FASB has issued a proposed Accounting Standards Update, or ASU, to provide temporary optional guidance to ease the potential burden in accounting for (or recognizing the effects of) reference rate reform on financial reporting. In particular the proposed ASU is meant to address the expected discontinuance of LIBOR.
Without any relief by FASB any contract modifications resulting from contract modification to implement a new reference rate would be required to be evaluated in determining whether the modifications result in the establishment of new contracts or the continuation of existing contracts. The application of existing accounting standards on modifications could be costly and burdensome due to the significant volume of affected contracts and the compressed time frame for making contract modifications.
In addition, changes in a reference rate could disallow the application of certain hedge accounting guidance, and certain hedge relationships may not qualify as highly effective during the period of the market-wide transition to a replacement rate. The inability to apply hedge accounting because of reference rate reform would result in financial reporting outcomes that would not reflect entities’ intended hedging strategies when those strategies continue to operate as effective hedges.
The proposed ASU would simplify accounting analyses under current GAAP for contract modifications if qualifying criteria are met:
- Modifications of loans, debt, and other financial instruments would be accounted for by prospectively adjusting the effective interest rate.
- Lease modifications would be accounted for as a continuation of the existing contract with no reassessments or remeasurements.
- Modifications of contracts would not require a reassessment of whether an embedded derivative should be accounted for as a separate instrument.
- Modifications of contracts for which explicit guidance is not proposed would also be accounted for as a continuation of those contracts with no reassessments of previous determinations.
The proposed ASU would allow hedging relationships to continue without dedesignation upon the following changes in the critical terms of an existing hedging relationship due to reference rate reform:
- A change in the critical terms of a designated hedging instrument in a fair value, cash flow, or net investment hedge
- A change to rebalance or adjust the hedging relationship
- For a cash flow hedge, a change in the method used to assess hedge effectiveness when initially applying an optional expedient method and when reverting to the requirements under current GAAP.
Other matters addressed by the proposed ASU include:
- Providing optional expedients for existing fair value hedging relationships for which the derivative designated as the hedging instrument is affected by reference rate reform
- Providing temporary optional expedients for cash flow hedging relationships affected by reference rate reform.