Accounting health check: interest rate benchmarks transition

EY Published 02.12.2019

Despite being given a few more years to transition to alternative risk-free rates (RFRs), the replacing interbank offer rates (IBORs) and other benchmarks with new and reformed interest rate benchmarks will bring significant strategic, financial, operational and reputational challenges to any company with the financial instruments linked to IBOR as a rate. What makes these challenges more difficult to handle is that not only everything from sales and trading to treasury, risk management, legal and operations will be affected but also it will entail discussions with customers, lenders, and other stakeholders. Hence, financial market players should already initiate an assessment of their potential challenges and prepare a comprehensive plan on how to tackle them despite current uncertainties around reform.

Accounting challenges ahead

One key area for consideration that is usually overlooked by financial market players is the financial accounting and reporting implications of benchmarks transition, specifically, its impact on the hedge accounting, determination of fair value, modifications and classification of financial instruments including business model reassessment. Just using the current version of the International Financial Reporting Standards (IFRSs) in determining the impact of the benchmark transition creates big concerns for IFRS reporters as this may result in a significant untimely hit on profit or loss which does not provide useful and relevant financial information.

Due to the growing concern over its accounting implications, the International Accounting Standards Board (IASB) launched its benchmark transition project to provide narrow-scope reliefs dealing with the issues arising from, and only from, the transition to new interest rate benchmarks. The IASB divided it into 2 phases to cover separately the pre-replacement issues (Phase 1) – issues affecting financial reporting in the period before the reform, and the replacement issues (Phase 2) – issues that might affect financial reporting when an existing interest rate benchmark is either reformed or replaced.

Phase 1 – Pre-replacement issues

The move towards replacing existing interest rate benchmarks with alternative RFRs has, in turn, led to uncertainty about the long-term viability of these benchmarks. As a result, contractual cash flows of hedged items and hedging instruments will likely change when the existing interest rate benchmarks will be replaced by an alternative RFRs. Until decisions are made concerning what the alternative RFR will be and when the replacement will occur, uncertainties will exist regarding the timing and amount of future cash flows of the hedged items and hedging instruments. Based on IFRS 9 Financial Instruments and International Accounting Standard No. 39 (IAS 39) Financial Instruments: Recognition and Measurement (for entities who elected to continue the application of IAS 39 for hedge accounting), these uncertainties could affect an entity’s ability to meet specific forward-looking hedge accounting requirements in the periods before the replacement of the existing interest rate benchmarks. In some cases, such uncertainties could require entities to discontinue hedge accounting for hedging relationships that would otherwise qualify for hedge accounting. In addition, the current version of the standards may prevent entities from designation new hedging relationships that would otherwise qualify for hedge accounting. Discontinuation of hedge accounting might affect an entity’s reported profit or loss, especially for cash flow hedges as any gains or losses on the hedging instruments should be recognised directly in profit or loss, instead of being deferred in cash flow hedge reserve (in equity) for qualifying hedging relationships. In addition, any remaining amounts previously deferred in cash flow hedge reserve should be recycled immediately to profit or loss.

In connection with these Phase 1 issues, the IASB issued an exposure draft in May 2019 proposing the following amendments to IFRS 9 and IAS 39 to provide temporary narrow-scope reliefs:

Retrospective testing relief – In relation to the 3rd relief, affected hedges temporarily outside of 80%-125% testing threshold (IAS 39) are considered to pass the retrospective test.These proposed reliefs were welcomed by the banking industry and eagerly provided comment letters for their feedbacks, despite the very short comment period of one and a half months. The following feedbacks were considered by the IASB in their subsequent meetings:

  • Separately identifiable risk component in dynamic hedges – In relation to the fourth relief, for affected dynamic (macro) hedges (IAS 39) where de-designation and re-designation of exposures happen on a periodic basis, the “separately identifiable” assessment is only made when the hedged item is first designated.
  • Group of items designated as hedge item – The IASB clarified that the requirement to end the relief applies to each individual item within the designated group of items.

With these proposed reliefs, the transition phase, before the benchmarks are replaced, will be smoother for IFRS reporters with on-going hedging relationships, while still providing useful financial information during the period of uncertainty arising from the phasing out of various interest-rate benchmarks.

The amendments to IFRS 9 and IAS 39 were issued in September 2019, effective starting 1 January 2020 but IFRS reporters may choose to apply them earlier. The requirements must be applied retrospectively. However, the exposure draft clarifies that any hedge relationships that have previously been de-designated cannot be reinstated upon application, nor can any hedge relationships be designated with the benefit of hindsight.

Phase 2 – Replacement issues

While the Board developed solutions to the time-critical pre-replacement issues (Phase 1), more information became available about the replacement issues (Phase 2). As such, the Board is now discussing the replacement issues. The main Phase 2 issues are the following:

  • Modification/de-recognition accounting when the affected contracts are amended:
    • Are amendments in benchmark rates (specifically those resulting from IBOR reform) qualitatively trigger derecognition accounting or should a quantitative test be performed?
    • Regardless of whether modification and derecognition accounting will apply, both will have an impact on profit or loss using the current version of IFRS 9. IFRS reporters are expecting for relief in this area.
    • Performing quantitative derecognition assessment for thousands of contracts is operationally onerous
    • How to consider other amendments in the terms that are made at the same time when amendments for IBOR are made?
  • Hedge accounting issues:
    • Is amending the hedge items for IBOR replacement triggers the de-designation of the hedging relationship?
    • If IBOR-related amendments will trigger the de-designation of the hedging relationships, recycling amounts deferred in OCI to profit or loss will create a significant impact on profit or loss. IFRS reporters are expecting relief in this area.
    • Is it permissible to amend today the hedge accounting documentation to future proof existing hedge accounting relationships?
  • Other issues:
    • How the effective interest rate will be affected
    • Change in fair value estimates due to change in inputs
    • Change in fair value level – level 3 if IBORs become unobservable

Early preparation is critical

Benchmarks reform is stirring the global financial markets in a direction that is too uncertain at this moment. Despite the efforts of various regulatory and legislative bodies to mitigate the impact of the IBOR transition and to successfully implement the reform, the ultimate responsibility still lies with the financial market players and market infrastructure providers. The accounting impact of the IBOR transition is only one area, and clearly, this reform will also have a noticeable impact across several functions within each organisation, including treasury, sales/trading, risk management, legal, operations, tax, and accounting. Certain areas will require timely communication to affected customers, renegotiation of affected contracts, and revisiting pricing policies and valuation models, among others.

Establishing broad-based benchmarks reform transition project team early on, who will perform detailed impact analysis and will build up an organization’s responsiveness and adaptability, will be key to success in addressing impending operational and financial reporting challenges brought about by the benchmarks reform. Not preparing for the transition to new benchmarks is simply not an option.

 

 

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