The London Interbank Offered Rate (LIBOR) has become the world’s primary benchmark for short-term interest rates with more than $350 trillion in notional value in outstanding contracts globally. Due to a rate-setting scandal in 2012 and a significant decline in the transaction volume used to set LIBOR rates, it is expected that a number of banks currently reporting information used to set LIBOR will stop doing so after 2021 when their current reporting commitment ends, which could either cause LIBOR to stop publication immediately or cause LIBOR’s regulator to determine its quality has degraded to the degree that it is no longer representative of its underlying market. This is a global issue, and working groups have been formed in the U.S., the United Kingdom, the European Union, Japan and Switzerland to recommend an alternative rate to LIBOR for each respective currency. In the U.S., the Federal Reserve Board established the Alternative Reference Rates Committee, which identified the Secured Overnight Financing Rate (SOFR) as its preferred alternate rate. For more details on SOFR, see BKD’s article “LIBOR Is Dead – Long Live SOFR?”
Derivatives and floating-rate debt are widely used by states and other larger governments, certain business-type entities and pension plans. Reference rate reform will create enormous operational challenges, primarily due to the imminent sunset and significant volume of contracts tied to LIBOR that may need to be modified to replace the benchmark reference rate. For governments, LIBOR’s sunset will primarily affect the hedge accounting provisions of GASB Statement No. 53, Accounting and Financial Reporting for Derivative Instruments. For derivatives that are effective hedges, changes in their fair value are recognized as deferred outflows or deferred inflows of resources. If a hedging derivative becomes ineffective or terminates, a government would immediately recognize the accumulated deferrals in investment income; subsequent changes in the derivative’s fair value also would be recognized in investment income.
GASB has released a proposal to provide relief in applying generally accepted accounting principles to contracts, hedging relationships and other transactions affected by reference rate reform, most notably:
- Providing an exception for certain hedging derivative instruments to the hedge accounting termination provisions when an interbank offered rate (IBOR) is replaced as the reference rate of the hedging derivative instrument
- Clarifying the hedge accounting termination provisions when an IBOR is replaced as the reference rate of a hedged item
- Clarifying that the uncertainty related to the continued availability of IBORs does not, by itself, affect the assessment of whether a hedged expected transaction is probable
- Removing LIBOR as an appropriate benchmark interest rate for the qualitative evaluation of the effectiveness of an interest rate swap
- Identifying SOFR and the Effective Federal Funds Rate as appropriate benchmark interest rates for the qualitative evaluation of the effectiveness of an interest rate swap
- Clarifying the definition of reference rate, as it is used in Statement 53
- Providing an exception to the lease modifications guidance in Statement 87 for certain lease contracts that are amended to replace an IBOR as the rate on which variable payments depend
Comments are due by November 27, 2019, and a final standard is planned for March 2020.
Transition & Effective Date
If the proposal is approved, LIBOR would be removed as a reference rate for reporting periods that begin after December 15, 2020. All other provisions would be effective for reporting periods beginning after June 15, 2020. GASB encourages earlier implementation.
If approved, changes would be applied retroactively by restating financial statements, if practicable, for all prior periods presented. If restatement for prior periods is not practicable, the cumulative effect, if any, of applying these changes should be reported as a restatement of beginning net position—or fund net position, as applicable—for the earliest period restated. In the first period of adoption, the notes to financial statements should disclose the nature of the restatement and its effect. In addition, the reason for not restating prior periods presented should be disclosed.
The transition away from LIBOR will be complicated and likely will require significant hours to implement correctly for governments with a large volume of contracts. If you would like assistance with reference rate reform, contact your BKD trusted advisor.