposed relief, entities would continue hedge accounting, provided that the component was separately identifiable when the hedge was designated. However, no relief is proposed for new hedges in which the risk component is not separately identifiable at the inception of the hedging relationship.
When does it apply and what will happen next?
The IASB is aware that, without the reliefs, some hedges might fail to qualify for hedge accounting in the near future. It therefore aims to finalise the amendments in late 2019 and, to facilitate this, the Exposure Draft has a shorter than normal comment period, ending on 17 June 2019. The proposed effective date is accounting periods beginning on or after 1 January 2020, with earlier application permitted. It is also proposed that the amendments be applied retrospectively.
Where do I get more details?
For more information, please contact Sandra Thompson (firstname.lastname@example.org), Ian Farrar (email@example.com) or Mark Randall (firstname.lastname@example.org).