With the end of 2021 approaching, many companies are taking closer looks at their interest rate hedging activities as stakeholders prepare for the phase out of LIBOR. One aspect of the transition that we have been discussing with clients is how to manage the requirements of hedge accounting and how these may interact with the transition away from LIBOR. To ensure hedge accounting is achieved and maintained, many will carefully structure hedge positions to match their exposures to minimise mismatches. Additionally, it has been important to anticipate sources of ineffectiveness and address them in hedge documentation.
One question being asked by those looking to execute new hedges is whether they should look to structure hedges that anticipate LIBOR transition. Even in situations where the instruments in question do not have mechanisms to transition, hedgers may be considering whether or not they should be anticipating the transition in their documentation. Based on past experience with hedge accounting, these steps sound prudent and maybe even necessary. That said, it is important to remember that the transition away from a long used benchmark is an unusual event and beyond the control of those applying hedge accounting. The accounting standards setting community has recognized this, and before changing the way hedgers document or structure their interest rate hedges, it’s important to be up to date with standard setting activity on this topic.
Under both US GAAP and IFRS, managing changes in underlying rate for either the hedged exposure or hedging instrument was contemplated in the development of accounting reliefs. US GAAP finalized LIBOR transition reliefs in March. While the IASB has not finalised its guidance, an exposure draft was released and is now in a comment period with anticipated finalisation early in the second half of 2020.
Under both US GAAP and IFRS, managing changes in underlying rate for either the hedged exposure or hedging instrument was contemplated in the development of accounting reliefs
Under the finalised guidance for US GAAP (Accounting Standard Codification 848), many existing hedges will simply continue as they had been accounted for historically. In particular, there are meaningful reliefs from the strict criteria for using the Critical Terms Matched and Shortcut methods for hedge accounting. During the period of relief (which is until the end of 2022), some of the requirements for applying these methods may be disregarded. Where long-haul effectiveness testing is used, hedgers will be able to hedge benchmark rates; the FASB has already added the Secured Overnight Financing Rate (SOFR) to the list of eligible benchmark rates. Given the flexibility built into the guidance, current LIBOR hedgers will be able to adjust documentation at the time the relief is applied (e.g. when a hedged item or hedging instrument transitions).
Under IFRS, the proposed reliefs will give hedgers the opportunity to update hedge documentation for the impact of IBOR reform at the time of transition. In contrast to US GAAP, IFRS does not maintain a list of benchmark rates that can be hedged, instead there is a requirement that the risk being hedged be separately identifiable and reliably measureable. Historically this has not been a difficult hurdle to clear when designating a hedge of LIBOR; LIBOR has a highly developed and deep market allowing this assertion to be made when designating hedges. A key relief to keep an eye on as the IASB continues to consider feedback on its exposure draft is relief to the separately identifiable requirement. As initially drafted, the IASB was proposing a 24-month period post-designation in which it is expected the rate would become separately identifiable, which would allow hedgers to change the hedged risk to a LIBOR successor rate. This relief was developed with the hope that by the end of this period, markets in successor rates will be developed enough for hedgers to meet the hedge accounting criteria. This is something to keep an eye on especially since IFRS is more widely used in various jurisdictions and LIBOR reform in is varying stages across the globe. While more liquid capital markets may developed in that timeframe, others may struggle.
Under both GAAPs, the ability to adjust hedge designations and documentation at the time instruments transition will go a long way to ensuring hedges can continue to be accounted for as originally intended. However, it should be noted that the expected reliefs under IFRS anticipate that IBOR reform may still result in some ineffectiveness, whereas the US GAAP amendments provide solutions which could result in zero ineffectiveness. For both GAAPs, the ability to change the hedged risk allows hedgers to minimise any potential ineffectiveness that could result from transition. As commonly said when it comes to hedge accounting, specific facts and circumstances will weigh on the ultimate accounting outcome. Being familiar with the reliefs that are available or are proposed will go a long way to ensure your organization is ready for transition.
The key point to remember is that accounting reliefs are providing a way for companies to address accounting for transition. Companies do not need to immediately change existing hedge accounting documentation or anticipate LIBOR transition in new hedge designations (for the time being). Companies should be planning on how to transition their existing LIBOR based agreements and may want to consider hedging using new alternative rates. Thanks to the accounting reliefs discussed, entities will have ways to manage the impact of these actions to their financial statements if these actions are taken.
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