A massive and historic change is taking place across financial markets worldwide. The London Interbank Offered Rate (Libor), which is referenced in approximately $350 trillion of contracts, is expected to be eliminated in 2021. In the United States, the Secured Overnight Funding Rate (SOFR) has been identified as the preferred alternative to Libor. This change will affect companies that have assets, debt instruments, interest rate swap agreements or other contracts whose term extends beyond 2021 and references Libor.
Concerns have been raised that replacing Libor with an alternative reference rate may trigger a number of accounting, reporting, operational, tax and risk management challenges. The accounting and reporting concerns include the potential for contract modifications and extinguishments, as well as hedge accounting implications. In response to these concerns, the Financial Accounting Standards Board (FASB) has issued the Reference Rate Reform: Facilitation of the Effects of Reference Rate Reform on Financial Reporting proposal which includes “optional guidance for a limited time to ease the potential burden in accounting for (or recognizing the effects of) reference rate reform on financial reporting.” The FASB is currently evaluating the comment letter feedback on this proposal.
The impact of reference rate reform may be broader than what some companies may be thinking. Additional focus areas may include:
- Lease agreements that reference Libor
- Valuation models that have Libor as an input, which could affect impairment analysis, business valuations, notes receivables and certain debt instruments that have more than one accounting component (e.g., convertible debt that has debt and equity components for accounting purposes, or a debt instrument that has an embedded derivative which is accounted for separately)
- Information systems (e.g., a system that is set up only to accommodate Libor as input)
Steps that companies should take for reference rate reform
- Identify. Until the FASB issues a final standard, companies should identify contracts that reference Libor and are expected to mature after Libor’s elimination.
- Assess. Companies will need to assess if their contracts contain fallback provisions associated with rate changes.
- Amend. Contacts that do not include relevant fallback provisions will likely need to be amended.
- Plan ahead. Companies should give careful consideration to stating a reference rate in new contracts that are entered before Libor’s elimination.
- Take inventory. Understand what can and cannot be changed in the agreements. This will be essential in order to avoid creating secondary or tertiary impacts. For example, by modifying hedge agreements, not only could gains or losses be created, but additional embedded derivatives could be created. Taking inventory of these agreements will not only help companies be prepared for the changes, but may be an opportunity to examine interest rate exposure across a portfolio.
We recommend companies should speak with their lenders, auditors and advisors well ahead of the elimination date to avoid unintended consequences to their financial statements and tax positions.
Jump start your analysis
By using a collaborative approach across different lines of business to design and support a company’s needs, including technical accounting, IT system changes, valuation services and more, RSM can help you jump start your project. As your trusted advisor, RSM can help with:
- A high-level impact assessment to understand the magnitude of the change and potential accounting impacts and to be able to plan accordingly
- A complete inventory of contracts that are subject to reference rate reform
- Transition planning and project management to ensure reference rate issues are addressed in a timely manner
- Contract management to ensure completeness of the project
- Customer and stakeholder communications for awareness
- Risk and valuation model changes for proper and accurate valuations
- Hedging strategies to ensure risk is properly hedged and compliant with accounting guidance
- Financial reporting and detailing of tax impacts to compliance with generally accepted accounting principles and the tax code
RSM works with clients to develop practical solutions that meet both business and accounting needs.