Oh, sweet LIBOR. We hardly knew thee. Well, that's not quite true. After all, it's been around for 50 years now. But, alas, all good things must come to an end, right? And the same goes for the ol' London Interbank Offered Rate as LIBOR gets ready to ride off into the financial sunset at the end of 2021.
But wait. Isn't LIBOR an incredibly important benchmark rate used across the financial markets in everything from interest rate swaps and floating-rate notes to adjustable-rate mortgages and credit cards? In a word – yes. LIBOR is heavily-intertwined in global financial products and systems, which means companies need to fully understand the operational impacts and accounting considerations involved in the transition and plan accordingly. And Embark is here to help you formulate a transition plan that's as smooth and efficient as possible.
A Bit of Background on the LIBOR Transition
We know what you're thinking right now. If LIBOR is so important, why is it disappearing? It's really just a sign of the changing times rather than any overt political or financial undertow. The UK Financial Conduct Authority (FCA) and the Bank of England both said that they would no longer require their banks to publish a LIBOR rate after 2021.
While it might make life a bit easier for those particular banks, the more significant issue comes from the sheer number of contracts between companies and their counterparties using LIBOR as a reference rate in those agreements. Therefore, the global economy has been scrambling to find alternative reference rates to use in existing financial contracts, which, as you might imagine, isn't a completely straightforward process.
The Alternative Reference Rates Committee (ARRC) – convened by the Federal Reserve Board and the New York Fed to address the transition – designated the secured overnight financing rate (SOFR) as the preferred LIBOR replacement interest rate in the US, defining SOFR as:
A measure of the cost of borrowing cash overnight, collateralized by US Treasury securities, based on directly observable US Treasury-backed repurchase (repo) transactions.
However, since SOFR is an overnight rate and, therefore, inherently short-term, the ARRC also noted that some market participants could explore other US dollar reference rates that might be more appropriate for certain longer-term contracts. Still, while SOFR is the preferred benchmark interest rate in the United States, the proper reference rate for a contract ultimately depends on the originating jurisdiction for an individual agreement. Other countries could very well prefer different reference rates to serve as a replacement for those contracts.
Speaking of those contracts, some will have clauses known as fallback language that specifies what to do if something happened to LIBOR, making things far simpler for those involved. Many contracts, especially older ones still in effect, don't have such language, though, meaning companies and their counterparties must first identify agreements either directly impacted by LIBOR or those that feature some connected component to it. From there, they can amend the agreements based on an alternative rate and other necessary changes to the contract such as the spread above the reference rate.
The impact for companies goes far beyond the most obvious instruments like variable debt agreements. Many will find that LIBOR also affects a variety of other contracts, including derivatives and hedging, leases, and even receivables if there's a LIBOR-type of financing component attached, to name a few. Obviously, identifying and addressing the many possible contracts impacted by LIBOR can be an arduous, time-consuming process for some companies, and there's really no way to sugarcoat it. The good news, however, is that the FASB has your back to some extent.
Accounting for the LIBOR Transition
With the recent finalization of ASC 848, the FASB now provides a simpler route for companies looking at a mountain of contract modifications due to the LIBOR sunset. Depending on the type of contract it’s modifying, an organization can use an optional election under ASC 848 to avoid some of the hurdles it would ordinarily face during a contract modification.
Keep in mind that this election is part of a sunsetting standard, however, just like LIBOR itself. In other words, going forward, it won't have any basis in US GAAP to use as a reference for any future contract modifications. It's a one-and-done provision from the FASB specifically to help companies get through the LIBOR transition, pure and simple. As of December 31, 2022, it disappears.
Naturally, you start the process by identifying which contracts the LIBOR transition will impact, and go from there. We recommend answering a series of questions to fully understand what you need to do for your contracts, not advancing to the next question until you're sure you've left no stone unturned.
- Which contracts have provisions tied to LIBOR in some way?
- Are there clauses in those contracts that explain how to modify them if the reference rate goes away? Said differently, is there any fallback language?
- If not, which counterparties do you need to involve to renegotiate the contract?
- How will the necessary changes impact your financial reporting and systems?
- What do you need to communicate with your stakeholders regarding the changes to your business?
From our experience, most companies with a significant number of contracts impacted by the transition have already been sorting through and identifying what's affected. However, private companies and even smaller middle-market companies might be looking at the LIBOR sunset date – December 31, 2021 – and figuring they have plenty of time to address the situation.
If the LIBOR transition was occurring in a vacuum, we might be a bit more forgiving in watching companies kick the reference rate can down the road a bit. However, as we all know, these are not normal times, and accounting teams are already knee-deep in dealing with the repercussions from the COVID-19 pandemic and the ensuing financial crisis. Put another way, teams are already stretched extremely thin and there's certainly no assurance that things will get better at any point in the near future.
As depressing as that might sound, it's simply good business practice to start addressing the LIBOR transition as soon as possible. Companies should take advantage of the lead time they have right now rather than scrambling for information at the last minute. Since negotiations with counterparties are involved, contract modifications will take a fair amount of time.
Now, if it turns out that your company doesn't have much exposure to LIBOR sunsetting, then that's a definite accounting feather in your cap. But given the complexities potentially involved – derivatives, hedging contracts, and the like – there's no reason to wait for surprises to pop up midyear 2021. Unless you want an accounting mutiny on your hands, of course.
Diving in a bit deeper, there are some specific considerations to keep in mind regarding your accounting for the LIBOR transition.
- The optional expedients in ASC 848 only apply to LIBOR or another similarly sunsetting reference rate. They do not extend to unrelated changes like borrowing capacity or the maturity date of the agreement. In other words, amendments that change the amount or timing of cash flows unrelated to reference rate replacement would prohibit an entity from applying the guidance in ASC 848, even if those amendments are made in conjunction with amendments to the reference rate. Modifications to contract terms considered to be related and unrelated to the reference rate replacement are outlined in ASC 848-20-15-5 through 6.
- SOFR is not a forward-looking rate like LIBOR, so some banks may try to renegotiate terms based on SOFR but with different spreads to emulate a LIBOR-type reference rate to "normalize" it, at least relative to the term rates they're accustomed to.
- Depending on what side you're on, things like cash flow and interest expense could experience more variance depending on the reference rate selected after modifying a contract, particularly for large debt agreements and certain term loans.
- ASC 848-10-65-1(E) includes language requiring transition disclosures that essentially ask you to explain the nature and reason for applying the optional expedient under the standard. If elected, you must provide these disclosures each interim and annual period in the year of application. Likewise, the SEC has also requested additional disclosure on reference rate transition activities.
- You must make the election under ASC 848 for all contract modifications that (1) meet the scope of ASC 848 and (2) would be accounted for in accordance with the same ASC Topic or Subtopic. For example, all leases you modify for reference rate and account for under ASC 842 or ASC 840 would be subject to the optional expedient in ASC 848 if elected. You could not apply the guidance on an individual lease basis. However, an exception to the all-or-nothing approach exists for hedge accounting under ASC 815, generally permitting you to apply the optional expedients on a hedge-by-hedge basis.
Obviously, we've painted with a pretty broad brush, but that's because there's so much that can change from contract to contract or company to company. Basically, it's just a matter of sitting down and figuring out where the LIBOR transition applies to you and figuring out the best course of action. And Embark will be here to lend our experience and expertise every step of the way.