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LIBOR’s Looming End Leaves Hedgers, Lenders in a Bind

March 21, 2019, 8:47 AM

The demise of the world’s most widely used—but scandal-tinged—interest rate will have significant accounting and financial reporting ramifications beyond its expected market shakeup.

The London InterBank Offered Rate is tied to hundreds of trillions of dollars’ worth of debt, loans, and derivatives. Its expiration at the end of 2021, with no clear replacement benchmark on the horizon, is causing headaches for financial professionals and accountants worldwide as they try to figure out how to restructure debt and hedging contracts.

“This is really so pervasive, it’s going to affect literally every company out there,” said Ernie de Lachica, senior director at BDO USA LLP. Any business that has a loan likely has an interest rate tied to LIBOR, and banks making loans are going to have to figure out how to adjust the contracts once the rate goes away.

LIBOR’s ubiquity has confronted accountants with questions that need answers. Whatever rate will prove stable and reliable enough—and without threat of manipulation—to ultimately succeed LIBOR remains a work in progress. Regulators in several jurisdictions are pushing new benchmark interest rates tied to repurchase agreements but so far they haven’t gained the market acceptance of LIBOR.

One sign of the confusion: lenders are still inking long-term contracts tied to LIBOR. These will have to be modified or adjusted soon, and all of those adjustments have financial reporting implications.

The Financial Accounting Standards Board “really needs to issue some guidance,” said Rob Anderson, product manager at Chatham Financial, a financial advisory firm. “The questions are significant enough and, being a rules-based framework in the U.S., we’re going to need those rules to tell us how to treat this.”

FASB is getting ready to take action, and has pledged to fast-track guidance. Still, given the typical slow pace of accounting standard-setting, it may be some time before there’s clarity.

What’s LIBOR

Sometimes referred to as “the most important number in the world,” LIBOR is a benchmark interest rate based on the rate banks charge for unsecured loans from one bank to another. In 2012, an international investigation revealed bankers colluded for years to rig the rate so their bottom lines looked more profitable. The risk-free rate no longer looked so stable.

“They were just estimates, if you will, of what a firm was willing to pay for the borrowing but they weren’t necessarily linked to real transactions,” Adam Gilbert, financial services global regulatory leader with PricewaterhouseCoopers LLP, said. “And that’s where the trouble started.”

Regulators around the world started work to develop new benchmark rates tied to actual transactions to replace LIBOR and other interbank offered rates. In 2017, U.K. regulators announced that they would stop overseeing the rate by the end of 2021, effectively signaling its end.

The Federal Reserve in April 2018 started publishing the Secured Overnight Financing Rate (SOFR), to replace LIBOR denominated in U.S. dollars. The new SOFR rate represents interest rates for overnight secured borrowings, commonly referred to as repurchase agreements. The transactions are considered secure because the borrower posts U.S. Treasury securities as collateral.

Rulemakers Wrangle

FASB in August agreed to study what it needs to do in the lead-up to LIBOR’s expiration. The board in October also updated its hedge accounting guidance to allow SOFR to be considered a benchmark interest rate to qualify for hedge accounting.

That’s just the beginning. The board considers resolving questions around the demise of LIBOR as a top priority, a FASB staff member said at a not-for-profit advisory committee meeting on March 5. “The LIBOR transition is going to be quite an undertaking, and we don’t want accounting rules to be an impediment to this major initiative,” FASB assistant director Alex Casas said.

The London-based International Accounting Standards Board also is making moves. The standard-setter for international financial reporting standards (IFRS) on March 14 agreed to release for public comment a proposal aimed at easing uncertainties around the transition away from LIBOR and toward other, to-be-determined reference rates. The board wants to address questions such as whether moving a derivatives contract to a different rate could cause problems with risk management strategies. It plans to release the proposal in May.

Phase-Out’s Accounting Impact

The phase-out of LIBOR will affect two main areas of accounting: hedging and guidance used to modify debt contracts, financial reporting experts say.

Under existing U.S. generally accepted accounting principles, if a business modifies a loan or debt arrangement, it has to perform what is known as the 10 percent test. The test requires comparing the cash flows of the existing arrangement with the cash flows of the new arrangement. If they are within 10 percent of each other, it’s just a modification of an existing arrangement. More than that, it’s a new arrangement.

For one or two modifications, the task is relatively simple. But LIBOR is so pervasive that its end could mean analyzing millions of loan agreements to see if applying a LIBOR successor alters terms significantly enough to constitute a new arrangement.

“If I even just have to open each one for a second, think about the volume of hours it takes to do that,” Chatham’s Anderson said. “It can be very, very intensive in terms of time.”

Shorter-term contracts tied to LIBOR that will expire before 2021 won’t be affected by its expiration. But longer-term transactions, such as 25-year financing for a power generation facility with the loan’s interest rate tied to LIBOR, would be.

“Anyone that has debt on their books, it most likely is LIBOR-based. And all of that is going to need to be adjusted,” BDO’s de Lachica said.

FASB is considering whether to offer temporary relief from performing detailed mathematical calculations as LIBOR expires, Casas said March 5. Potentially, businesses could skip the detailed analysis if they meet certain criteria, he said.

“If it’s likely you’re going to pass the test, maybe there’s a way to get there qualitatively and maybe not run the numbers,” he said.

Hedge Accounting

In hedge accounting, businesses “hedge” their exposure to changes in foreign currencies, the price of raw materials, and interest rates by buying derivatives like futures and swaps.

Under U.S. GAAP, such transactions must be recorded at fair value in the income statement unless they meet certain requirements and are therefore eligible for hedge accounting. Hedge accounting is considered a favorable accounting treatment that allows businesses to keep swings out of earnings that can turn off investors and creditors. The rules to qualify for hedge accounting are stringent. If there are changes to a contract, that could call the qualification into question.

That’s where LIBOR comes in as the rate listed in many interest rate risk management contracts. If a business has to substitute a different rate in a derivatives contract when LIBOR expires at the end of 2021, it could raise questions if the change was significant enough to qualify for what’s known as a “de-designation"—essentially an end to qualifying for hedge accounting, said Stacy Keating, accounting advisory lead for LIBOR at KPMG LLP.

Overall, the pervasiveness of LIBOR means accountants will be grappling with questions in the lead-up to the rate’s end as well as determining how to proceed with new reference rates.

“There are so many aspects of instruments impacted by LIBOR—so many contracts,” Keating said. “And everything has to be accounted for, one way or another.”

To contact the reporter on this story: Nicola M. White in Washington at nwhite@bloombergtax.com

To contact the editors responsible for this story: Jeff Harrington at jharrington@bloombergtax.com; Steven Marcy at smarcy@bloombergtax.com